ACCOUNTING POLICIES cont.
REFUNDING AND ADVANCE REFUNDING BONDS – cont.
Required Note Disclosures – cont.
2. The economic gain or loss resulting from the transaction:
Economic Gain or Loss Explained. The economic gain or loss is computed by
determining the difference between the present value of cash flow requirements of the
old debt and the present value of cash flow requirements of the new debt. The interest
or discount rate used to determine the present value of the cash flows is a rate that
generally must be computed through trial and error (either manually or by using a
computer software package). The objective is to identify an interest rate that, when
applied to the cash flow requirements for the new debt, produces an amount equal to
the sum of the (1) proceeds of the new debt (net or premium or discount) and (2)
accrued interest, less the (a) underwriting spread and (b) nonrecoverable issuance
Computing the Required Note Disclosures
To clarify the computation of the differences in cash flow requirements and the economic
gain or loss arising from the refundings, GASB-7 has formulated a series of suggested
steps that may be followed to compute the required disclosures. The following
demonstrates how these suggested steps can be applied to specific circumstances.
Step 1: Compute the amount of resources that will be required to (1) make a payment
to the escrow agent in order to defease the debt and (2) pay issuance costs.
The payment to the escrow agent must be large enough to make all interest
payments and the principal payment based on either the call date or maturity
date of the old debt. Either the call date or the maturity date is used, depending
on which one is specified as the retirement date in the escrow fund agreement.
The amount of the required payment to the escrow agent is also dependent
upon the rate of return that can be earned in the escrow fund. The escrow rate
of return is determined by the market investment conditions and the allowable
yield on the escrow investment as determined by Treasury Department
regulations. The amount of the issuance costs must be added to the amount
that is paid to the escrow agent in order to determine the total amount of
resources required to defease the debt.
Step 2: Compute the effective interest rate target amount. The effective interest rate
target amount is computed by subtracting the amount of nonrecoverable
issuance costs from the amount of the resources required to defease the old
debt and to pay issuance costs (computed in Step 1). By reducing the amount
required to defease the old debt (and to pay issuance costs) by the
nonrecoverable issuance costs, the effective interest rate (to be computed in
Step 3) will be decreased. If all issuance costs are recoverable and the new
debt is sold at par, the coupon rate on the new debt will be the same as the
effective interest rate.