Irwin/McGraw-Hill 1 22 © The McGraw-Hill Companies, Inc., 1999 Corporations in Financial Difficulty Baker / Lembke / King

Irwin/McGraw-Hill 2  Debt restructuring arrangements  Creditors’ committee management  Transfer of assets  Debt restructuring arrangements  Creditors’ committee management  Transfer of assets Nonjudicial Actions

Irwin/McGraw-Hill 3  Chapter 1General Provisions  Chapter 3Case Administration  Chapter 5Creditors, the Debtor, and the Estate  Chapter 7Liquidation  Chapter 9Adjustment of Debts of a Municipality  Chapter 11Reorganization  Chapter 12Adjustment of Debts of a Family Farmer with Regular Annual Income  Chapter 13 Adjustment of Debts of an Individual with Regular Income  Chapter 1General Provisions  Chapter 3Case Administration  Chapter 5Creditors, the Debtor, and the Estate  Chapter 7Liquidation  Chapter 9Adjustment of Debts of a Municipality  Chapter 11Reorganization  Chapter 12Adjustment of Debts of a Family Farmer with Regular Annual Income  Chapter 13 Adjustment of Debts of an Individual with Regular Income Judicial Actions

Irwin/McGraw-Hill 4 Creditor Accounting for Impaired Loans On December 31, 20X5, Creditor Company holds an unsecured 10 percent note receivable for $30,000 from Peerless Products Corporation due on December 31, 20X6. The interest of $3,000 is currently in default. Creditor Company determines as of December 31, 20X5, that is it probable that the loan from Peerless Products will not be collected in full. The best estimate of the amount that will collected on December 31, 20X6, is $23,000.

Irwin/McGraw-Hill 5 Creditor Accounting for Impaired Loans Step 1: Determine if the loan is impaired by comparing its carrying value with the present value of the estimated future cash flows (effective interest rate, 10 percent). Carrying value of the loan: Principal$ 30,000 Accrued interest 3,000 Carrying amount$33,000 Present value of total future cash flows: Estimated total future cash flows$ 23,000 Present value factor for 10%, 1 yearx ,909 Creditor loss on impaired loan$12,091

Irwin/McGraw-Hill 6 Creditor Accounting for Impaired Loans Step 2: On December 31, 20X5, make entries to recognize the impaired loan receivable. The December 31, 20X5 balance sheet Impaired Note Receivable, including interest of $3,000$33,000 Less: Valuation Allowance for Impaired Loan-12,091 Present Value of Impaired Loan$20,909 Bad Debt Expense12,091 Valuation Allowance for Impaired Loans12,091 Impaired Notes Receivable30,000 Notes Receivable30,000

Irwin/McGraw-Hill 7 Creditor Accounting for Impaired Loans It is important to note that Peerless Products will not make any entries for the impaired loan.

Irwin/McGraw-Hill 8 Creditor Accounting for Impaired Loans On December 31, 20X6, Creditor Company will recognize interest revenue using the effective interest method. Accrued Interest Receivable ($30,000 x.10)3,000 Valuation Allowance for Impaired Loans909 Interest Revenue ($20,909 PV x.10)2,091 The balance in the valuation account is now $13,000 ($12,091 plus $909). Creditor Company receives only the $23,000 it had estimated. Cash23,000 Valuation Allowance for Impaired Loans13,000 Impaired Notes Receivable30,000 Accrued Interest Receivable6,000

Irwin/McGraw-Hill 9 Troubled Debt Restructuring On December 31, 20X6, the company has an unsecured current liability of $30,000 to Creditor Company, on which $3,000 interest has been accrued and is unpaid. Peerless Products Corporation has been negotiating with Creditor Company to restructure the current debt of $33,000 ($30,000 + $3,000).

Irwin/McGraw-Hill 10 Troubled Debt Restructuring Alternative 1: Transfer of cash in full settlement Carrying value of the debt: Principal$30,000 Accrued interest (10% for 1 year) 3,000$33,000 Cash flows(27,000) Restructuring difference (debtor = creditor)$ 6,000 The entry on Peerless Products books-- Notes Payable30,000 Accrued Interest Payable3,000 Cash27,000 Gain on Restructure of Debt6,000 Extraordinary if material

Irwin/McGraw-Hill 11 Troubled Debt Restructuring The entry required for Creditor Company-- Cash27,000 Allowance for Doubtful Accounts6,000 Notes Receivable30,000 Accrued Interest Receivable3,000 If creditor company had not provided adequately for uncollectible receivables, the bad debts expense account is debited instead of allowance for doubtful accounts.

Irwin/McGraw-Hill 12 Troubled Debt Restructuring Alternative 2: Transfer of noncash assets in settlement of debt Carrying value of the debt: Principal$30,000 Accrued interest (10% for 1 year) 3,000$33,000 Fair value of assets transferred(26,000) Restructuring difference (debtor = creditor)$ 7,000 Peerless Products agrees to transfer inventory with a book value of $45,000 and a fair value of 26,000 to Creditor Company in full settlement of the $33,000 debt.

Irwin/McGraw-Hill 13 The entry on Peerless Products’ books-- Notes Payable30,000 Accrued Interest Payable3,000 Loss on Disposal of Inventory19,000 Inventory45,000 Gain on Restructuring of Debt7,000 Troubled Debt Restructuring The entry on the creditor’s books-- Inventory26,000 Allowance for Uncollectibles7,000 Notes Receivable30,000 Accrued Interest Receivable3,000

Irwin/McGraw-Hill 14  Reduction of the stated interest rate for the remainder of the original debt.  Extension of the maturity date of the original debt at the lower rate of interest.  Reduction of part of the face amount of the original debt.  Reduction in the accrued interest.  Reduction of the stated interest rate for the remainder of the original debt.  Extension of the maturity date of the original debt at the lower rate of interest.  Reduction of part of the face amount of the original debt.  Reduction in the accrued interest. Troubled Debt Restructuring Alternative 3: Modification of terms

Irwin/McGraw-Hill 15  CV≤TFCV : No Gain or Loss; future interest.  CV> TFCF : Debtor Gain; no future interest.  CV≤TFCV : No Gain or Loss; future interest.  CV> TFCF : Debtor Gain; no future interest. Troubled Debt Restructuring Alternative 3: Modification of terms For Debtor

Irwin/McGraw-Hill 16 Troubled Debt Restructuring Case A: Carrying value of debt greater than modified total future cash flows--debtor gain and creditor loss (expense) recognized. Peerless Products Corporation, the debtor, owes $30,000 principal plus $3,000 accrued interest to Creditor. On December 31, 20X6, the two entities agree to the following modification of terms: 1.Forgive accrued interest of $3, Reduce the interest rate from 10 percent to 5 percent. 3.Extend the maturity date for one additional year to December 31, 20X7.

Irwin/McGraw-Hill 17 Carrying value of the debt: Principal$ 30,000 Interest 3,000 Carrying value of the debt$ 33,000$33,000 $33,000 Total future estimated cash flows: Total future principal$ 30,000 Total future contractual interest 1,500 Total future estimated cash flows$ 31,500(31,500) Present value factor, 10%, 1 yearx Present value of future cash flows$ 28,636(28,636) Restructuring difference$ 1,500 $ 4,364 Troubled Debt Restructuring Debtor Creditor

Irwin/McGraw-Hill 18 The entry on Peerless Products’ books-- Accrued Interest Payable3,000 Notes Payable (10%)30,000 Restructured Debt Payable (5%)31,500 Gain on Restructuring of Debt1,500 Troubled Debt Restructuring The entries on the creditor’s books-- Allowance for Uncollectibles4,364 Accrued Interest Receivable3,000 Valuation Allowance for Impaired Loans1,364 Impaired Notes Receivable (5%)30,000 Notes Receivable (10%)30,000

Irwin/McGraw-Hill 19 Troubled Debt Restructuring Case B: Carrying value of debt less than modified future cash flows; no gain recognized by the debtor. Peerless Products Corporation, the debtor, owes $30,000 principal plus $3,000 accrued interest to Creditor. On December 31, 20X6, the two entities agree to the following modification of terms: 1.Forgive accrued interest of $ Reduce the interest rate from 10 percent to 5 percent. 3.Extend the maturity date for one additional year to December 31, 20X7.

Irwin/McGraw-Hill 20 Carrying value of the debt: Principal$ 30,000 Interest 3,000 Carrying value of the debt$ 33,000$33,000 $33,000 Total future estimated cash flows: Total future principal$ 30,000 Remaining accrued interest not forgiven2,500 Total future contractual interest ($30,000 x.05 x 1 year) 1,500 Total future estimated cash flows$ 34,000(34,000) Present value factor, 10%, 1 year x Present value of total future cash flows$ 30,909(30,909) Restructuring difference$(1,000)$ 2,091 Troubled Debt Restructuring Debtor Creditor

Irwin/McGraw-Hill 21 The entry for Peerless Products’ books-- Accrued Interest Payable3,000 Notes Payable (10%)30,000 Restructured Debt Payable (5%)33,000 Troubled Debt Restructuring The entries on the creditor’s books-- Allowance for Uncollectibles2,091 Accrued Interest Receivable500 Valuation Allowance for Impaired Loans1,591 Impaired Notes Receivable (5%)30,000 Notes Receivable (10%)30,000

Irwin/McGraw-Hill 22 Troubled Debt Restructuring On December 31, 20X7, Peerless Products Corporation must pay $33,000 to extinguish the restructured debt and $1,000 interest expense. The entry on Peerless Products’ books-- Interest Expense1,000 Restructured Debt Payable (5%)33,000 Cash34,000

Irwin/McGraw-Hill 23 Troubled Debt Restructuring On December 31, 20X7, Peerless Products Corporation must pay $33,000 to extinguish the restructured debt and $1,000 interest expense. The entries on the creditor’s books-- Cash4,000 Valuation Allowance for Impaired Loans1,591 Accrued Interest Receivable2,500 Interest Revenue3,091 Cash30,000 Impaired Notes Receivable30,000 Click on this button for more information about Interest Revenue

Irwin/McGraw-Hill 24  Pre-petition liabilities subject to compromise as part of the reorganization proceedings should be reported separately from liabilities not subject to compromise.  The liabilities should be reported at the expected amount to be allowed by the bankruptcy court. If no estimate is possible, then the claims should be disclosed in the footnotes.  Pre-petition liabilities subject to compromise as part of the reorganization proceedings should be reported separately from liabilities not subject to compromise.  The liabilities should be reported at the expected amount to be allowed by the bankruptcy court. If no estimate is possible, then the claims should be disclosed in the footnotes. Chapter 11 Reorganization The balance sheet of a company in reorganization has the following special attributes:

Irwin/McGraw-Hill 25  Income statement amounts directly related to the reorganization, such as legal fees and losses on disposal of assets, should be reported separately as reorganization items in the period incurred.  Some of the interest income earned during reorganization is a result of the debtor not being required to pay debt and thus investing the available resources in interest-bearing sources. Such interest income should be reported separately as a reorganization item.  Earnings per share is disclosed, but any anticipated changes to the number of common shares or common stock equivalents outstanding as of a result of the reorganization plan should be disclosed.  Income statement amounts directly related to the reorganization, such as legal fees and losses on disposal of assets, should be reported separately as reorganization items in the period incurred.  Some of the interest income earned during reorganization is a result of the debtor not being required to pay debt and thus investing the available resources in interest-bearing sources. Such interest income should be reported separately as a reorganization item.  Earnings per share is disclosed, but any anticipated changes to the number of common shares or common stock equivalents outstanding as of a result of the reorganization plan should be disclosed. Chapter 11 Reorganization The income statement of a company in organization has the following special requirements:

Irwin/McGraw-Hill 26  The reorganization value of assets of emerging entity immediately before the date of confirmation is less than the total of all postpetition liabilities and allowed claims.  Holders of existing voting shares immediately before confirmation receive less than 50% of voting shares of emerging entity. This implies that the prior shareholder have lost control of emerging company.  The reorganization value of assets of emerging entity immediately before the date of confirmation is less than the total of all postpetition liabilities and allowed claims.  Holders of existing voting shares immediately before confirmation receive less than 50% of voting shares of emerging entity. This implies that the prior shareholder have lost control of emerging company. Chapter 11 Reorganization Fresh Start Accounting :

Irwin/McGraw-Hill 27 Chapter 11 Reorganization

Irwin/McGraw-Hill 28 Chapter 11 Reorganization

Irwin/McGraw-Hill 29 Chapter 11 Reorganization

Irwin/McGraw-Hill 30 Chapter 11 Reorganization

Irwin/McGraw-Hill 31 Chapter 11 Reorganization

Irwin/McGraw-Hill 32 (1) Assets pledged with fully secured creditors (2) Assets pledged with partially secured creditors (3) Free assets Chapter 7 Liquidation Statement of Affairs Assets: (1) Fully secured creditors (2) Partially secured creditors (3) Creditors with priority (4) Remaining unsecured creditors Liabilities:

Irwin/McGraw-Hill 33 (1) Cost of administering bankruptcy – accounting & legal (2) Liabilities arising from normal business during proceeding (3) Wages, salalries, or commissions – last 180 days (4) Employee benefit plan contribution – last 180 days (5) Deposit of customer. (6) Tax claim Chapter 7 Liquidation Creditor with priority

Irwin/McGraw-Hill 34 Chapter 7 Liquidation

Irwin/McGraw-Hill 35 Chapter 7 Liquidation

Irwin/McGraw-Hill 36 Chapter 7 Liquidation

Irwin/McGraw-Hill 37The End EndThe Chapter Twenty-Two