Advance Refunding and Defeasance Policy

Advance Refunding and Defeasance Policy

Authority:
-- GASB Codification Section D20
-- GASB Codification Section Co5

Effective Date:
7/1/95

Policy:
This section provides guidance on accounting and financial reporting for advance refundings that result in defeasance of debt reported in the general long-term debt account group (GLTDAG). It also provides guidance on accounting and financial reporting for current refundings and advance refundings resulting in defeasance of debt reported by proprietary funds of the state and its component units, and also college and university funds.

Refundings involve the issuance of new debt whose proceeds are used to repay previously issued (old) debt. The new debt proceeds may be used to repay the old debt immediately (a current refunding); or the new debt proceeds may be placed with an escrow agent and invested until they are used to pay principal and interest on the old debt at a future time (an advance refunding). Most advance refundings result in defeasance of debt. Defeasance of debt can be either legal or in substance. A legal defeasance occurs when debt is legally satisfied based on certain provisions in the debt instrument even though the debt is not actually paid. An in-substance defeasance occurs when debt is considered defeased for accounting and financial reporting purposes, as discussed below, even though a legal defeasance has not occurred. When debt is defeased, it is no longer reported as a liability on the balance sheet; only the new debt, if any, is reported as a liability.

Debt is considered defeased in substance for accounting and financial reporting purposes if the debtor irrevocably places cash or other assets with an escrow agent in a trust to be used solely for satisfying scheduled payments of both interest and principal of the defeased debt, and the possibility that the debtor will be required to make future payments on that debt is remote. The trust is restricted to owning only monetary assets that are essentially risk-free as to the amount, timing, and collection of interest and principal. The monetary assets should be denominated in the currency in which the debt is payable. For debt denominated in U.S. dollars, essentially risk-free monetary assets are limited to:

Direct obligations of the U.S. government (including state and local government securities that the U.S. Treasury issues specifically to provide state and local governments with required cash flows at yields that do not exceed Internal Revenue Service arbitrage limits).
Obligations guaranteed by the U.S. government.
Securities backed by U.S. government obligations as collateral and for which interest and principal payments on the collateral generally flow immediately through to the security holder.

Monetary assets held by the trust must provide cash flows that approximately coincide, as to timing and amount, with the scheduled interest and principal payments on the defeased debt.

For advanced refundings resulting in defeasance of debt reported in the GLTDAG, the proceeds of the new debt should be reported as an Other Financing Source - Proceeds of Refunding Bonds in the debt service fund receiving the proceeds. Payments to the escrow agent from resources provided by the new debt should be reported within the debt service fund as an Other Financing Use - Payment To Refunded Bond Escrow Agent. Payments to the escrow agent made from other resources of the entity should be reported as debt service expenditures. The GLTDAG should be adjusted for the increase or decrease in the amount of long-term debt.

If one large refunding issue is used to refund several smaller issues, some of which are reported in the GLTDAG and some in the proprietary or similar trust funds, appropriate allocations should be made.

For current refundings and advance refundings resulting in defeasance of debt reported by proprietary activities of the primary government and component units and colleges and universities, the following definitions apply:

Reacquisition price is the amount required to repay previously issued debt in a refunding transaction. In a current refunding, this includes principal of the old debt and any call premium. In an advance refunding, it is the amount placed in escrow that, together with interest earnings, is necessary to pay interest and earnings on the old debt and any call premium. Premium or discount and issuance costs pertaining to the new debt are not considered part of the reacquisition price, but instead are separate items related to and amortized over the life of the new debt.

Net carrying amount is the amount due at maturity, adjusted for any unamortized premium or discount and issuance costs related to the old debt.

The difference between the reacquisition price and the net carrying amount of the old debt should be deferred and amortized as a component of interest expense in a systematic and rational manner over the remaining life of the old debt or the life of the new debt, whichever is shorter. On the balance sheet, this deferred amount should be reported as a deduction from or an addition to the new debt liability.

For current refundings of prior refundings and for advance refundings of prior refundings resulting in defeasance of debt, the difference that is determined in accordance with the above paragraph, together with any unamortized difference from the prior refundings, should be deferred and amortized over the shorter of the original amortization period remaining from the prior refundings or the life of the latest refunding debt (that is, the new debt).

Regardless of the fund type or account group where the debt is reported, all agencies and component units of the state reporting entity that defease debt through an advance refunding or through current refundings reported by proprietary activities, should provide a general description of the transaction in the notes to the financial statements in the year of the refunding. The disclosures should include:

The difference between the cash flows required to service old debt and the cash flows required to service the new debt and complete the refunding. When measuring the difference between the two cash flows, additional cash used to complete the refunding paid from resources other than proceeds of the new debt should be added to the new debt cash flows. Accrued interest received at the bond issuance date should be excluded from the new debt cash flows.
The economic gain or loss resulting from the transaction. Economic gain or loss is the difference between the present value of the old debt service requirements and the present value of the new debt service requirements, discounted at the effective interest rate and adjusted for additional cash paid.

For disclosure purposes, the effective interest rate is the rate that, when used to discount the debt service requirements on the new debt, produces a present value equal to the proceeds of the new debt (including accrued interest) net of any premiums or discounts and any underwriting spread and issuance costs that are not recoverable through escrow account earnings. Issuance costs include all costs incurred to issue the bonds, including but not limited to insurance costs (net of rebates from the old debt), financing costs and other related costs (such as administrative costs).

The disclosures required by this section generally should be made for the primary government, including its blended component units, and, separately, for those discretely presented component units for which disclosures are essential to fair presentation. In all periods following an advance refunding or a current refunding for which debt defeased in substance remains outstanding, the amount of that debt, if any, outstanding at period-end should be disclosed.

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