©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter 14 Bankruptcy: Liquidation and Reorganization

2 Scope of Chapter Reasons for Business Failures The Bankruptcy Code Bankruptcy Liquidation Bankruptcy Reorganization

3 Reasons For Bankruptcy Poor Management. Excessive Debt. Inadequate Accounting. Inability to pay liabilities as they become due.

4 Reasons For Bankruptcy Unsecured Creditors often resort to lawsuits to satisfy their unpaid claims. Secured Creditors may force foreclosure proceedings for real property or may repossess personal property that collateralizes a security agreement.

5 Reasons For Bankruptcy Internal Revenue Services may seize the assets, for failure to pay FICA and income taxes withheld from employees. A business enterprise may be unable to pay its liabilities even though the current fair values of its assets exceed its liabilities.

6 Reasons For Bankruptcy An enterprise may experience a severe cash shortage in times of price inflation because of the lag between the purchase or production of goods at inflated costs and the recovery of the inflated costs through increased selling prices. State of insolvency.

7 Insolvent Means With reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity’s debts is greater than all of its property, at a fair valuation exclusive of –. 1. Property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors; and. 2. Property that may be exempted from property of the estate under … this title.

8 Insolvent Means With reference to a partnership, financial condition such that the some of such partnership’s debts is greater than the aggregate of, at fair valuation –. – All of such partnership’s property, exclusive of property of the kind specified in subparagraph 1 above; and. – The sum of the excess of the value of each general partner’s non-partnership property, exclusive of property of the kind specified in subparagraph 2 above, over such partner’s non-partnership debts;

9 Insolvent Means The terms insolvent and bankruptcy often are used as interchangeable adjectives. Such usage technically is incorrect. Insolvent refers to the financial condition of a person or business enterprise. Bankrupt refers to the legal state of a person or business enterprise.

10 The Bankruptcy Code For the first 89 years under the constitution, the United States had a national bankruptcy law for a total of only 16 years. During the periods in which national bankruptcy laws were not in effect, state laws on insolvency prevailed.

11 The Bankruptcy Code In 1898 a Bankruptcy Act was enacted that as amended, remained in effect for 80 years. This made state laws on insolvency to be relatively dormant. In 1978 the Bankruptcy Reform Act established the present Bankruptcy Code.

12 The Bankruptcy Code In 1980 the Bankruptcy Tax Act established a uniform group of income tax rules for bankruptcy and insolvency. In 1994 the Bankruptcy Code was amended by the Bankruptcy Reform Act of 1994.

13 The Bankruptcy Code The U.S. Supreme Court may prescribe by general rules the various legal practices and procedures under the Bankruptcy Code. Thus, the Federal Rules of Bankruptcy Procedures established by the Supreme Court constitute important interpretations of provisions of the Bankruptcy Code.

14 Bankruptcy Liquidation The process of bankruptcy liquidation under Chapter 7 of the Bankruptcy Code involves the realization (sale) of the assets of an individual or a business enterprise and the distribution of the cash proceeds to the creditors of the individual or enterprise.

15 Bankruptcy Liquidation Creditors having security interests collateralized by specific assets of the debtor generally are entitled to obtain satisfaction of all or part of their claims from the assets pledged as collateral.

16 Bankruptcy Liquidation The Bankruptcy Code provides for priority treatment for certain unsecured creditors; their claims are satisfied in full, if possible, from proceeds of realization of the debtor’s non-collateralized assets. Unsecured creditors without priority receive cash, in proportion to the amounts of their claims.

17 Bankruptcy Liquidation Thus, there are four classes of creditors in a bankruptcy liquidation: – Fully secured creditors. – Partially secured creditors. – Unsecured creditors with priority. – Unsecured creditors without priority.

18 Debtor’s (Voluntary) Petition Under chapter 7 of Bankruptcy Code, any person may file petition in a federal bankruptcy court for voluntary liquidation. Certain entities such as a rail road, an insurance company, a bank, a credit union, or a savings and loan association can not file voluntary petition under chapter 7.

19 Debtor’s (Voluntary) Petition The voluntary petition must be accompanied by supporting documents exhibiting petitioner’s debts and property. The debts are classified as –. – Creditors having priority. – Creditors holding security. – Creditors having unsecured claims without priority.

20 Debtor’s (Voluntary) Petition The debtor’s property is reported as follows –. – Real Property. – Personal Property. – Property claimed as exempt. Valuations of property are at market or current fair values. The debtor’s bankruptcy petition must also be accompanied by statement of financial affairs (different from accounting statement).

21 Creditors’ (Involuntary) Petition If a debtor other than a farmer, a nonprofit organization, or one of the types precluded from filing voluntary petitions owes amounts to 12 or more unsecured creditors who are not employees, relatives, stockholders, or other “insiders”, three or more of the creditors having unsecured claims totaling $ 10,000 or more may file in a federal bankruptcy court a creditors’ petition for bankruptcy, also known as an involuntary petition.

22 Creditors’ (Involuntary) Petition If fewer than 12 creditors are involved, one or more creditors having unsecured claims of $ 10,000 or more may file the petition. The creditors’ petition for bankruptcy must claim either. – The debtor is not paying debts as they come due or. – Within 120 days prior to the date of the petition, a custodian was appointed for or had taken possession of the debtor’s property.

23 Unsecured Creditors With Priority The following unsecured debts are to be paid in full, in the order specified if adequate cash is not available for all, out of a debtor’s estate before any cash is paid to other unsecured creditors: 1.Administrative Costs.

24 Unsecured Creditors With Priority 2.Claims arising after the commencement of a creditors’ bankruptcy proceeding but before appointment of a trustee or order for relief. 3.Claims for wages, salaries, and commissions, including vacation, severance, and sick leave pay not in excess of $ 4,000 per claimant, earned within 180 days before the date of filing the petition for bankruptcy.

25 Unsecured Creditors With Priority 4. Claims for contributions to employee benefit plans arising within 180 days before the date of filing the petition. The limit of such claim is $ 4,000 times the number of employees covered by the plans, less the aggregate amount paid to the covered employees under priority 3 above.

26 Unsecured Creditors With Priority 5.Claims by producers of grain or fishermen against storage or processing facilities, not in excess of $ 4,000 per claimant. 6.Claims for cash deposited for goods or services for the personal, family, or household use of the depositor, not in excess of $1,800 per claimant.

27 Unsecured Creditors With Priority 7.Claims for alimony, maintenance, or support of a spouse, former spouse, or child of the debtor, under a separation agreement, divorce decree, or court order. 8.Claims of governmental entities for various taxes, subject to varying time limitations.

28 Property Claimed As Exempt Certain property of petitioner is not included in the debtor’s estate. Residential Property. Life Insurance Policies payable upon death to spouse or relative.

29 Roles of Court, Creditors & Trustee The federal bankruptcy court oversees all aspects of bankruptcy proceedings. The first acts of the court is either to dismiss the petition or to grant an order for relief under the bankruptcy code. The court appoints an interim trustee after the order for relief, to serve permanently or until a trustee is elected by the creditors.

30 Roles of Court, Creditors & Trustee Within 10 to 30 days after the order for relief, court calls a meeting of the creditors. At the meeting, the “outsider” creditors appoint a trustee to manage the debtor’s estate. The trustee assumes custody of the debtor’s nonexempt property.

31 Roles of Court, Creditors & Trustee Trustee continues the operation of debtor’s business if directed by the court. Trustee realizes the free assets of the operating the debtor’s estate, and pay cash to unsecured creditors. The trustee is responsible for keeping accounting records to enable the filing of a final report with the court.

32 Roles of Court, Creditors & Trustee The bankruptcy code empowers the trustee to invalidate a preference, – defined as the transfer of cash or property to an “outsider” creditor for an existing debt, made while the debtor was insolvent and within 90 days of filing the bankruptcy petition, provided the transfer caused the creditor to receive more cash or property than would be receive in the bankruptcy liquidation. The trustee may recover from the creditor the cash or property constituting the preference and include it in the debtor’s estate.

33 Discharge of Debtor Once the debtor’s property has been liquidated, all secured and priority creditors’ claims have been paid, and all remaining cash has been paid to unsecured and non-priority creditors: – the debtor mar receive a discharge, defined as a release of debtor from all un-liquidated debts, except followings:

34 Discharge of Debtor – The taxes payable to United States or any state or subdivision, including taxes attributable to improper preparation of tax returns. – Debts resulting from the debtor.’ – Debts resulting from the debtor’s obtaining money or property under false pretense or willful conversion of the property of others. – Debts arising from embezzlement or other fraudulent acts of debtor.

35 Discharge of Debtor – Amounts payable for alimony, maintenance or child support. – Debts for willful and malicious injuries to the persons or property of others. – Debts for fines, penalties, or forfeitures payable to governmental entities, other than for tax penalties. – With certain exceptions, debts for educational loans made, insured, or guaranteed by governmental entities or by nonprofit universities or colleges.

36 Discharge of Debtor A debtor will not be discharged if any crimes, misstatements, or other malicious acts were committed by the debtor in connection with the court proceedings. In addition, a debtor will not be discharged if the current bankruptcy petition was filed within six years of a previous bankruptcy discharge to the same debtor.

37 The Statement of Affairs The accountant’s role in liquidation is concerned with proper reporting of the financial condition of the debtor and adequate accounting and reporting of the debtor’s estate. A business enterprise that enters bankruptcy liquidation is a quitting concern, not a going concern. The financial statement designed for a business enterprise entering liquidation is the statement of affairs.

38 The Statement of Affairs The purpose of the statement of affairs is to display the assets and liabilities of the debtor enterprise from a liquidation viewpoint. The assets displayed in the statement of affairs are valued at current fair values; carrying amounts are presented on a memorandum basis. Assets and liabilities are classified according to the rankings and priorities set forth in the Bankruptcy Code.

39 Accounting & Reporting for Trustees The accounting records of the debtor should be used during the period that a trustee carries on the operations of the debtor’s business. An accountability technique should be used once the trustee begins realization of the debtor’s assets. The interim and final reports of the trustee to the bankruptcy court are a statement of cash receipts and payments, a statement of realization and liquidation, supporting exhibits of assets not yet realized and liabilities not yet liquidated.

40 Bankruptcy Reorganization Chapter 11 of bankruptcy code provides for the court-supervised reorganization of a debtor business enterprise. Reorganization involves the reduction of amounts payable to some creditors, other creditors’ acceptance of equity securities of the debtor for their claims, and revision of the par or stated value of the common stock of the debtor.

41 Bankruptcy Reorganization A debtor’s petition for reorganization may be filed by a railroad or by any “person” eligible to petition for liquidation except a stockbroker or a commodity broker. Requirements for creditors’ petition for reorganization are the same as those for a liquidation petition.

42 Bankruptcy Reorganization During the process of reorganization, management or owner of the business enterprise may continue to operate the enterprise as debtor in possession. Alternatively, the bankruptcy court may appoint a trustee to manage the enterprise.

43 Bankruptcy Reorganization A trustee is appointed because of fraud, dishonesty, incompetence, or gross mismanagement by current owners or managers. A trustee may be appointed to protect the interests of creditors or stockholders of the enterprise. In some reorganization cases an examiner to investigate possible fraud or mismanagement by the current management.

44 Bankruptcy Reorganization Among the powers and duties of the trustee are the following: – Prepare and file in court a list of creditors of each class and their claims and a list of stockholders of each class. – Investigate the acts, conduct, property, liabilities, and business operations of the enterprise, consider the desirability of continuing operations, and formulate a plan for such continuance for submission to the bankruptcy judge. – Report to the bankruptcy judge any facts ascertained as to fraud against or mismanagement of the debtor enterprise.

45 Plan & Accounting for Reorganization The plan of reorganization submitted by the management or trustee to the bankruptcy court is given to the debtor enterprise’s creditors and stockholders, to the U.S. Secretary of the Treasury, and possibly to the SEC.

46 Plan & Accounting for Reorganization The plan must include provisions altering or modifying the interests and rights of the creditors and stockholders, as well as a number of additional provisions. SEC may review the plan and may be heard in the bankruptcy court’s consideration of the plan.

47 Plan & Accounting for Reorganization Before the plan is confirmed by court, it must be accepted by a majority of creditors, whose claims must account for two-thirds of the total liabilities, and by stockholders owning at least two-thirds of the outstanding capital stock of each class. If one or more classes of stockholders or creditors has not accepted a plan, the bankruptcy court may confirm the plan if the plan is fair and equitable to the non- acceptors.

48 Plan & Accounting for Reorganization The accounting for a reorganization typically requires: – journal entries for adjustments of carrying amounts of assets; – reductions of par or stated value of capital stock; – extensions of due dates and revisions of interest rates of notes payable; – exchanges of equity securities for debt securities; and the elimination of a retained earnings deficit.

49 Plan & Accounting for Reorganization The elimination of a retained earnings is associated with fresh start reporting for a reorganized enterprise whose liabilities exceed the reorganization value of its assets. Because of changes in the ownership of common stock of such an enterprise, it is no longer controlled by former stockholder group, and it is a new reporting enterprise.

50 Plan & Accounting for Reorganization Accountants must be careful to avoid charging post- reorganization operations with losses that arose before the reorganization. Disclosure of Reorganization: The elaborate and often complex issues involved in a bankruptcy reorganization are disclosed in a note to the financial statements for the period in which the plan of reorganization was carried out. The reorganized Company will account for the Reorganization Plan utilizing the `Fresh Start’ reporting principles contained in SOP 90-7