CFM3354 - Understanding loan relationships: particular situations

Restructuring debt

Where a company gets into trouble it may have to restructure its debt. This could take the form of changing the terms of the debt or converting the debt into equity.

Changing the terms of debt

A company may need to postpone the repayment date of a debt. If it has short-term debt which it will not be able to repay it may negotiate with its creditor to extend the term of the debt. Where this happens it will be a question of fact whether there is a new debt. The debtor might negotiate simply to change the repayment date or alternatively it might take out new borrowing on completely different terms, with the new borrowing being treated as repaying the old borrowing. If the terms of the existing debt are altered it will depend on the extent of the changes whether, legally, they bring about the rescinding or cancelling of the first debt and the substitution of a new debt.

Converting debt to equity

Where a debtor company is unable to repay its borrowings it may be that the creditor agrees to convert the debt into shares. Where this happens the terms of the conversion will indicate whether there is a release of part of the debt in exchange for the issue of shares, and how much of the debt is treated as released. The remaining debt will be treated effectively as repaid through the issue of the shares.

From the creditor's point of view this release is simply likely to recognise what the accounts will have indicated already, which is that the debt was unlikely to be repaid in full. The repayment of the remaining part of the debt through the issue of shares will be reflected in the accounts of the creditor by the removal of the debtor balance and the inclusion of the shares as assets of the company.

From the debtor's point of view the borrowings have been replaced by share capital. The release of part of the debt may create a profit in the accounts of the debtor company and the issue of shares will be reflected in the share capital and the share premium account where appropriate. Through the transaction the debtor has reorganised its capital structure. Instead of borrowings it now has share capital in issue. This may enable the company to raise more money through issuing further debt or through borrowing.