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Valuation of off-balance-sheet items: The case of in-substance defeased debt

Li, Mandy Man-Lai (1998) Valuation of off-balance-sheet items: The case of in-substance defeased debt. Professional Doctorate thesis, Murdoch University.

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This study examines whether debt constructively retired via an in-substance defeasance transaction is viewed as debt by the investors of the defeasing firm. In an in-substance defeasance, a debtor firm sets up an irrevocable trust consisting of risk-free securities dedicated for the eventual retirement of the defeased debt. Under existing accounting standards in the U.S., although the debt so defeased remains a legal liability of the debtor firm, with all the accompanying debt covenants remaining in effect, the debtor firm can nonetheless remove both the defeased debt and the irrevocable trust from its balance sheet. This accounting treatment is controversial because it violates the long-held tradition of not allowing firms to remove debt from the balance sheet before it is actually retired. It also raises a number of legal questions because the debtor firm is not released from any of the legal obligations associated with the defeased debt.

This study examines whether defeased debt is perceived by shareholders as debt. The methodology involves examining whether defeased debt is a significant explanatory variable for the value and risk of the debtor firm’s stock. Two types of tests are carried out. The first one, called a balance-sheet identity test, involves regressing the debtor firms’ equity value on their reported assets, reported liabilities, as well as on the defeased debt and the value of the related trust. The second test, called market-risk association test, regressed firm betas on leverage with and without the defeased debt in the leverage calculation. If the defeased debt is viewed as debt, then including it in the calculation of leverage would result in a higher R square. This test, therefore, involves comparing the R squares of the two regression.

The sample consists of 46 cases of in-substance defeasance carried out by 44 different U.S. firms, over a sample period from January 1, 1984 to December 31, 1994. To obtain this sample, a footnote search was conducted on the on-line database Lexis-Nexis. After initially identifying 500 plus firms whose financial statement footnotes carried the key words "in-substance", "defeasance", or "irrevocable trust", all the related footnotes were studied to screen out irrelevant cases. For the 100 plus firms that remained after this screening, financial data were collected from the Compustat PC Plus database. After discarding firms that were not on the Compustat database, 46 cases remained. In addition to these financial data, beta for each firm was estimated using 250 trading days’ stock returns from the CRSP tapes.

The results from the balance sheet identity test show that the defeased debt variable and the trust variable are not significant, thus leading to the possible inference that investors do not view defeased debt as debt. This finding was obtained again after controlling for possible heteroscedasticity. The results from the market-risk association test show that the R square is higher from the regression of beta on leverage without including defeased debt than when defeased debt is included in debt. Thus, the two types of tests lead to similar conclusions

In addition to concluding that investor do not view defeased debt as debt, alternative interpretations are given. One is that investors are not sophisticated enough to know that defeased debt should be part of debt, which is the functional fixation hypothesis. One could also attribute the failure to reject the null hypothesis to the lack of power in the test.

Item Type: Thesis (Professional Doctorate)
Murdoch Affiliation(s): Division of Business, Information Technology and Law
Notes: Note to the author: If you would like to make your thesis openly available on Murdoch University Library's Research Repository, please contact: Thank you.
Supervisor(s): Kim, Jeong-Bon
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