An Empirical Investigation of the Financial Statement Characteristics of Firms Engaging in In-Substance Defeasance of Debt.

Extinguishment of debt through in-substance defeasance is a powerful debt management tool that enables corporations to eliminate debt from their balance sheets and record substantial gains on extinguishment whenever market rates of interest exceed the coupon rate of defeased debt. Corporations engaging in in-substance defeasance must conform to the provision of Statement of Financial Accounting Standards No. 76, Extinguishment of Debt, issued by the Financial Accounting Standards Board in 1983. Critics of Statement No. 76 charge that in-substance defeasance may be used to window dress the financial statements. This study represents an initial test of the assertion that in-substance defeasance is chosen by firms as a tool for window dressing the financial statements. The major research question was: Can the window dressing hypothesis be used to identify statistically significant differences in the financial statement characteristics of defeased and defeasible firms? A defeasible firm is one that could record a gain by engaging in an in-substance defeasance transaction, but chooses not do so. Five research hypotheses were developed to test the window dressing motive. Each hypothesis dealt with a specific financial statement characteristic: (1) earnings growth, (2) nonrecurring losses, (3) current ratio, (4) debt-to-total-assets ratio, and (5) liquidity. Values for each of the five variables were computed for samples of defeased and defeasible firms. Data were analyzed using both univariate and multivariate (logistic regression) analysis. The major conclusion of this study is that the window dressing hypothesis cannot be ruled out as a significant factor influencing the decision to engage in in-substance defeasance of debt. Empirical evidence showed that firms with high liquidity, high leverage, and declining earnings per share are more likely to engage in in-substance defeasance of debt than firms holding defeasible debt, but without those financial characteristics. There was no evidence to indicate that firms defease current debt to window dress the balance sheet by increasing the current ratio. Nor was there any evidence to suggest that defeasance gains were used to mask nonrecurring losses