Chapter 13

Accounting for Legal Reorganizations and Liquidations

Background

• Companies that are unable to pay their debts as they become due are considered insolvent

• To ensure the equitable treatment of all parties involved with insolvent company (stockholders as well as creditors), laws have been written to provide structure for the bankruptcy process in the U.S.



• At present, legal guidance is provided primarily by the Bankruptcy Reform Act of 1978 as amended



• This law attempts to arrive at a fair distribution of a debtor's assets



• It also seeks to discharge the obligations of an honest debtor

Instigating the Bankruptcy Process

• Bankruptcy proceedings can be formally instigated by either the debtor or a group of creditors



• Voluntary petition is filed with the court by the insolvent company



• Involuntary petition must be filed by a minimum number of creditors

• After a bankruptcy petition is received, the court will normally grant an order for relief to halt all actions against the debtor

Classification of creditors

• Fully secured creditors



• hold a collateral interest in assets of the insolvent company having a value in excess of the related liability.



• any money received in excess of the debt is then used to pay unsecured creditors

• Partially secured creditors



• also have a collateral interest, but the expected net realizable value will not satisfy the entire obligation.



• remainder is considered unsecured

• Some unsecured obligations have priority over other unsecured debt. These are presented in order of priority below



• administrative expenses related to preserving and liquidating the estate



• obligations arising between the date that a petition is filed and the issuance of an order for relief



• Employees' claims for wages earned during the 90 days preceding the filing of the petition (limited to $4,000 per person)



• Employees' claims for contributions to benefit plans earned during the 180 days before the filing of the petition



• Claims of customers for deposits made to secure delivery of goods or services



• government claims for unpaid taxes

• Remaining unsecured creditors



• have no legal right to any specific property

• entitled to share in any funds that remain after all secured creditors are satisfied.

Statement of Financial Affairs

• Statement is usually produced by an insolvent company to disclose its current financial position at the beginning of the bankruptcy process

• Allows creditors to gauge their respective positions with respect to potential recovery

• May be used in determining whether a creditor favors liquidation or reorganization.

• Assets are reported at net realizable value along with disclosure of pledged amounts



• Pledged with fully secured creditors



• Pledged with partially secured creditors

• Available for priority liabilities and unsecured creditors (Free Assets)



• Liabilities are classified according to the security or priority of the creditor



• Liabilities with priority



• Fully secured creditors



• Unsecured creditors



• Stockholders

• Most of the asset balances reported in this statement are merely estimations or projections of future events.

Chapter 7 Bankruptcy - Liquidation

• Bankruptcy proceedings often conclude with the assets of the debtor being liquidated to satisfy creditor claims

• A trustee is appointed to oversee termination of business affairs, liquidation of noncash properties and the distribution of cash resources



• trustee's role is to preserve assets and protect creditors' interests



• may continue to operate the business until a logical concluding point arrives



• trustee may retain outside professionals such as attorneys, accountants and consultants

• The trustee prepares a periodic reporting of activities, frequently in the form of a Statement of Realization and Liquidation



• This statement indicates the book value and classification of remaining assets and liabilities



• It also discloses the effects of all transactions that have occurred to date.

Chapter 11 Bankruptcy - Reorganization

• An alternative to liquidation, this allows companies to stay in business and attempt to return to solvency



• Usually when Chapter 11 is filed, control over the company is retained by the ownership (called the debtor in possession)



• If fraud or mismanagement can be shown, the court has the power to appoint an independent trustee to assume control

• When reorganization is in process, the owners and managers are legally required to preserve all assets as of the date relief is ordered

• A reorganization plan has to be devised that can win the approval of each class of creditors and each class of stockholders, as well as the court



• The plan can initially only be filed by the debtor in possessions,



• but after a period of time, any interested party may file a reorganization plan



• Reorganization plans normally entail a specific course of action designed to save the company, and should usually include:



• specify the treatment of creditors and equity holders



• provide evidence showing how the company can become solvent



• proposed changes in company operations (closings, new products, etc.)



• plan for generating additional financing (sale of new equity)



• planned changes in management



• plans to settle debt of the company that existed before the order of relief was granted



• modifying terms of debt

Financial Reporting during Reorganization

• AICPA SOP 90-7 provides guidance for preparing financial statements while a company goes through reorganization

• The Income Statement during reorganization



• Revenues, Expenses, Gains and Losses are reported before income tax expense or benefits



• Interest expense is generally not incurred during reorganization



• Earnings before reorganization items and tax expenses - reported separately



• Reorganization items are then presented, including gains or losses on the sales of assets



• Reorganization costs are expensed as incurred



• Interest revenue which is generated because the company is holding funds for disbursement under reorganization is reported as a reorganization item

• The Balance Sheet during reorganization



• GAAP continues to apply



• Assets are reported at Book Value



• Liabilities subject to compromise because of the reorganization must be disclosed separately and reported on the basis of the expected amount of allowable claims

Fresh Start Accounting

• SOP 90-7 indicates that a company emerging from Chapter 11 is a new entity and must be accounted for at its new historical cost if

• The FMV of the assets of the emerging company is less than the total of the allowed claims as of the date of relief plus any subsequently incurred liabilities, and



• The original owners are left with less than 50% of the voting stock when the company emerges from bankruptcy



• The amount assigned to value the company is usually found by discounting to Net Present Vlaue the future cash flows for the reconstituted business



• This total value is then assigned to individual assets in the same way as in a purchase combination, with any excess assigned to an account similar to goodwill

• Liabilities are valued at the present value of cash flows, except for deferred taxes

• To make the required adjustments balance, Paid-in-Capital is often increased or decreased

• Any write-down of a liability creates a recognized gain

• Because this is considered a new entity, Retained Earnings must have a zero balance