Which of the following is a true statement regarding in-substance defeasance of bonds?

• A. The government may defease bonds without a trust.
• B. The government increases debt service fund balance to cover future payments.
• C. The government must place cash or other assets in an irrevocable trust sufficient to pay all future interest and principal payments for the debt being defeased.
• D. The government records the defeasance as a gain immediately.

Answer: (C)

In-substance defeasance happens when a government sets aside cash or other qualifying assets in an irrevocable trust that is designed to cover all remaining interest and principal payments on the debt being defeased. Because the resources are legally and practically dedicated to that debt, the obligation is considered extinguished for reporting purposes, even though the debt technically remains outstanding.

That is why the statement about placing cash or other assets in an irrevocable trust sufficient to pay all future payments is the correct one. Without such a trust, defeasance doesn’t meet the required criteria. Defeasance is not achieved by simply increasing a debt service fund balance, and the moment of defeasance is not treated as recognizing a gain; the liability is removed and the trust assets taken on in substitution, not booked as an immediate gain.