There are two principal methods of accounting for equity acquired in exchange for debt:

Writing-off, or fully providing against the value of the equity. This is clearly the most prudent approach and is required under the internal regulations of many banks. However, this policy may not always accurately reflect the underlying commercial substance of a debt for equity swap transaction. This is particularly so if the principal objective of a transaction is to restore some value to the company’s equity. The risk is that this accounting approach acts as a disincentive for banks to convert the necessary level of debt into equity, and thereby fail to agree to a robust financial restructuring. There is also a possibility that once fully provided, there would be little incentive for lenders to take a proactive role in maximising the value of their equity holdings.

Valuing the shares at the lower of cost and net realisable value. For this purpose, cost is the face value of debt converted and net realisable value is assumed to be the estimated realisation at the proposed exit date. The reporting accountants’ valuation of the company’s equity is usually used for this purpose. For short-term holdings, say, realisable within one year, the market value (if any) of the shares is likely to be the
appropriate indicator of their realisable value. This is providing the market for the company’s shares is relatively liquid. The risk associated with this approach is that there is pressure to take an optimistic view on realisable value and hence use a debt for equity swap transaction to delay making necessary provisions against problem loans.

The lender’s host country or internal regulations will often restrict the options available for the accounting treatment of shares acquired in distressed clients. It is important, however, to ensure that the accounting method adopted does not distort the substance of the transaction. A swap based on the fundamental financial and business issues will ultimately benefit all the parties involved.