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                                          american                       bankruptcy                                 institute

                                              issues and information for today’s busy insolvency professional

Fresh-start Reporting: An Opportunity for
Debtor Companies Emerging from Bankruptcy
Written by:
                                                                       About the Author                  Requirements Are Complex
John M. Bonora                                                                                               The fresh-start requirements
Marks Paneth & Shron LLP; New York                                                                       spelled out in SOP 90-7 are complex.                                      John Bonora, a director in the Litigation
                                                                                                         The statement sets forth a strict set of

                                                             and Corporate Financial Advisory
        usiness bankruptcies are surging.                    Services Group of New York accounting       rules for restatement and a timeline
        That fact is unsurprising given                      firm Marks Paneth & Shron, has more         for implementing fresh-start reporting.
        that we are in the midst of the                      than 30 years experience in litigation      Those executing the restructuring must
worst economic crisis since the Great                        consulting and bankruptcy services.         understand, among other factors, the
Depression, but the numbers are still                        He has advised litigation counsel, the      intricacies of determining fair value
startling. In 2008, there were 43,546                        courts, chapter 11 debtors and chapter      for tangible and intangible assets,
business bankruptcies—a 65 percent                           7 and 11 trustees.                          implications of timing issues, including
increase over 2007, and more than                                                                        the start date for fresh-start reporting, and
double the 2006 figure of 19,965. 1                         Accountants (AICPA) Statement of             best practices in “pushing down” fresh-
A total of 9,272 of those 2008 cases                        Position 90-7 (SOP 90-7), “Financial         start adjustments to subsidiary entities
involved a chapter 11 filing—again, a                       Reporting for Entities in Reorganization     and underlying ledgers.
dramatic increase over the 2007 and                         Under the Bankruptcy Code.”                      Added to this is the fact that fresh-start
2006 totals (there were 5,736 in 2007                                                                    reporting is not a stand-alone process. For
and 5,163 in 2006).2                                        How Companies Can Benefit                    companies that qualify, it is integral to the
    A chapter 11 filing is a dramatic                           Fresh-start reporting is exactly what    chapter 11 reorganization. The first step in
event in the life of any business—as                        it sounds like—a financial statement         the chapter 11 process is to reorganize the
witnessed in the intensive, far-reaching                    by the new entity as it emerges from         company to create a solvent, operationally
media coverage of the Chrysler and                          chapter 11, containing a “fresh”             viable entity. A key component is the
General Motors bankruptcies. For                            presentation of the newly-determined         restructuring and discharge of certain debt,
business leaders, advisors, employees                       value of assets after liabilities have       which is the essence of the reorganization
and interested parties, entry into chapter                  been cancelled or adjusted. Fresh-           plan. Then, if the entity qualifies, fresh-start
11 is life-altering.
Fresh-start Reporting Is
a Continuation of the
                                                              Financial Statements
Chapter 11 Process                                                                                       accounting considerations come into play:
                   For many companies,                      start reporting recognizes that, under       the question at hand is, what do we need to
                   the chapter 11                           certain conditions, the emerging entity      do to reset the balance sheet, in addition to
                   process is the first,                    is effectively new, and users of its         what we needed to get to that point?
                   but not the last, step                   financial statements are better served
                   in a reorganization.                     by revaluing the entity’s balance sheet      Few Business Leaders and
                   Companies that
                   successfully reorgan-
                                                            based on the “fair value” of the entity’s    Advisors Have Experience in
                                                            postconfirmation assets and liabilities.     Fresh-start Reporting
                   ize and meet a                               Fresh-start reporting can work in
                   strict set of criteria                                                                    Needless to say, many business
                                                            a company’s favor. It creates a clean        leaders have never been exposed to
John M. Bonora     qualify for fresh-                       balance sheet and can step up the value
                   start reporting—the                                                                   the intricacies of either the chapter 11
                                                            of the assets. It enables leadership to      process or fresh-start accounting, and
reporting requirements for qualifying                       wipe away the accumulated losses of the
emerging entities as promulgated by the                                                                  even when it comes to their advisors,
                                                            bankrupt company, and to say accurately      experience can be hard to come by.
American Institute of Certified Public                      to the marketplace that the new company      Many attorneys and accountants claim
1 Administrative Office of the U.S. Courts.                 coming out of bankruptcy is stronger.        chapter 11 experience—but the demands
2 Ibid.

           44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 •
of fresh-start reporting are likely beyond    liabilities; and (2) the holder of            of the proceeding (and of the whole
most of them. Only practitioners and          preconfirmation voting shares will            bankruptcy process) is to maximize
firms with extensive experience in fresh-     receive less than 50 percent of the voting    recovery by creditors and shareholders by
start accounting are truly qualified to       shares upon emergence.3                       preserving the company as a viable entity
guide a company through the process.              The purpose of the first condition is     with a going-concern value. The plan
Keep in mind that the leadership of the       to prevent the use of fresh-start reporting   specifies the treatment of all creditors and
new entity, together with its advisors,       by solvent companies. The second              equityholders, and shapes the financial
will need to support the reorganized          condition, the change-in-ownership            structure of the entity that emerges.
entity’s individual asset valuations to       requirement, is, in concert with the first         Among the most significant
the company’s auditors. The situation is      condition, intended to prevent companies      elements of the plan is the determination
demanding and the stakes are high, and        from filing a chapter 11 petition solely      of reorganization value. Generally
penalties will apply for delayed reporting.   for the purpose of adopting fresh start       speaking, the reorganization value is
A review of the specific demands will         reporting and writing up the carrying         the fair value of the entity—what a
illustrate its complexities, and show why     value of assets.                              willing buyer would pay for the assets
the process is best navigated with the                                                      immediately after restructuring—without
help of an expert.                            Determining Reorganization                    taking into account the liabilities. While
                                              Value and Developing the                      that description is straightforward in
Criteria: When Does a                                                                       concept, the determination of fair value is
                                              Disclosure Statement
Company Qualify for                               Since fresh-start reporting is an         an intricate and time-consuming process
Fresh-start Reporting?                        integral element of the bankruptcy            that usually involves extensive arm’s-
    SOP 90-7 clearly states that              process for companies that meet the           length negotiation—and sometimes
companies emerging from chapter 11            qualifying conditions, the process begins     litigation—among the interested parties.
qualify for fresh-start reporting if two      with the bankruptcy filing itself. The             At the conclusion of negotiations,
conditions are met: (1) the reorganization    filing of the bankruptcy petition starts      the disclosure statement is prepared.
value of the entity’s assets is less than     the reorganization proceeding. The goal       This is required under the Bankruptcy
the total of all claims and postpetition      3 AICPA SOP 90-7.12, Nov. 19, 1990.
                                                                                            Code in order to enable a hypothetical
                                                                                            “reasonable investor” to make
                                                                                            an informed judgment about the
                       Figure 1: Pro Forma Financial Statements                             bankruptcy plan. 4 The Code does not
                                                                                            identify the elements of the disclosure
                                                                                            statement, but in practice the statement
                                                                                            usually includes a summary of the plan,
                                                                                            historical and prospective information,
                                                                                            and a pro forma balance sheet reporting
                                                                                            the reorganization value and capital
                                                                                            structure of the emerging entity.5
                                                                                            The Pro Forma Balance Sheet:
                                                                                            Basis for the Fresh-start
                                                                                            Requirements Test
                                                                                                While the Code does not specifically
                                                                                            require a valuation in order to approve a
                                                                                            disclosure statement,6 a valuation is almost
                                                                                            always prepared for companies that meet
                                                                                            the criteria for fresh-start reporting. The
                                                                                            mechanism for presenting the valuation
                                                                                            is the pro forma balance sheet. The
                                                                                            development of the pro forma balance
                                                                                            sheet involves two main considerations:
                                                                                                1. The pro forma recording of the
                                                                                                effects of the plan, such as
                                                                                                    • debt extinguishment;
                                                                                                    • cancellation of old common stock;
                                                                                                    • estimation of the settlement
                                                                                                    amount of allowed claims; and
                                                                                                    • issuance of new stock and debt; and
                                                                                                2. Adjusting the balance-sheet values
                                                                                                to “fair value,” such as
                                                                                                    • valuing and writing up or
                                                                                                    down receivables, inventory
                                                                                                    and fixed assets;
                                                                                            4 §1125(a)(1).
                                                                                            5 SOP 90-7.11.
                                                                                            6 SOP 90-7.37.

      44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 •
         • valuing the reorganized entity’s     and fuller disclosure. In this context it      Challenges in Fresh-start
         intangible assets and adding them      represents a way to clear accumulated
         to the balance sheet;                  distortions from the balance sheet and         Reporting: Establishing
         • calculating the present value        establish that the new entity is, in fact,     the Reporting Date
         of all liabilities that will survive   a healthier company.                               Once the criteria are clearly met,
         the reorganization and recording           The new asset valuation presented in       the real work begins and a central
         adjustments and/or additions,          the pro forma balance sheet is the basis       challenge is determining the reporting
         including pension and post-            for determining whether the new entity         date. According to SOP 90-7, fresh
         retirement benefits, leases or         meets fresh-start reporting criteria—          start reporting should be applied “as
         deferred taxes, including the          this is the asset valuation that must be       of the confirmation date or as of a
         impact of the newly identified,        weighed against claims and postpetition        later date when all material conditions
         separable intangible assets; and       liabilities. If the asset value is less than   precedent to the plan’s becoming
         • eliminating prior retained           claims and liabilities, then according to      binding are resolved.” 7 “Material
         earnings (deficit) and recording       SOP 90-7, one of the two conditions for        conditions precedent” are conditions
         other direct charges to equity,        fresh-start reporting has been met.            that could delay or impede the debtor’s
         including cancellation of debt or                                                     ability to emerge from bankruptcy.
         net operating loss carryforwards.      Determining the                                These might include:
     In Figure 1 (taken from a real             Preconfirmation Shareholders’                      • Exit financing for which a lender
entity that went through the chapter 11                                                            has not yet been established;
                                                Participation in the New Entity                    • Pending appeals;
reorganization and fresh-start reporting            The second test for fresh-start
processes), the first column shows the                                                             • An SEC settlement; and
                                                reporting is to determine whether the
preconfirmation balance sheet at the                                                               • Other external factors—regulatory,
                                                holders of preconfirmation voting shares
point of filing the bankruptcy petition.                                                           for example—not under the debtor’s
                                                will receive less than 50 percent of the
The second column reflects pro forma                                                               control.
                                                voting shares in the new entity. Like other
recording of the plan effects, most                                                                Beyond that, SOP 90-7 has absolutely
                                                steps in bankruptcy and re-emergence, this
visibly the extinguishment of debt.                                                            nothing to say about the date on which
                                                can be a complex and lengthy process,
The third column shows the many                                                                to begin fresh-start reporting. The
                                                especially when there are debt-for-equity
additional adjustments necessary to                                                            usual practice—in order to minimize
                                                exchanges and aggregated shareholders
arrive at fair value. The combined                                                             disruption to the organization—is to
                                                whose holdings must be analyzed. A
effects of the two produce the pro                                                             choose a fiscal month-end, usually
                                                particularly challenging situation is one
forma balance-sheet results, which                                                             close to the confirmation date or the
                                                in which there has been a change in the
appear in the fourth column.                                                                   emergence date, depending on when the
                                                parent company ownership structure.
     Valuing intangible assets carries its                                                     “material conditions precedent,” if any,
                                                Consider, for example, the case of a U.S.
own set of challenges. Regardless of                                                           are resolved.
                                                company—a subsidiary of a Korean
whether an intangible asset was reported
on the balance sheets of the original
                                                company—coming out of bankruptcy. The          Issues in Fresh-start
                                                Korean company had been restructured
entity, it should be reported on the pro        in complex ways that made it hard to           Implementation
forma balance sheet if it results from          determine whether the U.S. entity had              While it is possible that the fresh-start
contractual rights (legal or other), and if     or had not been subject to a change of         reporting date will coincide with a fiscal
it can be easily separated from the entity      ownership. The debtor’s financial advisors     year end, in 99-plus percent of situations,
and sold, transferred, exchanged, licensed      usually lead the analysis, with help from      that is not going to be the case. Most
or rented. As for goodwill—any portion          the debtor’s counsel and the debtor’s          emerging entities will need to establish
of the reorganization value that cannot be      treasury department.                           cut-off procedures for closing their books
attributed to tangible or intangible assets                                                    7 SOP 90-7.35.
is to be treated as goodwill.
     The extensive work involved in
the balance-sheet adjustments is, of                                    Figure 2: Fresh-start Reporting Timeline
course, just one example of a broader
movement toward “fair value” as a
standard for valuing assets. Although
fair value accounting has received
significant attention in the wake of
the global financial crisis, the truth
is that for many nonfinancial assets,
and in the absence of a merger or
acquisition, the accounting standard
remains historic cost-based, and this
is reflected on the balance sheets
of thousands of companies. The
application of fair value standards in
the development of the reorganized
entity’s pro forma balance sheet is part
of a trend toward greater transparency

       44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 •
in the middle of the year, and there are        Conclusion: A Job for
many accounting steps involved. “Stub
period” income statements must be               Professionals
generated for the period leading up to               As these examples illustrate, fresh-
the fresh-start date and for the first year     start reporting is an intricate process—
of the emerged entity’s operations.             one made even more challenging because
    In addition, it will be necessary to        it plays out in the context of a bankruptcy,
“push down” the balance-sheet valuation         which is already challenging. Simply put,
and cancellation of debt adjustments to         fresh-start reporting is not an obligation
the level of the legal entities that actually   that C-level executives should meet on
housed the assets and debts in the first        their own. However gifted they are in
place. It is an intricate, but necessary,       business and finance, they likely will not
task to ensure that the adjustments             have enough exposure to the process to
appear on the correct underlying ledgers        carry it off effectively. The same may be
and subsystems.                                 true of professional advisors (attorneys
                                                and accountants) who are not specialists
Initial Financial Statement:                    with extensive experience in the specific
                                                demands of fresh-start reporting.
Making Sure Transparency                             A leadership team or professional
Wins Out                                        counsel managing a bankruptcy
    The initial financial statement issued      reorganization should secure an
under fresh-start reporting rules carries       experienced advisor—one with a strong
a special burden: It must fulfill the           background in fresh-start accounting
obligation of transparency that has been        and in the practical challenges of similar
the goal of the entire reorganization           cases. Without a qualified guide, fresh-
process. Specifically, the initial financial    start reporting can be a hazardous—or
statement must disclose:                        even disastrous—process, but with
    • the adjustments made to the               a qualified professional on hand to
    historical amounts of individual            manage the steps, fresh start-reporting
    assets and liabilities;                     can be exactly what the name implies: a
    • the amount of debt forgiveness;           representation of the scorekeeper’s role
    • the amount of prior retained              in the entity’s renewal. n
    earnings or deficit eliminated; and
    • how reorganization value was              Reprinted with permission from the ABI
    determined—that is, the valuation           Journal, Vol. XXVIII, No. 6, July/August 2009.
    methods, including key assumptions.         The American Bankruptcy Institute is a multi-
Since the fresh-start financial statement is,   disciplinary, nonpartisan organization devoted
by definition, a new beginning, it is not       to bankruptcy issues. ABI has more than
comparable with the financial statements        12,000 members, representing all facets of
issued before the confirmation date, and        the insolvency field. For more information,
comparative financial statements including      visit ABI World at
pre- and postconfirmation reporting
periods should not be presented.
Timeline: Step by Step
Through the Fresh-start
Accounting Process
     A review of the steps involved in
fresh start-reporting (see Figure 2)
clearly shows that the process falls into
two distinct phases: (1) steps undertaken
during the chapter 11 reorganization, up
to and including the plan confirmation;
and (2) the steps undertaken to
implement fresh -start reporting if the
entity qualifies. Fresh-start requirements
testing sits between the two phases:
It takes place in the late stages of plan
development, as the pro forma balance
sheet is created. Then, if fresh-start
reporting criteria are met, it drives the
considerations undertaken during the
fresh-start reporting process itself.

       44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 •

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