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: – 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. #1

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

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?