Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 20 Corporations in Financial Difficulty

20-2 Learning Objective 1 Understand the courses of action available to financially distressed firms.

20-3 Overview  A company in financial difficulty has a large number of alternatives. Bankruptcy is only a final course.  A company may petition the courts for bankruptcy to protect itself from an onslaught of legal suits. Some have also attempted to void union contracts by petitioning for bankruptcy. U.S. auto industry?

20-4 Courses of Action  Nonjudicial Actions Formal agreements between the company and its creditors are legally binding but are not administered by a court.  Bankruptcy is the final step for a financially distressed business.

20-5 Nonjudicial Actions  Debt Restructuring Arrangements Extension of due dates of its debt Decrease of the interest rate on the debt Modification of other terms of the debt contract  Composition agreement Creditors agree to accept less than the face amount of their claims

20-6 Nonjudicial Actions  Creditors’ committee management Creditors may agree to “assist” the debtor in managing the most efficient payment of creditors’ claims. Most creditors’ committees are advisory. Counsel closely with the debtor Do not want to assume additional liabilities and problems of actual operation of the debtor Usually initiated with a plan of settlement proposed by the debtor

20-7 Nonjudicial Actions  Transfer of assets Debtors may transfer assets to obtain quick cash Example: Factoring receivables Assets may be sold “with recourse” or “without recourse” A transfer of financial assets is considered a sale only if the transferor has surrendered control over the transferred assets. SFAS 140

20-8 Judicial Actions Bankruptcy is a judicial action administered by bankruptcy courts and bankruptcy judges using the guidance provided in Title 11 of the United States Bankruptcy Code. Chapters of the Bankruptcy Code 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 13Adjustment of Debts of an Individual with Regular Income

20-9 Judicial Actions  Either the debtor or its creditors may decide that a judicial action is best. The debtor may file a voluntary petition seeking judicial protection in the form of an order of relief against the initiation or continuation of legal claims by the creditors. Creditors may file an involuntary petition against the debtor. Certain conditions must exist before creditors may file a petition.

20-10 Practice Quiz Question #1 Which of the following is usually NOT one of the debt restructuring arrangements available to companies in distress? a.Extension of due dates. b.Extension of additional loans from the same lenders to pay off current debt. c.A decrease in interest rates. d.Modification of debt terms. e.None of the above. Which of the following is usually NOT one of the debt restructuring arrangements available to companies in distress? a.Extension of due dates. b.Extension of additional loans from the same lenders to pay off current debt. c.A decrease in interest rates. d.Modification of debt terms. e.None of the above.

20-11 Practice Quiz Question #2 Which of the following statements is true? a.A Chapter 11 bankruptcy leads to the liquidation of the corporation. b.A Chapter 7 bankruptcy leads to the reorganization of the corporation’s debt. c.A Chapter 11 bankruptcy leads to the reorganization of the corporation’s debt. d. A Chapter 7 bankruptcy leads to the adjustments of debt for an individual. Which of the following statements is true? a.A Chapter 11 bankruptcy leads to the liquidation of the corporation. b.A Chapter 7 bankruptcy leads to the reorganization of the corporation’s debt. c.A Chapter 11 bankruptcy leads to the reorganization of the corporation’s debt. d. A Chapter 7 bankruptcy leads to the adjustments of debt for an individual.

20-12 Learning Objective 2 Understand Chapter 11 reorganizations and be able to prepare financial statements for debtors-in- possession as well as a plan of recovery.

20-13 Chapter 11 Reorganizations  Temporary protection from creditors  Allows time needed to reorganize the debtor company return its operations to a profitable level  If granted protection, the company receives an order of relief to suspend making any payments on its prepetition debt  Bankruptcy court administers reorganizations. Can appoint trustees to direct the reorganization

20-14 Chapter 11 Reorganizations  The company continues to operate while it prepares a plan of reorganization.  A disclosure statement is transmitted to all creditors and other parties eligible to vote on the plan of reorganization.  The bankruptcy court then evaluates the responses to the plan from creditors and other parties and either confirms the plan of reorganization or rejects it.

20-15 Chapter 11 Reorganizations  Statement of Position No Provides guidance for financial reporting for companies in reorganization Financial statements should distinguish between transactions and events directly associated with the reorganization and those associated with ongoing operations

20-16 Chapter 11 Reorganizations  Fresh start accounting SOP 90-7 states that fresh start reporting should be used as of the confirmation date of the plan of reorganization if both the following conditions occur: 1.The reorganization value of the assets of the emerging entity immediately before the date of confirmation is less than the total of all postpetition liabilities and allowed claims. 2.Holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity.

20-17 Chapter 11 Reorganizations  Fresh start accounting Compute the reorganization value of the emerging entity’s assets Fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the entity’s assets The reorganization value is then allocated to the assets using the allocation of value method

20-18 Chapter 11 Reorganizations  Fresh start accounting A reorganization value in excess of amounts assignable to identifiable assets is reported as an intangible asset The emerging company’s liabilities are recorded at the present values of the amounts to be paid Any retained earnings or deficits are eliminated A set of final operating statements is prepared just prior to emerging from reorganization In essence, the company is a new reporting entity after reorganization

20-19 Chapter 11 Reorganizations  Companies not qualifying for fresh start accounting should: Determine whether assets are impaired Report liabilities at the present values of the amounts to be paid Any gain or loss on the revaluation of the liabilities can be extraordinary or ordinary Unusual and infrequent = extraordinary

20-20 Chapter 11 Reorganizations  Companies not qualifying for fresh start accounting should: Recognize a liability for a cost associated with an exit or disposal activity when the liability is incurred, not at the earlier time the company makes a commitment to an exit plan LT assets are divided between 1.Those to be held and used and 2.Those to be sold

20-21 Chapter 11 Reorganizations  Plan of reorganization – Components 1.Disposing of unprofitable operations 2.Restructuring of debt with specific creditors 3.Revaluation of assets and liabilities 4.Reductions or eliminations of claims of original stockholders and issuances of new shares to creditors or others

20-22 Practice Quiz Question #3 Which of the following statements is true about fresh start accounting? a.Fresh start accounting focuses on pre- bankruptcy book values. b.Fresh start accounting allows management to revalue assets to any value they feel is “fair and normal.” c.Fresh start accounting is no longer legal in the U.S. d. Fresh start accounting focuses the fair value of assets a willing buyer would pay to acquire them. Which of the following statements is true about fresh start accounting? a.Fresh start accounting focuses on pre- bankruptcy book values. b.Fresh start accounting allows management to revalue assets to any value they feel is “fair and normal.” c.Fresh start accounting is no longer legal in the U.S. d. Fresh start accounting focuses the fair value of assets a willing buyer would pay to acquire them.

20-23 Chapter 11 Reorganizations PRACTICE—E20-2

20-24 Plan of Reorganization EliminationReduction$2 par of Debt SurvivingofCommonStockTotalRecovery and EquityDebtAssets% Value$% Post-petition liabilities (30,000) 100% Claims/Interest: Accounts Payable(80,000) 8,000 (72,000) 90 Notes Payable, 10%(150,000)25,000 (125,000) 83 Related Int. Payable(16,000)16, Bonds Payable, 12%(200,000) 100 Related Interest Payable (24,000) 18,000 (6,000) 25 Total(470,000)67,000 Common shareholders: Common Stock(100,000) 100% (200,000) Additional Paid-In(200,000)171,000 (29,000) Retained Earnings Deficit 178,000 (178,000) Total(622,000) (40,000)(230,000)(203,000)100% (229,000)(662,000)

20-25 (1)Accounts Payable80,000 Notes Payable, 10%150,000 Interest Payable40,000 Cash6,000 Accounts Receivable (net)72,000 Land85,000 Gain on Disposal of Land40,000 Gain on Discharge of Debt67,000 Record discharge of debt. Journal entries to record reorganization

20-26 (1)Accounts Payable80,000 Notes Payable, 10%150,000 Interest Payable40,000 Cash6,000 Accounts Receivable (net)72,000 Land85,000 Gain on Disposal of Land40,000 Gain on Discharge of Debt67,000 Record discharge of debt. (2)Common Stock ($1 par)100,000 Additional Paid-In Capital171,000 Gain on Disposal of Land40,000 Gain on Discharge of Debt67,000 Common Stock ($2 par)200,000 Retained Earnings178,000 Record change in par value of stock and elimination of deficit. Journal entries to record reorganization

20-27 Learning Objective 3 Understand Chapter 7 liquidations and be able to prepare a statement of affairs.

20-28 Chapter 7 Liquidations  Liquidations are administered by the bankruptcy courts in the interests of the corporation’s creditors and shareholders.  The intent in liquidation is to maximize the net dollar amount recovered from disposal of the debtor’s assets.

20-29 Chapter 7 Liquidations  Classes of creditors Secured creditors Have liens, or security interests, on specific assets, often called “collateral” A creditor with such a legal interest in a specific asset has the highest priority claim on that asset Creditors with priority Unsecured creditors having no collateral claim against specific assets but have priority over other unsecured creditors

20-30 Chapter 7 Liquidations  Classes of creditors Unsecured creditors The lowest priority is given to these claims Paid only after secured creditors and unsecured creditors with priority are satisfied Often receive less than the full amount of their claim

20-31 Chapter 7 Liquidations  Statement of Affairs The basic accounting report made at the beginning of the process. Presents the expected realizable amounts from Disposal of the assets, The order of creditors’ claims, and The expected amount that unsecured creditors will receive as a result of the liquidation. A different report, also entitled the “Statement of Affairs,” is a list of questions the debtor must answer as part of the bankruptcy petition.

20-32 Chapter 7 Liquidations  Statement of Affairs An important planning report for the anticipated liquidation of a company. The Statement of Affairs includes Book values of the debtor company’s balance sheet accounts, Estimated fair market values of the assets, Order of the claims, and Estimated deficiency to the general unsecured creditors.

20-33 Practice Quiz Question #4 Which of the following is NOT one of the classes of creditors that could be paid in a Chapter 7 liquidation? a.Secured creditors. b.Unsecured creditors. c.Creditors in jeopardy. d. Creditors with priority. Which of the following is NOT one of the classes of creditors that could be paid in a Chapter 7 liquidation? a.Secured creditors. b.Unsecured creditors. c.Creditors in jeopardy. d. Creditors with priority.

Chapter 7 Liquidations PRACTICE—E

a.Schedule to calculate amount available for general unsecured creditors: Total estimated fair values$471,000 Claims of secured creditors: Notes payable and interest (Receivables and Inventory)$115,000 Bonds payable and interest (Land and Building) 231,000 (346,000) $125,000 Claims of creditors with priority: Wages payable$ 9,500 Taxes payable 14,000 (23,500) Available to general unsecured creditors$101,500 E20-4 Solution 20-35

b.Accounts payable$ 95,000 Notes payable and interest$195,000 Less: Secured by receivables and inventory (115,000) 80,000 Total unsecured claims$175,000 Estimated dividend: $101,500 = 58% $175,000 E20-4 Solution 20-36

b.Accounts payable$ 95,000 Notes payable and interest$195,000 Less: Secured by receivables and inventory (115,000) 80,000 Total unsecured claims$175,000 Estimated dividend: $101,500 = 58% $175,000 c. Group Credit PercentageDistributed Accounts Payable$ 95,00058%$ 55,100 Wages Payable9, ,500 Taxes Payable14, ,000 Notes Payable80, ,400 and Interest115, ,000 Bonds Payable and Interest231, ,000 $471,000 E20-4 Solution 20-37

Book Values Fair Values Amt Avail to Unsecured Claims Estimated G/L on Realization ASSETS: (1) Assets pledged with fully secured creditors 100,000Land80,000(20,000) 220,000Building (net)160,000(60,000) 240,000 Less Bond Payable(220,000) Less Interest on Bonds Payable(11,000) 9,000 (2) Assets pledged with partially secured creditors 60,000Receivables50,000(10,000) 90,000Inventory65,000(25,000) 115,000 Less Notes Payable(190,000) Less Interest on Notes Payable(5,000) (3) Free assets: 16,000Cash16, ,000Equipment100,000 (150,000) Estimated Amount Available 125,000 Less Creditors with Priority (23,500) (a) Net estimated amount available to unsecured creditors: 101,500 Estimated Deficiency 73, ,000(265,000) Total Unsecured Debt from liabilities 175,000 (b) Percent paid out to unsecured creditors:0.58cents on the dollar E20-4 Solution 20-38

Estimated Amount Unsecured LIABIITLIES AND STOCKHOLDERS' EQUITY: (1) Fully Secured Creditors 220,000Bond Payable220,000 11,000Interest Payable11,000 (2) Partially secured creditors 190,000Notes Payable190,000 5,000Interest Payalbe5,000 Less receivables and inventory(115,000) 80,000 (3) Creditors with Priority 9,500Wages Payable9,500 14,000Taxes Payable14,000 23,500 (4) Remaining unsecured creditors 95,000Accounts Payable 95,000 (5) Stockholders' equity 191,500BV of Stockholders' Equity (736, ,500) 736,000(Carry up to asset section) 175,000 E20-4 Solution 20-39

Chapter 7 Liquidations PRACTICE—P

Assets Estimated Amount Available Estimated to Gain BookCurrent Unsecured(Loss) on Value Values Claims Realization (1)Assets pledged with fully secured creditors: $ 50,000 Accounts receivable (net) $ 50,000 Less: 12% note payable and interest (44,000) $ 6,000 80,000 Land $110,000 $ 30, ,000 Plant and equipment (net) 150,000 (12,000) $260,000 Less: Mortgages payable and interest(234,600) 25,400 (2)Assets pledged with partially secured creditors: 30,000 Marketable securities$ 22,000 (8,000) Less: 10% note payable and interest (29,400) 79,000 Inventory$ 75,000 (4,000) Less: Accounts payable(105,000) (3)Free assets: 5,000 Cash$ 5,000 5,000 55,000 Accounts receivable (net)55,000 81,000 Inventory76,000 (5,000) 7,000 Prepaid insurance1,500 (5,500) 250,000 Plant and equipment (net)190,000 (60,000) 72,000 Franchises 30,000 (42,000) Estimated amount available $388,900 Less: Creditors with priority (45,000) Net available to unsecured creditors $343,900 Estimated deficiency 82,500 $871,000$(106,500) Total unsecured debt$426,

Liabilities and Equities Estimated BookAmount ValueUnsecured (1)Fully secured creditors: $ 44,000 12% note payable and interest$ 44, ,600 Mortgages payable and interest 234,600 $278,600 (2)Partially secured creditors: 29,400 10% note payable and interest$ 29,400 Less: Marketable securities (22,000)$ 7, ,000 Accounts payable$105,000 Less: Inventory (75,000)30,000 (3)Creditors with priority: -0- Estimated liquidation expenses$ 13,000 20,000 Wages payable20,000 12,000 Taxes payable 12,000 $ 45,000 (4)Unsecured creditors: 160,000 Accounts payable160, ,000 Notes payable212,000 17,000 Interest payable17,000 (5)Stockholders' equity: 240,000 Common stock (203,000) Retained earnings (deficit) $871,000 $426,400 b. % to unsecured creditors: $343,900= 80.65% $426,

20-43 Learning Objective 4 Understand trustee accounting and reporting.

20-44 Additional Considerations  Trustee accounting and reporting Chapter 11 reorganization: Bankruptcy courts appoint trustees to manage a company under Management fraud, Dishonesty, Incompetence, or Gross mismanagement The trustee then attempts to rehabilitate the business

20-45 Additional Considerations  Trustee accounting and reporting Chapter 7 liquidations: the trustee expeditiously Liquidates the company and Pays creditors in conformity with the legal status In some cases, the court appoints a trustee to operate the company for a short time in an effort to obtain a better price for the company in entirety rather than selling it piecemeal

20-46 Additional Considerations  Trustee accounting and reporting Trustees examine the proof of all creditors’ claims against the debtor company Sometimes the trustee receives title to all assets as a receivership, Becomes responsible for the actual management of the debtor, and must direct a plan of reorganization or liquidation

20-47 Additional Considerations  Trustee accounting and reporting The general form of the trustee’s opening entry, accepting the assets of the debtor company, is as follows: AssetsXXX Debtor Company – In ReceivershipXXX

20-48 Additional Considerations  Trustee accounting and reporting Statement of realization and liquidation a monthly report prepared for the bankruptcy court shows the results of the trustee’s fiduciary actions

20-49 Additional Considerations  Sections of the statement of realization and liquidation

20-50 Practice Quiz Question #5 Which of the following is NOT true about bankruptcy trustees? a.Trustees are often appointed in a Chapter 11 bankruptcy when management cannot be trusted. b.Trustees can be considered voluntary employees of the company. c.In a Chapter 7 bankruptcy, the trustee liquidates the company and pays the creditors. d. In a Chapter 11 bankruptcy, the trustee attempts to rehabilitate the business. Which of the following is NOT true about bankruptcy trustees? a.Trustees are often appointed in a Chapter 11 bankruptcy when management cannot be trusted. b.Trustees can be considered voluntary employees of the company. c.In a Chapter 7 bankruptcy, the trustee liquidates the company and pays the creditors. d. In a Chapter 11 bankruptcy, the trustee attempts to rehabilitate the business.

Conclusion The End 20-51