CHAPTER 19

1. CHAPTER 19 BANKRUPTCY REORGANIZATIONS AND LIQUIDATIONS

2. FOCUS OF CHAPTER 19 • Bankruptcy Statutes • Bankruptcy Reorganizations • Liquidations • Accounting by Trustees

3. Bankruptcy Statutes: Their Significance • Under the bankruptcy statutes, a company is placed under the protection of the bankruptcy court.This means that: • Creditors are prevented from taking legal action individually otherwise available to them. • Creditors’ legal rights are thus suspended for an indefinite period.

4. Bankruptcy Statutes: Their Significance • When a corporation is in bankruptcy proceedings, the bankruptcy judge controls the company. • A subsidiary in bankruptcy proceedings cannot be consolidated by its parentbecause the parent has lost control.

5. Bankruptcy Statutes: Applicability • Thebankruptcy statutes apply to: • Individuals. • Partnerships. • Corporations. • Municipalities.

6. Bankruptcy Statutes: Applicability • Thebankruptcy statutes do not apply to: • Insurance companies. • Certain financial institutions, such as banks and savings and loans, which are subject to alternative regulations.

7. Bankruptcy Statutes: Types of Petitions • A company can file for bankruptcy protectionby filing a voluntary petition. • A company’s creditors can file an involuntary petition if the debtor: • Is generally NOT paying its debts as they become due or • Has appointed a custodian orgiven possession of its property to a custodian.

8. Bankruptcy Statutes: Creditors With Priority • A special class of creditors created by the bankruptcy statutes is called “creditors with priority.” • These creditors are given statutory priority over the claims of other unsecured creditorswith regard to payment.

9. Bankruptcy Statutes: Creditors With Priority • Creditors Claims With Priority: • Administrative expenses related to the bankruptcy proceeding (postpetition claims). • Wages, salaries, and commissions earned within 90 days before the bankruptcy filing (up to $4,000 per employee). • Employee benefit plan claims (specified). • Depositsby individuals. • Taxes.

10. Bankruptcy Statutes: Chapter 7 Vs. Chapter 11 • Chapter 7 of the Bankruptcy Statutes: • Deals with liquidations: • Sell the assets, pay the creditors, close down the business. • Chapter 11 of the Bankruptcy Statutes: • Deals with reorganizations: • Certain debts are forgiven & the company is able to get a “fresh start.”

11. Bankruptcy Statutes: Chapter 11 Vs. Troubled Debt Restructuring • Filing for bankruptcy reorganizationis a last resort short of liquidation. • Most companies prefer to attempt a troubled debt restructuring outside of the bankruptcy court. Advantages are: • Can be done in far less time. • Avoids the stigma of having gone through bankruptcy proceedings.

12. Chapter 11 BankruptcyReorganizations: Management’s Role • In a Chapter 11 bankruptcy filing, the debtor’s management usually: • Continues to manage and operate the company. • Develops a plan of reorganization,to be submitted to creditors and the bankruptcy court.

13. Chapter 11 BankruptcyReorganizations:Debt Forgiveness • If the creditors approve of any plan of reorganization, certain debt is forgiven. • Formally, this is referred to as a“discharge of indebtedness.” • Certain debt cannot be discharged under the bankruptcy statutes, such as: • Taxes • Debt incurred under false pretenses.

14. Chapter 11 BankruptcyReorganizations:Accounting Issues • The Accounting Issues: • How to calculate whether any debt has been forgiven. • This issue includes whether interest should be imputed. • How to report a forgiveness of debt.

15. Chapter 11 BankruptcyReorganizations: Accounting Issues • These are the identical issues that exist in troubled debt restructurings, which are governed by FAS 15. • However, the AICPA’s SOP 90-7, which applies exclusively to bankruptcy reorganizations applies—NOT FAS 15.

16. Chapter 11 BankruptcyReorganizations: SOP 90-7 • The central idea of SOP 90-7 is that the entity that emerges from Chapter 11 be deemed a new entity for which fresh-start financial statements should be prepared. • No beginning retained earnings or deficit (deficits usually exist) is reported. • A small percentage of entities emerging from Chapter 11 will not qualify for fresh-start accounting under SOP 90-7.

17. Chapter 11 BankruptcyReorganizations: SOP 90-7 • Under SOP 90-7, comparative financial statements that straddle a confirmation date cannot be presented because it would be an inappropriate comparison of: • A former entityand • A new entity.

18. Chapter 11 BankruptcyReorganizations: SOP 90-7 • Under SOP 90-7, any forgiveness of debt (“discharge of indebtedness”) is: • Calculated by determining the present value of amounts to be paid using appropriate current interest rates. • Reported as an extraordinary item in the predecessor entity’s final statement of operations.

19. Chapter 11 BankruptcyReorganizations: SOP 90-7 • Under SOP 90-7, all assets are restated to reflect their fair value at the date of reorganization. Three steps are required: • Determining the “reorganization value” of the entity—an amount that approximates what a “willing buyer” would pay for the assets of the emerging entity immediately afterthe restructuring. #1

20. Chapter 11 BankruptcyReorganizations: SOP 90-7 • Allocating the reorganization value to the entity’s tangible and intangible assets. • Reporting any unallocated value as goodwill (subsequently to be evaluated periodically for impairment). #2 #3

21. Chapter 11 BankruptcyReorganizations: SOP 90-7 • Under SOP 90-7, the “old entity” prior tothe confirmation date is to report: • Bankruptcy related losses and expenses in a separate “REORGANIZATIONS ITEMS” category in its statement of operations.

22. Chapter 11 BankruptcyReorganizations: SOP 90-7 • Also under SOP 90-7, the “old entity” prior to the confirmation date is to report IN ANY BALANCE SHEETS ISSUED, its liabilitiesin the following specified categories: • PRE PETITION liabilities subject to compromise, • PRE PETITION liabilities notsubject to compromise (priority), and • POST PETITION liabilities (priority).

23. Chapter 7 Bankruptcy Liquidations • In a Chapter 7 filing (for liquidation). the court usually appoints a trustee to liquidate the company. • Trustees have the power tovoidfraudulent and preferential transfers made by the debtor within certain specified periods preceding the filing date.

24. Chapter 7 Bankruptcy Liquidations • In a Chapter 7 filing, a special statement (called the “statement of affairs”)is prepared on a “quitting concern” basis. • This statement provides information concerning how much money each class of creditors canexpect to receive on liquidation of the company. • This is a pro forma (“as if ”) statement.

25. Accounting By Trustees • If the court or creditors desire information that discloses the trustee’s responsibility for the book balances existing when the trustee was appointed, a statement of realization and liquidation can be prepared. • This is a historical statement in its entirety (nothing pro forma about it).

26. Review Question #1 Which accounts are adjusted to a zero balance in a bankruptcy reorganization that qualifies for fresh start accounting?A. Accumulated depreciation. B. Additional Paid-in Capital. C. Retained Earnings. D. Accumulated Deficit. E. None of the above.

27. Review Question #1With Answer Which accounts are adjusted to a zero balance in a bankruptcy reorganization that qualifies for fresh start accounting?A. Accumulated depreciation. B. Additional Paid-in Capital. C. Retained Earnings.D. Accumulated Deficit.E. None of the above.

28. Review Question #2 Which classifications are NOT used in a debtor’s balance sheet issued prior to adopting fresh start accounting in a bankruptcy reorganization?A. Prepetition liabilities—subject to compromise.B. Prepetition liabilities—not subject to compromise.C. Postpetition liabilities—subject to compromise.D. Postpetition liabilities—not subject to compromise.

29. Review Question #2With Answer Which classifications are NOT used in a debtor’s balance sheet issued prior to adopting fresh start accounting in a bankruptcy reorganization?A. Prepetition liabilities—subject to compromise.B. Prepetition liabilities—not subject to compromise.C. Postpetition liabilities—subject to compromise.D. Postpetition liabilities—not subject to compromise.

30. Review Question #3 How is a discharge of indebtedness in a bankruptcy reorganization that qualifies for fresh start accounting reported? A. Extraordinary item in old entity’s statements. B. Extraordinary item in new entity’s statements. C. A credit to Additional Paid-in Capital. D. A credit directly to Retained Earnings. E. An item in Other Comprehensive Income.

31. Review Question #3With Answer How is a discharge of indebtedness in a bankruptcy reorganization that qualifies for fresh start accounting reported? A. Extraordinary item in old entity’s statements. B. Extraordinary item in new entity’s statements. C. A credit to Additional Paid-in Capital. D. A credit directly to Retained Earnings. E. An item in Other Comprehensive Income.

32. End of Chapter 19 Time to Clear Things Up—Any Questions?