Corporations in Financial Difficulty

1. Chapter 20 Corporations in Financial Difficulty

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

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?

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.

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

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

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

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.

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.

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

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. • A Chapter 7 bankruptcy leads to the adjustments of debt for an individual.

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.

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

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.

15. Chapter 11 Reorganizations • Statement of Position No. 90-7 • 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

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: • 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. • Holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity.

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

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

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. 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 • Those to be held and used and • Those to be sold

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

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. • Fresh start accounting focuses the fair value of assets a willing buyer would pay to acquire them.

23. Chapter 11 Reorganizations PRACTICE—E20-2

24. Plan of Reorganization

25. Journal entries to record reorganization

26. Journal entries to record reorganization

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

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.

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

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

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.

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.

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. • Creditors with priority.

34. Chapter 7 Liquidations PRACTICE—E20-4

35. E20-4 Solution

36. E20-4 Solution

37. E20-4 Solution

38. E20-4 Solution

39. E20-4 Solution

40. Chapter 7 Liquidations PRACTICE—P20-7

43. Learning Objective 4 Understand trustee accounting and reporting.

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

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

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

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: Assets XXX Debtor Company – In Receivership XXX

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

49. Additional Considerations • Sections of the statement of realization and liquidation

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. • In a Chapter 11 bankruptcy, the trustee attempts to rehabilitate the business.