Debt-to-Equity Swap

Learn the Ins and Outs of These Common Deals

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In the financial world, debt-to-equity swaps are common transactions that enable a borrower to transform loans into shares of stock, or equity. Most commonly, a financial institution, such as an insurer or bank, holds the new shares after the original debt is transformed to equity shares.

Equity is money that's invested into a corporation or enterprise by owners, who are called shareholders. The shareholder usually receives voting rights and can vote in yearly meetings that concern the corporation or enterprise’s management or next steps.

If the entity pays dividends, the shareholder receives cash flow from equity he owns.

If the shareholder sells the equity, he might realize a profit, loss or no change in the original capital invested. Equity of the entity or corporation is calculated by subtracting combined assets from total liabilities. The net worth of the corporation or enterprise represents equity, or what the entity owns less what the entity owes.

A Debt-to-Equity Swap

When converting debt to equity, the lender converts a loan amount or loan amount represented by outstanding bonds into equity shares. No cash exchange occurs in the debt-to-equity swap.

Here's how it works: Corporation A might owe Lender X $10 million. Instead of continuing to make payments on this debt, Corporation A might agree to give Lender X a $1 million, or 10 percent, ownership share in the company in exchange for the debt.

This type of transaction might occur if a company is having some financial difficulties and isn't easily able to meet the payments on its debt obligations.

A company might also want to improve its cash flow by converting debt to equity. In some cases, lenders might request a debt-to-equity swap, while in others, the corporation might ask for one.

Debt-to-equity swaps can happen as a result of bankruptcy proceedings. For example, if Corporation A can't make the payments on the debt owed to Lender X, Corporation A might declare bankruptcy.

As part of this process, Lender X might receive equity in Corporation A in exchange for the debt. If this occurs in bankruptcy, it would be subject to approval by the bankruptcy court.

Accounting for the Debt-to-Equity Swap

To account for the debt-to-equity swap, the corporation’s financial department makes journal entries on the date of the transaction. Converting the entire $10 million loan to equity on the date of the transaction allows the corporation to debit the books by the full $10 million. The common equity account is then credited by the new equity issue, in this example, at $1 million, or 10 percent.

The financial department also deducts the interest expense to report any losses incurred in the debt-to-equity swap conversion.