The term in-substance defeasance refers to the process of purchasing securities and placing them in an irrevocable trust. The principal and interest of those securities is then used by the company to pay off the principal and interest on bonds they've issued. In-substance defeasance is one of two processes a company can use to lower the amount of debt appearing on its balance sheet, the other being reacquisition of debt.
Issuing long-term bonds represents an important source of financing for many companies. Oftentimes companies establish a sinking fund, which is used to repay investors when the bonds mature. At this point, the debt is said to be extinguished.
If a company reacquires debt before the scheduled maturity date, the transaction is referred to as the early extinguishment of debt. Debt is considered extinguished when there is no further obligation to an external party to transfer economic benefits. When that occurs, the obligation can be removed from the company's balance sheet.
In-substance defeasance occurs when a security, in this case bonds issued by a company, are secured by another asset. This includes both cash and a cash equivalent such as a liquid investment. The assets placed in the trust should be near risk-free as to timing and collection of principal and interest. In practice, these are usually securities backed by the U.S. government. The cash or investments are placed in an irrevocable trust, which can only be used to pay the interest due on the bonds as well as pay investors the face value of the bonds when they mature.
Accounting rules require companies to report the gain or loss that occurs with early extinguishment of debt. In the past, this was reported as an extraordinary item. FASB ASC 470-50-45: Debt-Modifications and Extinguishments-Other Presentation Matters now states they are only classified as an extraordinary item if the event is considered both unusual in nature and infrequent in occurrence. Companies should also disclose in their financial statements how the cash flows of the irrevocable trust align with the interest and principal payments due on the bonds.