Lindall Limited (LL) has a 10-year loan issued by the bank that is due in five years. The VP Finance feels that the company is carrying too much debt on its statement of financial position and would like to repay the loan early. Unfortunately the early repayment penalty is significant and therefore LL is looking for other options to reduce the amount of debt on the statement of financial position. Currently, the company is looking at the following transaction:
• Set up a trust that will be used to repay the principal and interest on the original loan as these payments come due.
• Transfer funds to the trust in the amount equal to the present value of the principal and interest payments.
• Invest the funds in low-risk investments such that the investments will be able to generate sufficient return to make the principal and interest payments.
The VP Finance is not sure whether they need the bank to discharge the original loan and agree to look to the trust for repayment (legal defeasance). She would like to derecognize the debt on the LL statement of financial position once the deal is in place. LL follows IFRS.
Instructions
Adopt the role of the ethical accountant and discuss the financial reporting issues. What is the difference between legal defeasance and in-substance defeasance? How does this affect the accounting? Are there arguments for removing the debt under both legal and in-substance defeasance? How should the company account for the defeasance arrangement?