Debt refinancing considerations

By Redgienald G. Radam

First Published in Business World (7/22/2013)

GIVEN the current environment of low interest rates, debt refinancing could be a viable liability management strategy that companies can consider. However, while the benefits of debt refinancing seem to be very attractive, a company must be mindful of its accounting implications.

Borrowers and lenders may negotiate to refinance an existing debt with a new one (a “debt exchange”), or revise the terms of the existing debt (a “debt modification”). A debt modification is usually done by changing the interest rate, the maturity date or payment schedule, or a combination of both. Whether the borrower opts for a debt exchange or a debt modification, the exercise usually involves costs. Since such costs could be significant, companies need to be mindful of the possibility of an immediate hit to their profit and loss.

In addition to considering the accounting for refinancing costs, companies also need to determine whether, for financial reporting purposes, the refinancing gives rise to a new obligation (and consequently, an extinguishment of the existing debt) or just a continuation of the existing debt. This is an important consideration as extinguishing the existing debt could also affect the company’s bottom line, since the new debt will have to be recognized at fair value. Any difference between the fair value of the new debt and the carrying amount of the extinguished debt is recognized in profit and loss. As the carrying amount of the extinguished debt would include unamortized debt issue costs, derecognition of such debt also means the acceleration of the amortization of those debt issue costs. Moreover, all transaction costs incurred relating to such refinancing will have to be expensed immediately.

Philippine Accounting Standards (PAS) No. 39, Financial Instruments: Recognition and Measurement provides guidance on the accounting for debt refinancing. Under PAS 39, a debt refinancing will result in the extinguishment of the existing debt (the original debt) and the recognition of the newly issued or modified debt (the new debt) if the terms of the new debt are substantially different from those of the original debt. Determining what is substantially different requires both qualitative and quantitative assessments of the magnitude of the impact on the cash flows of the revised instrument.

If there is a fundamental change in the terms of an instrument, as in cases where the currency denomination is modified or there is an inclusion or exclusion of derivative-like features (e.g., conversion feature and interest rate cap or floor), the revised instrument will be treated as a new debt. However, if the changes only pertain to changes in interest rates or payment dates, PAS 39 requires the application of what is referred to as the 10% test to determine if the changes in cash flows are substantial.

Under the 10% test, the company compares the present value of the cash flows of the new debt (including any fees paid), discounted using the original effective interest rate of the old debt, with the carrying value of the old debt. If the difference is at least 10%, then modifying the terms is deemed to be substantial. In such instance, the old debt is extinguished and the new debt is recognized at fair value. As mentioned earlier, this would give rise to a hit in profit and loss for the difference between the fair value of the new debt and the carrying value of the old debt, as well as for any refinancing costs incurred. Moreover, if the terms of the new debt include derivative-like features, such features have to be assessed if they need to be separately accounted for as derivative instruments. PAS 39 also provides guidance on conducting the assessment. If the embedded derivatives must be accounted for separately, then this may introduce volatility to the company’s balance sheet and profit and loss, as the embedded derivatives will be carried at fair value, with fair value changes recognized in profit and loss.

On the other hand, if the changes made to the old debt are not fundamental and the 10% threshold is not breached, the company will continue to recognize the original debt, and any refinancing costs incurred will be capitalized as part of the carrying value of the original debt. Moving forward, the original debt, as adjusted for the refinancing costs incurred, will be measured at amortized cost. As the refinancing, however, has resulted in changes in the future cash flows on the debt, a new effective interest rate will be applied to the original debt.

Given that there may be two significantly different accounting treatments for a debt refinancing exercise, companies should be mindful of the accounting implications when structuring their refinancing schemes. While the structure they decide on could result in their desired cash flows, those benefits may not be reflected on their financial statements as anticipated because of the specific PAS 39 requirements in accounting for a refinancing. As companies look into the costs and benefits of doing a refinancing, the impact on financial reporting should be considered to avoid frustration and surprises when the transaction is eventually recognized in the company’s books.

Redgienald G. Radam is an associate director of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.