Accounting for Legal Reorganizations and Liquidations Chapter Thirteen Accounting for Legal Reorganizations and Liquidations McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Bankruptcy 13-2 A basic assumption of accounting is that a business is a going concern (will remain in business). Occasionally, a business becomes insolvent (unable to pay debts as they come due). An insolvent business can either cease to exist, or can seek a legal remedy called bankruptcy.

What happens to a business when it fails? 13-3 Who gets the assets? Are the creditors protected? If the assets are sold, who gets the money? How it the business failure reported?

Bankruptcy Reform Act of 1978 (as amended) 13-4 Strives to achieve two goals in connection with insolvency cases: 1) the fair distribution of assets to creditors, and 2) the discharge of an honest debtor from debt.

Bankruptcy Reform Act of 1978 13-5 Two basic forms of filings Voluntary Bankruptcy Involuntary Bankruptcy

Court Response to the Petition 13-6 Neither a voluntary nor involuntary petition automatically creates a bankruptcy. Court may reject voluntary petitions if the action is considered detrimental to the creditors Court may reject involuntary petitions unless evidence indicates the debtor’s inability to meet obligations as they come due (slowness of payment is NOT sufficient cause!!)

Court Response to the Petition 13-7 If the court accepts the petition, it grants an order for relief. The order for relief halts all actions against the debtor. This automatic stay prohibits creditors from collecting debts without the court’s permission A trustee is appointed to oversee the bankruptcy process.

Classification of Creditors 13-8 Each level must be paid in full prior to making distributions to the next level. Top Priority Fully Secured Partially Secured Unsecured With Priority Unsecured Stockholders get what’s left over.

Unsecured Liabilities Having Priority 13-9 Administrative costs related to liquidation Debts arising between the filing date and the issuance of an order of relief. Employee claims for wages earned and/or benefit plan contributions earned during the 180 days prior to filing (limit $10,950 per employee, each claim). Customer deposits. Limited to $2,425 per customer. Government claims for unpaid taxes.

Reorganization or Liquidation? 13-10 How will the debtor be discharged from their obligations? Under Chapter 7, the debtor’s assets will be liquidated and the proceeds distributed to to creditors (based on their priority status) OR Under Chapter 11, the debtor will be permitted to reorganize and continue operations. (These “chapters” refer to the relevant sections of the Bankruptcy Reform Act)

Reorganization - Chapter 11 Bankruptcy 13-11 A legal way to “salvage” a company rather than liquidate it. The company is temporarily protected from its creditors. Creditors are encouraged to negotiate new terms with the company.

Reorganization Chapter 11 Bankruptcy 13-12 Control of the company is normally maintained by the owners (“debtor in possession”) Workers keep their jobs. Suppliers keep their customers. Customers maintain their source of supply.

Reorganization Chapter 11 Bankruptcy 13-13 Financial Reporting During Reorganization Gains, losses, revenues and expenses resulting from the reorganization process are reported separately. Liabilities are restated. Current versus noncurrent classification not applicable.

Fresh Start Accounting 13-14 Fresh Start Accounting Assets are restated to current market value. Liabilities are stated at the discounted present value of future cash payments. R/E is set to zero. Normally, APIC is adjusted to balance.