Accounting for Refundings 101May 23, 2011
Due to low interest rates, refundings have become pretty popular recently. It can get very confusing to account for them, especially since there are two different ways, one way for government funds and one way for proprietary funds (which also includes government-wide). Footnote disclosures must also be added.
GASB Statement No. 7 discusses advance refundings resulting in defeasance of debt within the government funds. In an advance refunding transaction, new debt is issued to pay off the old debt either as it matures or at an earlier call date. In many instances, the advance refunding results in a defeasance of debt, where the proceeds of the new debt are placed in an escrow account until the maturity or call date of the old debt. If one large refunding issue is used to refund several smaller issues, some of which are reported in government funds and some in proprietary funds, a method of allocation should be used.
The new debt should be reported as an other financing source called “refunding bonds” in the fund receiving the proceeds. Payments to the escrow agent from resources provided by the new debt should be reported as an other financing use called “payment to refunded bond escrow agent.” Payments to the escrow agent made from other resources of the entity (such as issuance costs) should be reported as debt service expenditures.
A footnote disclosure should be added describing the advance refunding transaction in the year it occurred, whether it was reported in the government funds or the proprietary funds. The difference between the cash flows required to service the old debt and the cash flows required to service the new debt and complete the refunding is the first required disclosure. This amount can be found in the Cash Flow and Yield Verification Report on the page labeled Savings, which shows the annual savings between the old debt service and refunding debt service. The second required disclosure is the economic gain or loss resulting from the transaction, which is the difference between the present value of the old debt service and the present value of the refunding debt service. This figure can be found on the same page of the Cash Flow and Yield Verification Report, portrayed as the net present value savings. The amount of the outstanding defeased debt at period-end is another required disclosure. This can be obtained from the Cash Flow and Yield Verification Report on the page labeled Escrow Requirements. The last required disclosure is the amount in escrow at period-end, which can be obtained from the escrow statement. The last two required disclosures must also be disclosed in the years following the advance funding.
GASB Statement No. 23 discusses accounting and financial reporting for refunding of debt reported by proprietary activities. This covers both advance refundings as explained in GASB Statement No. 7 as well as current refundings, where the proceeds are used to immediately pay off the old debt, rather than at a future time such as with advance refundings.
In proprietary funds, the difference between the reacquisition price and the net carrying amount of the old debt must be deferred and amortized as a component of interest expense in a systematic and rational manner over the shorter of the life of the old debt or new debt. This can be accomplished by using the effective-interest method, straight-line or proportionate-to-stated-interest-requirements. Straight-line is obviously the easiest and should not generate amortization expenses materially different from using the other methods. The 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, this includes the amount placed in escrow. Any premium or discount and issuance costs pertaining to the new debt are not considered part of the reacquisition price, so they are separately 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 deferred amount should be reported on the balance sheet as a deduction from or an addition to the new debt liability. It may be reported net, with either a parenthetical or note disclosure of the deferred amount in refunding, or it may be reported gross, with both the debt liability and related deferred amount presented on the balance sheet.
The required disclosures from GASB Statement No. 7 should be made for current or advance refunding reported by proprietary activities.
It is much easier to go through all of these steps by creating a template in Excel. First, show the difference between the reacquisition price compared to the net carrying amount of the old bonds, which will result in the deferred amount in refunding. Then, use the Sources and Uses of Funds page of the Cash Flow and Yield Verification Report to show the funds provided (issuance of refunding bonds, premium, etc) compared to the funds used (issuance costs, underwriters discount, etc). The result should be the same as the reacquisition price. Create a table to amortize each item (deferred amount in refunding, issuance costs and premium). Then use the values to create your journal entries for the government funds, proprietary funds and government-wide financial statements.
You have now passed Accounting for Refundings 101!