Accounting for Legal Reorganizations and Liquidations

							CHAPTER
   19

 BANKRUPTCY
 REORGANIZATI
      ONS
     AND
 LIQUIDATIONS
FOCUS OF CHAPTER 19
•   Bankruptcy Statutes
•   Bankruptcy Reorganizations
•   Liquidations
•   Accounting by Trustees
  Bankruptcy Statutes:
     Their Significance
• Under the bankruptcy statutes, a company
  is placed under the protection of the
  bankruptcy court. This means that:
   – Creditors are prevented from taking
     legal action individually otherwise
     available to them.
   – Creditors’ legal rights are thus
     suspended for an indefinite period.
  Bankruptcy Statutes:
     Their Significance
• When a corporation is in bankruptcy
  proceedings, the bankruptcy judge
  controls the company.

• A subsidiary in bankruptcy proceedings
  cannot be consolidated by its parent
  because the parent has lost control.
   Bankruptcy Statutes:
          Applicability
• The bankruptcy statutes apply to:
   – Individuals.
   – Partnerships.
   – Corporations.
   – Municipalities.
  Bankruptcy Statutes:
          Applicability
• The bankruptcy statutes do not apply to:
   – Insurance companies.
   – Certain financial institutions, such as
     banks and savings and loans, which are
     subject to alternative regulations.
    Bankruptcy Statutes:
      Types of Petitions
• A company can file for bankruptcy
  protection by filing a voluntary petition.
• A company’s creditors can file an
  involuntary petition if the debtor:
   – Is generally NOT paying its debts as they
     become due or
   – Has appointed a custodian or given
     possession of its property to a
     custodian.
  Bankruptcy Statutes:
 Creditors With Priority
• A special class of creditors created by
  the bankruptcy statutes is called
  ―creditors with priority.”
• These creditors are given statutory
  priority over the claims of other
  unsecured creditors with regard to
  payment.
      Bankruptcy Statutes:
     Creditors With Priority
• Creditors Claims With Priority:
  – Administrative expenses related to the
    bankruptcy proceeding (postpetition
    claims).
  – Wages, salaries, and commissions
    earned within 90 days before the bankruptcy
    filing (up to $4,000 per employee).
  – Employee benefit plan claims (specified).
  – Deposits by individuals.
  – Taxes.
     Bankruptcy Statutes:
  Chapter 7 Vs. Chapter 11
• Chapter 7 of the Bankruptcy Statutes:
  – Deals with liquidations:
     • Sell the assets, pay the creditors, close
       down the business.
• Chapter 11 of the Bankruptcy Statutes:
  – Deals with reorganizations:
     • Certain debts are forgiven & the
       company is able to get a “fresh start.”
   Bankruptcy Statutes: Chapter
  11 Vs. Troubled Debt Restructuring

• Filing for bankruptcy reorganization is a
  last resort short of liquidation.
• Most companies prefer to attempt a troubled
  debt restructuring outside of the
  bankruptcy court. Advantages are:
   – Can be done in far less time.
   – Avoids the stigma of having gone through
     bankruptcy proceedings.
    Chapter 11 Bankruptcy
Reorganizations: Management’s Role

• In a Chapter 11 bankruptcy filing, the
  debtor’s management usually:
   – Continues to manage and operate the
     company.
   – Develops a plan of reorganization, to
     be submitted to creditors and the
     bankruptcy court.
    Chapter 11 Bankruptcy
Reorganizations: Debt Forgiveness

• If the creditors approve of any plan of
  reorganization, certain debt is forgiven.
   – Formally, this is referred to as a
      “discharge of indebtedness.”
• Certain debt cannot be discharged under
  the bankruptcy statutes, such as:
   – Taxes
   – Debt incurred under false pretenses.
    Chapter 11 Bankruptcy
Reorganizations: Accounting Issues

• The Accounting Issues:
   – How to calculate whether any debt has
     been forgiven.
      • This issue includes whether interest
        should be imputed.
   – How to report a forgiveness of debt.
     Chapter 11 Bankruptcy
Reorganizations: Accounting Issues

 • These are the identical issues that exist in
   troubled debt restructurings, which are
   governed by FAS 15.
 • However, the AICPA’s SOP 90-7, which
   applies exclusively to bankruptcy
   reorganizations applies—NOT FAS 15.
  Chapter 11 Bankruptcy
 Reorganizations: SOP 90-7

• The central idea of SOP 90-7 is that the
  entity that emerges from Chapter 11 be
  deemed a new entity for which fresh-start
  financial statements should be prepared.
• No beginning retained earnings or deficit
  (deficits usually exist) is reported.
• A small percentage of entities emerging from
  Chapter 11 will not qualify for fresh-start
  accounting under SOP 90-7.
  Chapter 11 Bankruptcy
 Reorganizations: SOP 90-7

• Under SOP 90-7, comparative financial
  statements that straddle a confirmation
  date cannot be presented because it
  would be an inappropriate comparison of:
   – A former entity and
   – A new entity.
  Chapter 11 Bankruptcy
 Reorganizations: SOP 90-7

• Under SOP 90-7, any forgiveness of debt
  (“discharge of indebtedness”) is:
   – Calculated by determining the present
     value of amounts to be paid using
     appropriate current interest rates.
   – Reported as an extraordinary item in
     the predecessor entity’s final statement
     of operations.
   Chapter 11 Bankruptcy
  Reorganizations: SOP 90-7

 • Under SOP 90-7, all assets are restated to
   reflect their fair value at the date of
   reorganization. Three steps are required:
#1 – Determining the “reorganization value”
      of the entity—an amount that
      approximates what a “willing buyer”
      would pay for the assets of the
      emerging entity immediately after the
      restructuring.
   Chapter 11 Bankruptcy
  Reorganizations: SOP 90-7

#2 – Allocating the reorganization value to
     the entity’s tangible and intangible
     assets.
#3 – Reporting any unallocated value as
     goodwill (subsequently to be
     evaluated periodically for impairment).
 Chapter 11 Bankruptcy
Reorganizations: SOP 90-7

• Under SOP 90-7, the “old entity” prior to
  the confirmation date is to report:
   – Bankruptcy related losses and
     expenses in a separate
     “REORGANIZATIONS ITEMS”
     category in its statement of operations.
  Chapter 11 Bankruptcy
 Reorganizations: SOP 90-7
• Also under SOP 90-7, the “old entity”
  prior to the confirmation date is to report
  IN ANY BALANCE SHEETS ISSUED, its
  liabilities in the following specified
  categories:
   – PRE PETITION liabilities subject to
     compromise,
   – PRE PETITION liabilities not subject to
     compromise (priority), and
   – POST PETITION liabilities (priority).
  Chapter 7 Bankruptcy
      Liquidations
• In a Chapter 7 filing (for liquidation). the
  court usually appoints a trustee to
  liquidate the company.
• Trustees have the power to void
  fraudulent and preferential transfers
  made by the debtor within certain specified
  periods preceding the filing date.
   Chapter 7 Bankruptcy
       Liquidations
• In a Chapter 7 filing, a special statement
  (called the “statement of affairs”) is
  prepared on a “quitting concern” basis.
• This statement provides information
  concerning how much money each class of
  creditors can expect to receive on
  liquidation of the company.
   – This is a pro forma (―as if ‖) statement.
 Accounting By Trustees
• If the court or creditors desire information
  that discloses the trustee’s responsibility for
  the book balances existing when the trustee
  was appointed, a statement of realization
  and liquidation can be prepared.
   – This is a historical statement in its
      entirety (nothing pro forma about it).
      Review Question #1
Which accounts are adjusted to a zero
balance in a bankruptcy reorganization
that qualifies for fresh start accounting?

A.   Accumulated depreciation.
B.   Additional Paid-in Capital.
C.   Retained Earnings.
D.   Accumulated Deficit.
E.   None of the above.
        Review Question #1
               With Answer

Which accounts are adjusted to a zero
balance in a bankruptcy reorganization
that qualifies for fresh start accounting?

A.   Accumulated depreciation.
B.   Additional Paid-in Capital.
C.   Retained Earnings.
D.   Accumulated Deficit.
E.   None of the above.
       Review Question #2
Which classifications are NOT used in a
debtor’s balance sheet issued prior to
adopting fresh start accounting in a
bankruptcy reorganization?

A. Prepetition liabilities—subject to compromise.
B. Prepetition liabilities—not subject to
   compromise.
C. Postpetition liabilities—subject to compromise.
D. Postpetition liabilities—not subject to
   compromise.
             Review Question #2
                    With Answer
Which classifications are NOT used in a debtor’s
balance sheet issued prior to adopting fresh
start accounting in a bankruptcy reorganization?

A. Prepetition liabilities—subject to compromise.
B. Prepetition liabilities—not subject to
   compromise.
C. Postpetition liabilities—subject to
   compromise.
D. Postpetition liabilities—not subject to
   compromise.
      Review Question #3
How is a discharge of indebtedness in a
bankruptcy reorganization that qualifies for
fresh start accounting reported?
A. Extraordinary item in old entity’s statements.
B. Extraordinary item in new entity’s
    statements.
C. A credit to Additional Paid-in Capital.
D. A credit directly to Retained Earnings.
E. An item in Other Comprehensive Income.
        Review Question #3
              With Answer
How is a discharge of indebtedness in a
bankruptcy reorganization that qualifies for
fresh start accounting reported?
A. Extraordinary item in old entity’s
    statements.
B. Extraordinary item in new entity’s
    statements.
C. A credit to Additional Paid-in Capital.
D. A credit directly to Retained Earnings.
E. An item in Other Comprehensive Income.
End of Chapter 19
Time to Clear Things Up—Any
          Questions?