1 Notes on Business EducationJan - Feb 2005

NOTESon business education

Debt restructuring: alternativesand implications

By Ma. Gina T. Manaligod*Assistant Professor

*Ms. Gina Manaligod is a faculty of the Accountancy Deparment, De La Salle University - Manila

Published by the De La Salle University - College of Business and Economics(CHED Center of Development for Business and Management Education)

Center for Business and Economics Research and Development (CBERD)

Volume 8 No. 1 Jan-Feb 2005

IntroductionMany companies across the world

currently experience financial troubleduring the past few years because ofrecent global economic setbacks. Cash-strapped companies struggle to meetdebt obligations and covenants at a timewhen lenders who are also facing thesame economic problems look for waysto protect their own financial interests.Before being forced into bankruptcy, afinancially distressed company and itslenders can employ debt restructuringschemes that sufficiently reduce thedebtor’s cash crunch so it can improveoperations and avoid bankruptcy. Aclassic example of this is the case of abig steel company in the USA which hasbeen struggling with its earningperformance since 2003. The companyproceeded with a restructuring of its debtand became optimistic they will emergefinancially stronger because of a vastlyreduced debt (see Box 1).

Financially troubled companiesmay resort to debt restructuring as anavenue to financial recovery. FASB(Financial Accounting Statements Board)Statement No. 15 states that a troubleddebt restructuring occurs when thecreditor, for reasons related to the

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Box 1.A big steel company

in Ohio, USA has beenstruggling with its earningsperformance because salesvolumes are down todepressed levels andresulting price pressures.During 2004, this steelcompany reported a fiscalsecond quarter net loss of$13.4 million compared with an $11.8 million loss in the same period lastyear. For the first six months of fiscal year 2004, the company posted a $17.5million net loss compared with a P37.4 million loss a year earlier. Instead ofgiving up and turning to bankruptcy proceedings, management kept theflame of hope burning by pursuing alternative courses of action.Management continued to concern itself on how to make the company aviable and financially sound steel supplier.

The company proceeded with a restructuring of its cost and debt tosupport operations and meet capital expenditure needs. The restructuringfocused on reducing the aggregate principal amount outstanding in its$300 million secured notes and revising the terms governing interestpayments. At the same time, the company’s parent company is willing tomake additional significant cash infusion necessary for a successful financialrestructuring. Management is optimistic that they will emerge from thisprocess financially stronger with a vastly reduced debt load (Sacco 2004)

debtor’s financial difficulties grants aconcession to the debtor that it wouldotherwise not consider. The standardgoes on to say that the creditor ’sobjective, whatever the form ofconcession that may be granted, is tomake the best out of a difficult situation.The creditor expects to obtain more cashor other value from the debtor to increasethe probability of receipt, by granting theconcession than by not granting it(Pariser 1989).

FASB Statement No. 15 furtherstates that among the factors to considerwhen assessing whether debtors areexperiencing financial difficulties includewhether the company (1) is in default onits debt; (2) has either filed or will soonfile for bankruptcy; (3) is able to continueas a going concern; (4) projectionsindicate that cash flows will beinsufficient to satisfy its contractual debtobligations; (5) has outstandingsecurities that have been de-listed; or (6)has limited access to capital due todeteriorating credit worthiness (Beier andPrinzivalli 2003). If these financialdifficulties are caused by temporarymarket forces and not by badmanagement, it may still be cured byrestructuring debt agreements ratherthan by forcing liquidation.

A troubled debt restructuring maybe achieved in either of two ways. First,the debt may be settled at the time ofrestructuring. In this situation, thecreditor may try to actually settle the debtoutright at the time of the troubled debtrestructuring. The creditor may agree toaccept an asset with a fair value less thanthe carrying amount of the liability asfinal settlement of the debt. The types

of asset that companies may offer introubled debt restructuring include cash,receivables, inventory, property, plantand equipment and intangible assets.This arrangement is called an asset swap.

Creditors may also accept otherforms of payment such as equityinstruments like common stock and

preferred stock. This arrangement isreferred to as equity swap.

The debt may also be continuedbut with modified terms. Under this likelyoccurrence, the creditor allows the debtto continue but modifies the terms of thedebt agreement to make it easier for thedebtor to comply. To recoup part of theirinvestment, creditors often considerpartial principal settlements, paymentextensions or holidays, interest rateadjustments or any combination of theabove concessions. Some lenders mayalso accept modifications to non-cashterms such as covenants, waivers,recourse, provisions or collaterization,while others may demand representationto the company’s board of directors

Creditors may also accept other forms of payment suchas equity instruments like common stock and preferred stock.This arrangement is referred to as equity swap.

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Box 2.An example of shares of stock given in

exchange for debt forgiveness is the Maynilad

case. The local creditors of Maynilad WaterServices had agreed in principle to convert three

billion pesos of debt to coupon-generating

voting, convertible and redeemable preferredshares of Maynilad. After the restructuring,

Maynilad would be 39 percent owned by

MWSS, 19 percent by Suez group, 2 percent byMetrobank and 4 percent by Maynilad

employees. Benpres Holdings Corporation would

continue to hold the remaining 36 percent of thetotal equity interest of Maynilad

(www.money.inq7.net, 2004).

(Beier and Prinzivalli 2003). This type isknown as modification of debt terms.

Special accounting procedures areapplied when companies undergotroubled debt restructuring. Properapplication of these accounting rulesaffects the reporting of debt and equityin the balance sheet and subsequentoperating and income performance asshown on the income statement.

Asset SwapUnder asset swap, the debt is

settled through the use of an asset. Thedebtor must have an asset available forpayment of the loan. The debtor mayneed to adjust the carrying amount ofthe asset to its fair value prior torecording its exchange for a debt. Thedifference between the carrying amountand the fair value of the asset is recordedas an ordinary gain or loss on dispositionof assets. Moreover, the differencebetween the carrying amount of the debtand the fair value of the asset given up isalso recorded as an ordinary gain on debtrestructuring (Valix, 2004).

Impact on Financial StatementsAn asset swap will certainly bring

a decrease in total assets and totalliabilities. The total financial resourcesavailable for business operations willdecline. Liquidity and long term solvencywill suffer because the decrease in totalassets will affect the ability of thebusiness to meet its future commitments.It is therefore imperative for the debtorto consider this implication beforepursuing an asset swap. Limited financialassets may hamper the company’s accessto credit thereby hampering businessoperations. On the other hand, debt toequity ratio will improve because of thereduction in the amount of liabilitywithout affecting the capital of thebusiness.

An asset swap will have a positiveeffect on the income statement becauseof the recognition of an accounting gainas a result of the debt restructuring anda follow-on increase to reportedstockholders’ equity. The increase in theoverall net income of the company,however, will warrant consideration interms of income tax.

If the asset given up in an assetswap is cash, total cash outflows willincrease thereby reducing the balance ofthe cash account. Otherwise, an assetswap will have no effect on the cash flowstatement. Only the applicable incometax resulting from the recognition of thegain on debt restructuring will affect thecash position of the business.

Key Stakeholders’ ConcernsOwners of the business will find

asset swap both favorable andunfavorable. It can be consideredfavorable because of the positive effecton the income performance broughtabout by the recognition of theaccounting gain on debt restructuring.This will provide a higher return on theirinvestment improving earnings per share.On the other hand, owners may find anasset swap uncomfortable because of thedecrease in total assets. A decline in totalassets may have a negative financial andoperating impact.

Creditors will be wary of the payingability of the company even after the debtrestructuring agreement because of theeffect of the asset payment on theliquidity and solvency position of thecompany.

Equity SwapIn an equity swap, the payment to

settle debt is in the form of shares of thedebtor’s stocks. An example of this isthe celebrated Maynilad case where itslocal creditors agreed to convert the debtto preferred shares (see Box 2). Thedebtor must have available unissuedshares available for issuance. UnderPhilippine accounting standards, noaccounting gain on debt restructuring isrecognized. The carrying amount of theliability is the basis of recording theissuance of shares of stocks. Anydifference between the carrying amountof the liability and the par value of theshares of stock is credited to anadditional paid in capital account (Valix2004).

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Impact on Financial StatementsAn equity swap has no effect on

total assets because no asset was usedto settle the debt. Liquidity and solvencyposition will remain the same. On theother hand, total liabilities will decline asa result of the payment of a debt whilestockholders’ equity will increase as aresult of the issuance of the shares ofstocks. Debt to equity ratio will improvebecause of the decrease in total liabilities.

An equity swap has no effect onthe income statement because noaccounting gain is recognized.

Likewise, it has no effect on thecash flow statement because the cashaccount is not affected by thetransaction.

Key Stakeholders’ ConcernsStockholders may favor an equity

swap because there is no significanteffect on the financial position of thebusiness and no adverse effectwhatsoever on the income performanceof the business. However, the equityinterest of the stockholders may beaffected with the infusion of additionalissued shares. Ownership interest ofexisting stockholders will be diluted withthe conversion of the status of thecreditors to that of stockholders. Existingstockholders should be aware of thisimplication before pursuing an equityswap because some of the powers likevoting powers and policy making powersthat they used to enjoy may be curtailedby the new stockholders.

Prospective lenders will find anequity swap to be a convenient debtrestructuring scheme because theliquidity and solvency position of thebusiness remain unaffected by thisarrangement.

Modification of Debt TermsIf a troubled company does not

wish to make use of an asset or issueshares of stocks as payment for a loan,the debtor may negotiate with thecreditor certain concessions referred toas modifications of debt terms. Thecreditor may agree to reduce or delayinterest payments. Sometimes, thematurity amount is reduced or thematurity date is postponed to a later date.The more likely occurrence is it will callfor a combination of these concessions.

The accounting proceduresdepends on whether, under the newagreement, total cash payments are lessthan the carrying amount of the debt ortotal cash payments still exceed the

carrying amount of the debt. When thetotal future cash payments are less thanthe carrying amount of the debt, a journalentry is prepared closing the existingliability accounts and setting up a newliability account equal to the future cashpayments. The difference between thecarrying amount of the old debt and thefuture cash payments under therestructured debt is recorded as a gainon the date of restructure. The gain isrecorded as an ordinary gain in theincome statement. No interest is recordedthereafter. All subsequent cashpayments result in the reduction ofprincipal (Spiceland 2004)

When the total future cashpayments are more than the carryingamount of the debt, no reduction of theexisting debt is necessary and no entryis required at the time of the debtrestructuring. Future cash payments areapplied as payment on the accruedinterest, interest expense and principal.(Valix 2004). In other instances, thecompany simply reports a reducedinterest charge in future income

If a troubled company does not wish to make use of anasset or issue shares of stocks as payment for a loan, thedebtor may negotiate with the creditor certain concessionsreferred to as modifications of debt terms.

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statements. The interest charge will bethe discount rate that equates the presentvalue of the future cash payments to thecarrying amount of the debt. Noaccounting gain is recognized in thebooks of the debtor. (Beier and Prinzivalli2003).

Impact on Financial StatementsIf the future cash payments under

the restructured debt are less than thecarrying amount of the debt, a journalentry is prepared debiting the existingliability accounts and crediting a newliability account for the restructured debtand a gain account for the difference.This entry is prepared on the date ofrestructure. As such, the financialposition of the business is not affectedby the restructuring agreement becausethere is no change in total assets, totalliabilities and total stockholders’ equity.The troubled debt still exists in the booksof the debtor as of this date but undernew terms. However, the future cashpayments will certainly affect balancesheet accounts, in particular the cash andthe liability accounts.

If the future cash payments of therestructured debt are more than theexisting debt, no journal entry is preparedat the time of the restructuring. Thefinancial position of the businessremains the same on the date of therestructure. The troubled debt continuesto exist in the books of the debtor and iscarried under their existing liabilityaccount. However, the future paymentson interest and principal will decreasetotal assets and total liabilities.

Under the modification of debtterms, the effect of the restructuring onthe balance sheet accounts is delayedand spread over the new repayment

period. The income statement will onlybe affected if the future cash paymentsunder the restructured debt are less thanthe carrying amount of the old debtbecause an accounting gain isrecognized. This gain is recorded as anordinary gain which increases netincome. However, the future cashpayments will affect the income statementonce interest expense is recorded. Therecording of interest expense willdecrease net income.

On the date of restructuring, thereis no effect on the cash flow statementbecause there is no payment made yeton this date. However, the future cashpayments whether applied as paymenton accrued interest, interest expense orprincipal will increase cash outflowthereby decreasing the cash balance.The effect on the cash flow of thebusiness is spread over the newrepayment period.

Key Stockholders’ ConcernStockholders of a financially

distressed company will findmodification of debt terms favorablebecause the overall effect on the financialposition and income performance of abusiness is not much affected. The debtwill still be paid but at a later date. Hence,on the date of the debt restructure thereis no effect on the balance sheet. If a gainis to be recognized, the effect on theincome statement is positive.

Payment of the debt is usuallypostponed to a later date. Hence, thecorresponding effect on the financialstatements is likewise delayed and spreadover the new repayment period. The pesoamount of the effect is sometimes

reduced because of the concessionsaccepted by the creditor.

Most lenders will also findmodification of debt terms acceptablebecause the debt is paid in cash althoughthe amount may be reduced and theschedule of payment may be delayed.The liquidity and solvency position ofthe business may not be adverselyaffected by the new arrangement becausethe same effects would have happenedeven if there is no debt restructuring.

Conclusion andRecommendations

In conclusion, modification of debtterms seems to be the safest and mostconvenient debt restructuring scheme.The effect on the balance sheet andincome statement is minimal. Cashoutflows in all future periods aresignificantly reduced because of theconcessions that may be allowed oninterest and principal payments.Stockholders may find this arrangementfavorable because their equity interestwill be maintained thus preservingpowers that they currently enjoy.Creditors may also find this scheme safebecause the liquidity and solvencyposition of the company remainunaffected by the modification of the debtterms.

It is important for companies toassess how debt restructuring will affectcertain aspects of the business. Debtorsmust be aware that debt restructuringsaffect cash flow, performance measuresand key balance sheet accounts. Theseconsequences should not be overlooked.Management should understand theimpact of debt restructuring on theircompany’s key financial indicators andhow various stakeholders will view theresults.

Stockholders of a financially distressed company willfind modification of debt terms favorable because the overalleffect on the financial position and income performance ofa business is not much affected.

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NOTESon Business Educationis published by the De La SalleUniversity - College of Business andEconomics Research andDeveloment (CBERD)Vol. 8 No. 1 Jan-Feb 2005

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BibliographyBeier, R. and Prinzivalli, D.. Restructuring Debt at Troubled Companies. Capital

Eyes, January 2003.Pariser, D. Financial Reporting Implications of Troubled Debt. The CPA

Journal, February 1989.Sacco, J.. WCI to Restructure Debt While Earnings Flounder. American

Metal Market, May 14, 2004.Spiceland, J. D., Sepe, J., Tomassini, L.(2004). Intermediate Accounting

International Edition. Mc-Graw Hill Companies.Valix, C. (2004). Financial Accounting Volume 2. GIC Enterprises and Company.

In our next issue

Updates on Philippine Accounting Standard(PAS) / International Accounting Standard (IAS)16: Property, Plant and Equipment

Ms. Hilda Salendrez of the Accountancy Department discussesthe main changes in IAS16 like recognition of subsequent costs,measurement, and depreciation.