Chapter Thirteen Accounting for Legal Reorganizations and Liquidations Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective 13-1 Describe the history and current status of bankruptcy and bankruptcy laws. 13-2

Bankruptcy 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. 13-3

Accounting for Legal Reorganizations and Liquidations What happens to a business when it fails? Who gets the assets? If the assets are sold, who gets the money? Are the creditors protected? How is the business failure reported? 13-4

Size of Recent American Bankruptcies Total Assets Company Bankruptcy Date (in Billions) Lehman Brothers 07/15/2008 $691 Washington Mutual 09/26/ WorldCom 07/21/ General Motors 06/01/ CIT Group 11/01/ Enron 12/02/ Conseco 12/17/ MF Global Holdings, LTD 10/31/ Chrysler 04/30/ Thornburg Mortgage 05/01/

Bankruptcy Reform Act of 1978 The Act 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. 13-6

Learning Objective 13-2 Explain the difference between a voluntary and involuntary bankruptcy. 13-7

Company files a petition with courts requesting bankruptcy. When facing prospect of severe losses or a difficult operating environment, companies will seek voluntary Chapter 11. Bankruptcy Reform Act of 1978 Creditors file petition with the court. Can force company into liquidation under Chapter 7 or receiving protection under Chapter 11. Involuntary BankruptcyVoluntary Bankruptcy 13-8

Criteria for Forcing Involuntary Bankruptcy When there are 12 or more unsecured creditors:  At least 3 must sign the petition  Those that sign must have total unsecured debts of at least $15,325 If there are fewer than 12:  Only 1 must sign  The minimum debt limit remains $15,325  (Debt limit balances are adjusted every three years based on the Consumer Price Index) 13-9

Court Response to the Petition  Neither a voluntary nor involuntary petition automatically creates a bankruptcy.  Bankruptcy Court may reject voluntary petitions if the action is considered detrimental to the creditors.  Bankruptcy 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!!) 13-10

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

Learning Objective 13-3 Identify the various types of creditors as they are labeled during a bankruptcy

Fully Secured Partially Secured Unsecured Classification of Creditors Net realizable value of the collateral exceeds the amount of the obligation. These creditors are completely protected by the pledged property. The value of the collateral covers only a portion of the obligation. The remainder is considered unsecured. All other liabilities are unsecured; creditors have no legal right to any of the debtor’s specific assets. They are entitled to share only in any funds that remain after all secured claims have been settled

1. 1. 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 $12,475 per employee, each claim) Customer deposits. Limited to $2,775 per customer Government claims for unpaid taxes. Unsecured Liabilities Having Priority 13-14

Learning Objective 13-4 Describe the difference between a Chapter 7 bankruptcy and a Chapter 11 bankruptcy

Liquidation or Reorganization? How will the debtor be discharged from its obligations?   Under Chapter 7, the debtor’s assets will be liquidated and the proceeds distributed 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) 13-16

Learning Objective 13-5 Account for a company as it enters bankruptcy

Statement of Financial Affairs  To begin bankruptcy proceedings, the debtor normally prepares a statement of financial affairs.  This schedule provides information on the company’s current financial position to help all parties determine the actions to take.  It is especially important to unsecured creditors to decide whether to push for reorganization or liquidation

Assets labeled as:   Pledged with fully secured creditors.   Pledged with partially secured creditors.   Available for priority liabilities and unsecured creditors. Debts labeled as:   Liabilities with priority.   Fully secured creditors.   Partially secured creditors.   Unsecured creditors. Statement of Financial Affairs Debtor’s assets and liabilities are reported according to the classifications relevant to a liquidation

Learning Objective 13-6 Account for the liquidation of a company in bankruptcy especially when using the liquidation basis of accounting

Liquidation - Chapter 7 Bankruptcy Interim Trustee is appointed by court.   Changes locks, and secures assets and records.   Posts notices that assets are in possession of US trustee.   Compiles all financial records.   Obtains possession of all corporate records A committee of unsecured creditors is appointed to help protect the group’s interest

Committee of Creditors  Consults with the trustee concerning estate administration  Makes recommendations regarding the trustee’s performance  Submits to the court questions affecting estate administration  (The selection of this committee is to help ensure fairness and to protect the creditor group’s interests.) 13-22

Appointed by the court; approved by the creditors. Has possession and control of the debtor’s assets. Can void property transfers made 90 days prior to the petition filing. Prepares the statement of realization and liquidation. Role of the Trustee Charged with preserving the assets and preventing loss of the estate 13-23

Trustee tracks the liquidation of a company’s assets. Statement of Realization and Liquidation Included Information 1. 1.Account balances at the date on which the Order for Relief was filed Cash receipts generated by sale of property Cash disbursements by the trustee Write-offs and recognition of previously unrecorded liabilities

April FASB issued Accounting Standards Update No ‐ 07: “Liquidation Basis of Accounting,” which is to take affect for annual reporting periods beginning after December 15, FASB addresses four essential questions about a company being liquidated. Liquidation Basis of Accounting 13-25

1 When is a company viewed as actually being in liquidation so that the liquidation basis of accounting is applied? 2 At a minimum, what statements should be reported during liquidation to be in conformity with U.S. GAAP? 3 How should the liquidating company’s assets be reported during this period? 4 How should the liquidating company’s liabilities be reported during this period? Liquidation Basis of Accounting 13-26

Liquidation basis is first applied when liquidation becomes imminent, that is: 1. when a plan has been approved by the court or by people who have such authority and 2. 2.the chance that the plan will be blocked or that the entity will return from liquidation is remote. Proper approval of the plan is usually the point at which the liquidation basis becomes required by U.S. GAAP. Liquidation Basis of Accounting 13-27

Financial reporting for the liquidating entity:   must include a statement of changes in net assets in liquidation to investors and other claimants.   An income statement or a statement of comprehensive income serves little purpose.   Company must issue a statement of net assets in liquidation to allow all interested parties to gain information about the net assets available for distribution. Liquidation Basis of Accounting 13-28

Liquidation Basis of Accounting On the Statement of Net Assets:   assets are reported at the estimated amount of cash (or other consideration) expected as a result of the liquidation process (a figure not necessarily the same as fair value).   all of the assets of the company that can be used to generate cash during the liquidation process are reported

Liquidation Basis of Accounting Liabilities:   No attempt is made to anticipate the legal release that might come from the bankruptcy process.   liabilities continue to be reported as normal unless actual changes take place.   the company should accrue the estimated costs to dispose of its assets as well as other costs that are expected

Learning Objective 13-7 List the provisions that are often found in a bankruptcy reorganization plan

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

Reorganization - Chapter 11 Bankruptcy  Control of the company is normally maintained by the owners (“debtor in possession”)  Creditors may take over as new owners.  Workers keep their jobs.  Suppliers keep their customers.  Customers maintain their source of supply

Reorganization - Chapter 11 Bankruptcy A plan of reorganization must be put forth within 120 days and approved within 180 days by the debtor in possession. Examples include Plans:  Proposing changes in company’s operations.  For generating additional monetary resources.  For changes in management of the company.  To settle debts that existed when the order of relief was issued

Reorganization - Chapter 11 Bankruptcy Acceptance of reorganization plan requires approval by:  Two-thirds of the dollar amount and more than one-half of the creditors who vote  Two-thirds of each class of stockholders who vote  Confirmation by the court  The court can also force acceptance of a plan that was voted down (known as a “cram down”).  As a final alternative, the court can convert a Chapter 11 Bankruptcy to a Chapter 7 Liquidation at any time

Learning Objective 13-8 Account for a company as it moves through reorganization

Financial Reporting During Reorganization Reorganization raises specific accounting questions :  Differentiating income from operations and transactions connected to the reorganization  Reporting debt  Reporting basis of assets due to reorganization FASB’s Accounting Standards Codification Topic 852, Reorganizations, requires financial statements be prepared  During the reorganization and  When entity emerges from reorganization

The Income Statement During Reorganization  Gains, losses, revenues and expenses of the reorganization are reported separately from normal operations on the income statement.  Interest does not usually accrue on the debt owed as of the date of reorganization.  Interest revenue that would not have been earned except for bankruptcy is reported separately as a reorganization item

Balance Sheet During Reorganization  Assets are still reported at book value.  Current versus noncurrent classification not applicable for liabilities subject to reduction by the court’s acceptance of the plan.  These liabilities should be reported separately at the amount of the claims.  Liabilities not subject to reduction are all shown as current versus non-current

Learning Objective 13-9 Describe the financial reporting for a company that successfully exits bankruptcy as a reorganized entity

Fresh Start Reporting When a company emerges from Chapter 11, GAAP permits fresh start reporting if two conditions are met: 1. The reorganization (or market) value of the assets are less than the total of the allowed claims as of the date of the order for relief plus any subsequent liabilities. 2. The original owners are left with less than 50% of the voting stock

Fresh Start Accounting  Assets are restated to individual current value.  Liabilities (except deferred income taxes) are stated at the present value of future cash payments.  Normally, APIC is adjusted to balance.  Retained Earnings is set to zero