Income statements, in addition to interest expense, report gains and losses on bond retirements, both ordinary and extraordinary. The liability section of balance sheets shows the company's long-term debt with resulting changes in long-term liquidity ratios. The statements of cash flows disclose interest expense paid and the effects of both inflows and outflows from long-term debt transactions.

Sinking fund debentures have a long history in corporate finance. Funds transferred to a trustee provide not only collateral for the liability created but also are used to extinguish the debt.

Bond Characteristics

The formal loan agreement (the bond indenture) specifies the authorized dollar amount of the issue, the term of the bonds, maturity date, and periodic interest with payment dates. If applicable, the indenture states conversion and call privileges, sinking fund requirements, restrictions as to the payment of dividends, and the maximum debt to equity ratio permitted by the borrower. Under the Trust Indenture Act of 1939, an independent trustee is appointed to protect the interests of both the issuer and investors. The bond indenture specifies the duties and responsibilities of the trustee.

Types of Bonds

Callable Bonds. Debentures that are subject to redemption at the option of the issuer before their scheduled maturity.

Convertible Bonds. Debentures that may be exchanged usually for other securities at the option of the investor.

Serial Bonds. Debentures under a single indenture that specify a schedule of maturities for groups of bonds.

Term Bonds. Debentures that all mature on the same date.

Sinking Fund Bonds. Debentures that require the issuer to establish a (sinking) fund for the orderly retirement of the bonds.

How a Bond Sinking Fund Works

A trustee plan is a simple arrangement for debt liquidation as stated in the bond indenture. The trustee receives periodic payments from the issuer based upon a fund accumulation schedule, which is usually fixed. However, deposits can also vary in amount based upon gross revenue, net income, or some other specified criteria.

Although the fund will be applied to the retirement of debt, the corporation may not use the fund to offset the related liability except in those circumstances when the debt comes under the "in substance defeasance" rules.

Sinking fund bonds require the issuer to make periodic cash contributions to a sinking fund trustee. The goal is to reduce the risk to bondholders through these periodic transfers. As a corollary, and very often the reason for using the sinking fund approach, borrowing costs of the issuer are usually reduced.

A company that needs to borrow should consider issuing sinking fund bonds. Such bonds permit a company to hedge its borrowing costs when there is a change in interest rates. Moreover, a sinking fund bond is de facto a serial bond without the inflexibility inherent with serial bonds which require scheduled payments of principal and interest.

After the initial offering, an increase in interest rates provides the issuer of sinking fund bonds with some favorable options. One option would be the use of "in substance defeasance." This is an arrangement where no risk government securities are deposited with a trustee for the purpose of paying both bond interest and principal as they become due. GAAP permit the issuer to remove from the balance sheet the bond liabilities and related assets used to extinguish (defease) the debt. In substance defeasance differs from sinking funds held by a trustee because the right of offset against liabilities is not permitted under GAAP.

Under the defeasance rules, the income statement shows the gain (or loss) from the extinguishment of debt. Another alternative would be simply to fulfill the periodic payment requirement of the sinking fund debenture by making a deposit with the trustee. A third choice would be an ope market purchase of existing debt; the gain on the current portion of the extinguishment would be reported as ordinary income while the gain on the non-current portion would be shown as extraordinary. The corporation delivers the repurchased securities to the trustee thus satisfying the bond indenture agreement.

In substance defeasance can also improve the company's debt to equity ratio. This fact, along with other detailed quantitative and qualitative analyses, such as profitability and liquidity, can translate into improved credit ratings by such services as Moody's and Standard & Poor's.

When a decrease in interest rates occurs, a company would normally fulfill its sinking fund obligation under the specified terms of the trust indenture by making a scheduled payment to the trustee. Usually there would be no advantage to an in-substance defeasance of the sinking fund obligation when interest rates decrease. However, a company might decide to pre-refund such debt through an open market purchase to take advantage of lower borrowing costs.

Callable Debentures versus Sinking Fund Debentures

A callable bond permits an issuer to retire its debt prior to maturity. This feature is favorable to a company when interest rates decline. However, callable bondholders now require a higher premium for accepting such bonds in order to compensate for both market and interest rate risks. Consequently, this additional interest cost may be too great in relation to alternative types of financing.

It is reasonable to question why a company would issue a sinking fund debenture when it is de facto a serial bond. The rationale is that the company has the option either to retire a portion of the debt by an open market purchase or to transfer the scheduled payment to the trustee.

Sinking fund bonds give the issuer more flexibility than serial bonds which require scheduled mandatory payments of both principal and interest.

Convertible Debentures versus Sinking Fund Debentures

Convertible bonds, at the option of the bondholder, may be converted into other securities, usually common stock. Although these instruments may be attractive to investors, they can have serious and unfavorable implications for the issuer. For example, upon conversion, deductible interest expense for dividend paying companies will become a nondeductible dividend distribution. Moreover, the improvement in a company's debt to equity ratio may be overshadowed by the dilution in primary earnings per share. Another disadvantage is that non-voting bondholders would become voting stockholders who may shift the direction and control of the company.

Summary of Financial Reporting Options - Extinguishment of Debt

The accompanying sidebar sets forth selected accounting principles that apply to the extinguishment of sinking fund debt. The sidebar shows that according to FASB 4, furthe expanded under FASB 64, issuers of sinking fund debentures report gains and losses as ordinary from extinguishments when fulfilling sinking fund contractual covenants. In contrast, bond maturing serially do not qualify as sinking fund obligations; thus such extinguishment gains and losses are classified as extraordinary. However, FASB 76 applies to serial and term bonds as well as sinking fund bonds.

Choose Sinking Fund Bonds

Given that interest rates would be approximately the same for either sinking fund obligations or serial bonds, a company should select the sinking fund option. This choice allows an issuer, as market conditions warrant, either to make periodic retirements of the bond that would be mandatory with the issue of serial bonds or to make scheduled payments to the bond trustee. Such alternatives, available with sinking fund obligations, greatly reduce a company's vulnerability to both market an interest rate risks.