Defeasance

Definition of Defeasance

Defeasance is a financial strategy wherein a company irrevocably commits specific assets, usually in the form of government or high-quality securities, to meet its long-term obligations. The primary purpose of defeasance is to eliminate liabilities from a company’s balance sheet when these liabilities do not have provisions for early repayment. By using defeasance, a company effectively removes the debt from its financial statements, thereby improving its financial ratios and potentially enhancing its creditworthiness.

Examples of Defeasance

Corporate Bond Defeasance: A corporation issues bonds with a 10-year maturity. As interest rates fall, the corporation wishes to refinance its debt. However, the bonds include no-call provisions, preventing early repayment. The corporation uses defeasance by purchasing U.S. Treasury securities that will generate sufficient cash flows to cover the interest and principal payments on the original bonds, thus removing the liability from its balance sheet.
Municipal Bond Defeasance: A city has issued municipal bonds to finance infrastructure projects. Seeing an opportunity to lower interest costs, the city executes an advance refunding by setting aside funds from tax revenues in a trust account, purchasing Treasury securities earmarked to extinguish the existing debt. This advances the debt servicing obligation without violating no-call provisions and frees up the city’s balance sheet.

Frequently Asked Questions (FAQs)

Q1: When is defeasance commonly used? A1: Defeasance is typically used when a company wants to remove debt from its balance sheet but faces restrictions on early repayment or when refinancing debt to improve financial metrics.

Q2: What types of securities are used for defeasance? A2: High-quality, low-risk securities such as U.S. Treasury bonds are commonly used for defeasance due to their reliability and predictability in cash flows.

Q3: How does defeasance affect a company’s financial statements? A3: By removing the liability from the balance sheet, defeasance can positively impact a company’s debt ratios and overall financial health, potentially leading to better credit ratings and lower borrowing costs.

Q4: Can defeasance be reversed? A4: No, defeasance is irrevocable. Once the assets are committed to meet the obligation, the decision cannot be undone.

Q5: What’s the difference between defeasance and a sinking fund? A5: A sinking fund involves setting aside money periodically for debt repayment, reducing the principal over time. Defeasance, on the other hand, involves using assets to fully offset the debt obligation at once, removing the maintenance burden.

Sinking Fund: A fund established by periodically setting aside money for the gradual repayment of a debt.
Call Provision: A feature in bonds or other debt instruments that allows the issuer to repurchase and retire the debt before its maturity date.
Advance Refunding: The process of refinancing outstanding debt by issuing new bonds and using the proceeds to retire the existing debt, often through defeasance.
Unsecured Debt: Debt that is not applied with collateral and relies solely on the issuer’s creditworthiness.

Online References to Online Resources

Suggested Books for Further Studies

“Corporate Finance” by Stephen A. Ross, Randolph W. Westerfield, and Jeffrey F. Jaffe - Fundamental concepts in corporate finance including debt management and defeasance.
“Intermediate Accounting” by Donald E. Kieso, Jerry J. Weygandt, and Terry D. Warfield - Detailed academic coverage of financial reporting and management techniques.
“Fixed Income Analysis” by Frank J. Fabozzi - In-depth discussion on bonds and fixed income securities, crucial for understanding defeasance.

Accounting Basics: “Defeasance” Fundamentals Quiz

### What primary benefit does defeasance provide to a company's balance sheet? - [ ] Increases total assets - [x] Eliminates specific liabilities - [ ] Boosts equity value - [ ] Reduces tax liability > **Explanation:** Defeasance allows a company to irrevocably commit assets to meet long-term obligations, effectively removing the associated liabilities from the balance sheet. ### When can defeasance be particularly advantageous? - [ ] When a company has surplus cash - [x] When early debt repayment is restricted - [ ] During infrequent financial audits - [ ] For short-term debts > **Explanation:** Defeasance is particularly advantageous when a company faces restrictions on early debt repayment but still seeks to improve its financial position. ### What type of assets are typically used in defeasance? - [ ] Corporate stocks - [x] U.S. Treasury bonds - [ ] High-yield bonds - [ ] Commodity futures > **Explanation:** High-quality, low-risk assets such as U.S. Treasury bonds are typically used for defeasance due to their reliable cash flows. ### What is the irrevocability aspect of defeasance? - [ ] It can be reversed at a cost - [ ] Temporary until the next fiscal year - [x] Once enacted, it cannot be undone - [ ] Dependent on board approval > **Explanation:** Defeasance is irrevocable, meaning once the decision is made and assets are committed to retiring the liability, it cannot be undone. ### Which term shares similarities with defeasance but operates gradually? - [x] Sinking Fund - [ ] Equity Financing - [ ] Revolving Credit - [ ] Bridge Loan > **Explanation:** A sinking fund involves periodic payments into a fund to repay debt gradually, contrasting with the one-time asset commitment in defeasance. ### How does defeasance influence a company's financial ratios? - [x] Positively by reducing liabilities - [ ] Negatively by increasing liabilities - [ ] Negatively by reducing assets - [ ] Removes equity > **Explanation:** Defeasance improves financial ratios by eliminating liabilities from the balance sheet, enhancing perceived financial health. ### Defeasance is most associated with which type of debt issuance? - [ ] Personal loans - [x] Bonds - [ ] Credit card debt - [ ] Overdrafts > **Explanation:** Defeasance is commonly linked with bonds, especially those with call restrictions, to remove them from the balance sheet effectively. ### What does defeasance eliminate from a company's balance sheet? - [ ] Total equity - [x] Specific liabilities - [ ] Shareholder dividends - [ ] All future revenues > **Explanation:** By allocating assets to meet specific debt obligations, defeasance eliminates those specific liabilities from a company's balance sheet. ### Which sector frequently uses defeasance for financial management? - [ ] Retail - [ ] Agriculture - [x] Municipal governments - [ ] Technology > **Explanation:** Municipal governments often use defeasance, such as in managing municipal bonds through advance refunding to free up fiscal space. ### Why can't defeasance be considered a refinancing method? - [ ] It decreases debt - [x] It uses assets to cover obligations instead of issuing new debt - [ ] It increases revenues - [ ] It requires no regulatory oversight > **Explanation:** Unlike refinancing, which involves issuing new debt to pay off old debt, defeasance uses existing assets to meet obligations, without affecting the total debt level.

Thank you for exploring the comprehensive subject of defeasance, and testing your knowledge through our detailed quiz. We hope this enhances your understanding of financial strategies in corporate finance!