In the financial world, debt-to-equity swaps are common transactions. The resulting hybrid transaction enables the 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 represents money invested into a corporation or enterprise by owners called shareholders. The equity owner usually receives voting rights, and may vote in the yearly meeting of shareholders concerning the corporation or enterprise’s management or next steps. If the entity pays dividends, the shareholder receives cash flow as he owns equity.
If the shareholder sells the equity held in the corporation or enterprise, he may achieve 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 corporate or enterprise represents equity, or what the entity owns less what the entity owes.
Converting debt to equity occurs when the lender converts a loan amount (or a loan amount represented by outstanding bonds) into equity shares. No cash exchange occurs in the debt-to-equity swap.
For example, if a corporation with an outstanding loan has interim financial difficulties, the lender may request a debt-to-equity swap. The corporation would give up a percentage of ownership in the business in order to exchange debt to equity shares. If the corporation owed $100 million, the company might agree to give the lender a 10 percent or greater ownership in the enterprise in exchange for the debt to equity conversion.
Accounting of the Debt-to-Equity Swap
The corporation’s financial department makes journal entries on the date of the debt-to-equity swap transaction date. Converting the entire $100 million loan to equity on the date of the transaction allows the corporation to debit the books by the full $100 million. The common equity account is then credited by the new equity issue (at $10 million, or 10 percent).
The financial department also deducts the interest expense to report any losses incurred in the debt-to-equity swap conversion.