NOTES

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)

on business education Volume 8 No. 1 Jan-Feb 2005

Debt restructuring: alternatives

and implications
By Ma. Gina T. Manaligod*
Assistant Professor

Introduction
Many companies across the world
currently experience financial trouble
during the past few years because of
recent global economic setbacks. Cash-
strapped companies struggle to meet
debt obligations and covenants at a time
when lenders who are also facing the
same economic problems look for ways
to protect their own financial interests.
Before being forced into bankruptcy, a
financially distressed company and its
lenders can employ debt restructuring
schemes that sufficiently reduce the
debtors cash crunch so it can improve
operations and avoid bankruptcy. A
classic example of this is the case of a
big steel company in the USA which has
been struggling with its earning
performance since 2003. The company
proceeded with a restructuring of its debt
and became optimistic they will emerge
financially stronger because of a vastly
reduced debt (see Box 1).
Financially troubled companies
may resort to debt restructuring as an
avenue to financial recovery. FASB
(Financial Accounting Statements Board)
Statement No. 15 states that a troubled
debt restructuring occurs when the
creditor, for reasons related to the

*Ms. Gina Manaligod is a faculty of the Accountancy Deparment, De La Salle University - Manila
Jan - Feb 2005 1 Notes on Business Education
debtors financial difficulties grants a
concession to the debtor that it would Box 1.
otherwise not consider. The standard A big steel company
goes on to say that the creditor s
in Ohio, USA has been
objective, whatever the form of
struggling with its earnings
concession that may be granted, is to
make the best out of a difficult situation. performance because sales
The creditor expects to obtain more cash volumes are down to
or other value from the debtor to increase depressed levels and
the probability of receipt, by granting the resulting price pressures.
concession than by not granting it During 2004, this steel
(Pariser 1989). company reported a fiscal
FASB Statement No. 15 further second quarter net loss of
states that among the factors to consider $13.4 million compared with an $11.8 million loss in the same period last
when assessing whether debtors are year. For the first six months of fiscal year 2004, the company posted a $17.5
experiencing financial difficulties include million net loss compared with a P37.4 million loss a year earlier. Instead of
whether the company (1) is in default on
giving up and turning to bankruptcy proceedings, management kept the
its debt; (2) has either filed or will soon
flame of hope burning by pursuing alternative courses of action.
file for bankruptcy; (3) is able to continue
as a going concern; (4) projections Management continued to concern itself on how to make the company a
indicate that cash flows will be viable and financially sound steel supplier.
insufficient to satisfy its contractual debt
obligations; (5) has outstanding The company proceeded with a restructuring of its cost and debt to
securities that have been de-listed; or (6) support operations and meet capital expenditure needs. The restructuring
has limited access to capital due to focused on reducing the aggregate principal amount outstanding in its
deteriorating credit worthiness (Beier and $300 million secured notes and revising the terms governing interest
Prinzivalli 2003). If these financial payments. At the same time, the companys parent company is willing to
difficulties are caused by temporary make additional significant cash infusion necessary for a successful financial
market forces and not by bad restructuring. Management is optimistic that they will emerge from this
management, it may still be cured by
process financially stronger with a vastly reduced debt load (Sacco 2004)
restructuring debt agreements rather
than by forcing liquidation.
A troubled debt restructuring may
be achieved in either of two ways. First, of asset that companies may offer in preferred stock. This arrangement is
the debt may be settled at the time of troubled debt restructuring include cash, referred to as equity swap.
restructuring. In this situation, the receivables, inventory, property, plant The debt may also be continued
creditor may try to actually settle the debt and equipment and intangible assets. but with modified terms. Under this likely
outright at the time of the troubled debt This arrangement is called an asset swap. occurrence, the creditor allows the debt
restructuring. The creditor may agree to Creditors may also accept other to continue but modifies the terms of the
accept an asset with a fair value less than forms of payment such as equity debt agreement to make it easier for the
the carrying amount of the liability as instruments like common stock and debtor to comply. To recoup part of their
final settlement of the debt. The types investment, creditors often consider
partial principal settlements, payment
extensions or holidays, interest rate
adjustments or any combination of the
Creditors may also accept other forms of payment such above concessions. Some lenders may
also accept modifications to non-cash
as equity instruments like common stock and preferred stock. terms such as covenants, waivers,
This arrangement is referred to as equity swap. recourse, provisions or collaterization,
while others may demand representation
to the companys board of directors

Notes on Business Education 2 Jan - Feb 2005

 If the asset given up in an asset
swap is cash, total cash outflows will
Box 2. increase thereby reducing the balance of
An example of shares of stock given in the cash account. Otherwise, an asset
exchange for debt forgiveness is the Maynilad swap will have no effect on the cash flow
case. The local creditors of Maynilad Water statement. Only the applicable income
Services had agreed in principle to convert three tax resulting from the recognition of the
gain on debt restructuring will affect the
billion pesos of debt to coupon-generating
cash position of the business.
voting, convertible and redeemable preferred
shares of Maynilad. After the restructuring, Key Stakeholders Concerns
Maynilad would be 39 percent owned by Owners of the business will find
MWSS, 19 percent by Suez group, 2 percent by asset swap both favorable and
Metrobank and 4 percent by Maynilad unfavorable. It can be considered
employees. Benpres Holdings Corporation would favorable because of the positive effect
on the income performance brought
continue to hold the remaining 36 percent of the
about by the recognition of the
total equity interest of Maynilad accounting gain on debt restructuring.
(www.money.inq7.net, 2004). This will provide a higher return on their
investment improving earnings per share.
On the other hand, owners may find an
asset swap uncomfortable because of the
decrease in total assets. A decline in total
(Beier and Prinzivalli 2003). This type is Impact on Financial Statements assets may have a negative financial and
known as modification of debt terms. operating impact.
An asset swap will certainly bring
Special accounting procedures are Creditors will be wary of the paying
a decrease in total assets and total
applied when companies undergo ability of the company even after the debt
liabilities. The total financial resources
troubled debt restructuring. Proper restructuring agreement because of the
available for business operations will
application of these accounting rules effect of the asset payment on the
decline. Liquidity and long term solvency
affects the reporting of debt and equity liquidity and solvency position of the
will suffer because the decrease in total
in the balance sheet and subsequent company.
assets will affect the ability of the
operating and income performance as business to meet its future commitments.
shown on the income statement. It is therefore imperative for the debtor Equity Swap
to consider this implication before In an equity swap, the payment to
Asset Swap pursuing an asset swap. Limited financial settle debt is in the form of shares of the
Under asset swap, the debt is assets may hamper the companys access debtors stocks. An example of this is
settled through the use of an asset. The to credit thereby hampering business the celebrated Maynilad case where its
debtor must have an asset available for operations. On the other hand, debt to local creditors agreed to convert the debt
payment of the loan. The debtor may equity ratio will improve because of the to preferred shares (see Box 2). The
need to adjust the carrying amount of reduction in the amount of liability debtor must have available unissued
the asset to its fair value prior to without affecting the capital of the shares available for issuance. Under
recording its exchange for a debt. The business. Philippine accounting standards, no
difference between the carrying amount An asset swap will have a positive accounting gain on debt restructuring is
and the fair value of the asset is recorded effect on the income statement because recognized. The carrying amount of the
as an ordinary gain or loss on disposition of the recognition of an accounting gain liability is the basis of recording the
of assets. Moreover, the difference as a result of the debt restructuring and issuance of shares of stocks. Any
between the carrying amount of the debt a follow-on increase to reported difference between the carrying amount
and the fair value of the asset given up is stockholders equity. The increase in the of the liability and the par value of the
also recorded as an ordinary gain on debt overall net income of the company, shares of stock is credited to an
restructuring (Valix, 2004). however, will warrant consideration in additional paid in capital account (Valix
terms of income tax. 2004).

Jan - Feb 2005 3 Notes on Business Education

Impact on Financial Statements
An equity swap has no effect on
total assets because no asset was used
to settle the debt. Liquidity and solvency
position will remain the same. On the
other hand, total liabilities will decline as
a result of the payment of a debt while
stockholders equity will increase as a
result of the issuance of the shares of
stocks. Debt to equity ratio will improve
because of the decrease in total liabilities.
An equity swap has no effect on
the income statement because no
accounting gain is recognized.
Likewise, it has no effect on the
cash flow statement because the cash
account is not affected by the
transaction.

Key Stakeholders Concerns

Stockholders may favor an equity
swap because there is no significant
effect on the financial position of the
business and no adverse effect
whatsoever on the income performance
of the business. However, the equity Modification of Debt Terms carrying amount of the debt. When the
interest of the stockholders may be If a troubled company does not total future cash payments are less than
affected with the infusion of additional wish to make use of an asset or issue the carrying amount of the debt, a journal
issued shares. Ownership interest of shares of stocks as payment for a loan, entry is prepared closing the existing
existing stockholders will be diluted with the debtor may negotiate with the liability accounts and setting up a new
the conversion of the status of the creditor certain concessions referred to liability account equal to the future cash
creditors to that of stockholders. Existing as modifications of debt terms. The payments. The difference between the
stockholders should be aware of this creditor may agree to reduce or delay carrying amount of the old debt and the
implication before pursuing an equity interest payments. Sometimes, the future cash payments under the
swap because some of the powers like maturity amount is reduced or the restructured debt is recorded as a gain
voting powers and policy making powers maturity date is postponed to a later date. on the date of restructure. The gain is
that they used to enjoy may be curtailed The more likely occurrence is it will call recorded as an ordinary gain in the
by the new stockholders. for a combination of these concessions. income statement. No interest is recorded
Prospective lenders will find an The accounting procedures thereafter. All subsequent cash
equity swap to be a convenient debt depends on whether, under the new payments result in the reduction of
restructuring scheme because the agreement, total cash payments are less principal (Spiceland 2004)
liquidity and solvency position of the than the carrying amount of the debt or When the total future cash
business remain unaffected by this total cash payments still exceed the payments are more than the carrying
arrangement. amount of the debt, no reduction of the
existing debt is necessary and no entry
is required at the time of the debt
If a troubled company does not wish to make use of an restructuring. Future cash payments are
applied as payment on the accrued
asset or issue shares of stocks as payment for a loan, the interest, interest expense and principal.
debtor may negotiate with the creditor certain concessions (Valix 2004). In other instances, the
referred to as modifications of debt terms. company simply reports a reduced
interest charge in future income

Notes on Business Education 4 Jan - Feb 2005

 reduced because of the concessions
Stockholders of a financially distressed company will accepted by the creditor.
Most lenders will also find
find modification of debt terms favorable because the overall modification of debt terms acceptable
effect on the financial position and income performance of because the debt is paid in cash although
the amount may be reduced and the
a business is not much affected. schedule of payment may be delayed.
The liquidity and solvency position of
the business may not be adversely
statements. The interest charge will be period. The income statement will only affected by the new arrangement because
the discount rate that equates the present be affected if the future cash payments the same effects would have happened
value of the future cash payments to the under the restructured debt are less than even if there is no debt restructuring.
carrying amount of the debt. No the carrying amount of the old debt
accounting gain is recognized in the because an accounting gain is Conclusion and
books of the debtor. (Beier and Prinzivalli recognized. This gain is recorded as an
2003). ordinary gain which increases net
Recommendations
Impact on Financial Statements In conclusion, modification of debt
income. However, the future cash
If the future cash payments under terms seems to be the safest and most
payments will affect the income statement
the restructured debt are less than the convenient debt restructuring scheme.
once interest expense is recorded. The
carrying amount of the debt, a journal The effect on the balance sheet and
recording of interest expense will
entry is prepared debiting the existing income statement is minimal. Cash
decrease net income.
liability accounts and crediting a new outflows in all future periods are
liability account for the restructured debt significantly reduced because of the
On the date of restructuring, there
and a gain account for the difference. concessions that may be allowed on
is no effect on the cash flow statement
This entry is prepared on the date of interest and principal payments.
because there is no payment made yet
restructure. As such, the financial Stockholders may find this arrangement
on this date. However, the future cash
position of the business is not affected favorable because their equity interest
payments whether applied as payment
by the restructuring agreement because will be maintained thus preserving
on accrued interest, interest expense or
there is no change in total assets, total powers that they currently enjoy.
principal will increase cash outflow
liabilities and total stockholders equity. Creditors may also find this scheme safe
thereby decreasing the cash balance.
The troubled debt still exists in the books because the liquidity and solvency
The effect on the cash flow of the
of the debtor as of this date but under position of the company remain
business is spread over the new
new terms. However, the future cash unaffected by the modification of the debt
repayment period.
payments will certainly affect balance terms.
sheet accounts, in particular the cash and It is important for companies to
Key Stockholders Concern assess how debt restructuring will affect
the liability accounts. Stockholders of a financially
If the future cash payments of the certain aspects of the business. Debtors
distressed company will find must be aware that debt restructurings
restructured debt are more than the modification of debt terms favorable
existing debt, no journal entry is prepared affect cash flow, performance measures
because the overall effect on the financial and key balance sheet accounts. These
at the time of the restructuring. The position and income performance of a
financial position of the business consequences should not be overlooked.
business is not much affected. The debt Management should understand the
remains the same on the date of the will still be paid but at a later date. Hence,
restructure. The troubled debt continues impact of debt restructuring on their
on the date of the debt restructure there companys key financial indicators and
to exist in the books of the debtor and is is no effect on the balance sheet. If a gain
carried under their existing liability how various stakeholders will view the
is to be recognized, the effect on the results.
account. However, the future payments income statement is positive.
on interest and principal will decrease Payment of the debt is usually
total assets and total liabilities. postponed to a later date. Hence, the
Under the modification of debt corresponding effect on the financial
terms, the effect of the restructuring on statements is likewise delayed and spread
the balance sheet accounts is delayed over the new repayment period. The peso
and spread over the new repayment amount of the effect is sometimes

Jan - Feb 2005 5 Notes on Business Education

 NOTES
Bibliography
Beier, R. and Prinzivalli, D.. Restructuring Debt at Troubled Companies. Capital
Eyes, January 2003.
Pariser, D. Financial Reporting Implications of Troubled Debt. The CPA on Business Education
Journal, February 1989. is published by the De La Salle
Sacco, J.. WCI to Restructure Debt While Earnings Flounder. American University - College of Business and
Metal Market, May 14, 2004. Economics Research and
Spiceland, J. D., Sepe, J., Tomassini, L.(2004). Intermediate Accounting Develoment (CBERD)
International Edition. Mc-Graw Hill Companies. Vol. 8 No. 1 Jan-Feb 2005
Valix, C. (2004). Financial Accounting Volume 2. GIC Enterprises and Company.
Editorial Board
Dr. Michael Alba
In our next issue email: albam@dlsu.edu.ph
Updates on Philippine Accounting Standard Dr. Myrna Austria
(PAS) / International Accounting Standard (IAS) email: austriam@dlsu.edu.ph
16: Property, Plant and Equipment
Michael Angelo Cortez
email: cortezm@dlsu.edu.ph
Ms. Hilda Salendrez of the Accountancy Department discusses
the main changes in IAS16 like recognition of subsequent costs, Secretary
measurement, and depreciation. Liza Pajo
For comments, suggestions and
contributions, call (632) 5244611
loc. 149 or telefax (632)3030869 or
email cberesearch@dlsu.edu.ph

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Notes on Business Education 6 Jan - Feb 2005