In 1996, the Wall Street Journal reported the following headline: Exxon Completes Big Debt Restructuring, Raising 2nd-Quarter
Question:
€œDefeasance€ is the act of undoing something, and in this case refers to the cancellation of debts owed by Exxon. However, instead of an outright repurchase or redemption of the debt, the in-substance defeasance technique achieves results with similar economic substance (hence €œin substance€) using a series of other transactions.
1. Exxon purchased a $312 million portfolio of bonds issued by the U.S. federal government.
2. These government bonds were transferred to a trust and managed by a trustee. At the same time, Exxon transferred to the trust $515 million of its debt.
3. The trust used the cash flows received from the government bonds to cover the cash payments on Exxon's debt.
Exxon structured this series of transactions such that the cash flow from the government bonds would balance out interest and principal payments on Exxon€™s debt transferred into the trust. Since the trust was now making the payments on Exxon€™s debt, the company had in substance redeemed the debt; economically, Exxon did not need to make any further payments on the debt, although nominally and legally the company was still responsible to the bondholders. From the bondholders€™ perspective, nothing had changed€”they still held debt issued by Exxon and they would receive bond payments as scheduled.
Example 1-A Structure of Exxon€™s substance transactions
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As a result of the in-substance defeasance, Exxon removed $515 million of liabilities from its balance sheet. As it spent only $312 million to purchase the government bonds, the company recorded a gain of $203 million before tax and $130 million after tax in the second quarter of 1996.
In the previous quarter, Exxon earned $1.24 billion, or $1.43 a share, down about 23% from the year earlier. Revenue in this quarter was $27.11 billion, down about 10%.
The older Exxon bonds bear interest coupons of 5.8% to 6.7% and they were issued close to par value. At the time of the in-substance defeasance, they were selling at a sharp discount from their face value due to much higher yields.
Exxon said the refunding would be financed out of cash balances, short-term borrowings, and medium-term debt if necessary. In May 1995, Exxon said it planned to raise as much as $500 million by selling debt securities in 1996. The external financing would be the first Exxon debt sold in the U.S. in several years, and analysts viewed the announcement as another sign of financial pressure on the company.
In addition to the in-substance defeasance, Exxon had also used debt-for-equity swaps to bolster its earnings and balance sheet. In such swaps, a corporation exchanges shares of its stock for outstanding debt. In the six months preceding the in-substance defeasance Exxon had completed three such swaps, retiring a total of $147 million of debt.
The in-substance defeasance, together with the earlier debt-for-equity swaps, practically eliminated parent Exxon Corp.€™s long-term debt, which totaled $627 million on Dec. 31, 2005. However, long-term debt of Exxon Pipeline Co. and other Exxon subsidiaries totaled an additional $4.53 billion as of that date.
Required:
a. What motivated Exxon€™s €œretirement€ of the debt?
b. Why did the company opt to use the relatively complex in-substance defeasance rather than an outright repurchase or redemption?
c. Did the bond retirement make financial sense? How do you interpret the before-tax gain of $203 million?
d. Who won and who lost in this transaction?
e. Should the share price appreciate or depreciate because of this refinancing?
f. If you were the partner in charge of the audit of Exxon Corp., what would be your position regarding the $203 million gain from the in-substance defeasance?
g. Exxon was not the only company to use in-substance defeasance; in fact, it was gaining in popularity in the mid-1990s. How would you expect accounting standard setters to react to this trend?
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Overview This case illustrates many of the ideas in positive accounting theory It shows the depth to which companies will go to manage earnings by exploiting the flexibility in accounting standards It ...View the full answer
