Understanding Bankruptcy and Reorganizations in Accounting

1. Chapter Thirteen Accounting for Legal Reorganizations and Liquidations

2. Bankruptcy • A basic assumption of accounting theory is that a business is a going concern. • Occasionally, a business becomes insolvent; i.e., unable to pay its bills. • An insolvent business can either cease to exist, or can seek a legal remedy called bankruptcy.

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

4. Bankruptcy Reform Act of 1978 Strives to achieve two goals in connection with insolvency cases: • the fair distribution of assets to creditors, and • the discharge of an honest debtor from debt.

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

6. Bankruptcy Reform Act of 1978 Voluntary Bankruptcy • The company files the petition with the court requesting bankruptcy. • When facing the prospect severe losses or a difficult operating environment, companies will seek voluntary Chapter 11.

7. Bankruptcy Reform Act of 1978 Involuntary Bankruptcy • The company’s creditors file the petition with the court. • This can result in the company being forced into liquidation under Chapter 7 or receiving protection under Chapter 11.

8. Criteria for Forcing Involuntary Bankruptcy

9. Court Response to the Involuntary Petition • If the petition is not rejected by the court, an order of relief is issued. • The order of relief halts all actions against the debtor. • A trustee is appointed to oversee the bankruptcy process.

10. Classification of Creditors Fully Secured Partially Secured Unsecured With Priority Unsecured Top Priority Each level must be paid in full prior to making distributions to the next level. Common and preferred stockholders get what’s left over.

11. Unsecured Creditors with Priority • Administrative costs related to liquidating the company. • Debts arising between the filing date and the issuance of an order of relief. • Employee claims for wages earned during the 90 days prior to filing. Limited to $4,650 per employee. • Employee benefit plan claims during the 180 days prior to filing. Limited to $4,650 per employee. • Customer deposits. Limited to $2,100 per customer. • Government claims for unpaid taxes.

12. Prepared at the start of the proceedings. Helps the creditors to decide whether to push for reorganization or liquidation. Statement of Financial Affairs 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.

13. Liquidation - A Chapter 7 Bankruptcy Interim Trustee is appointed by the court. • Changes locks. • Posts notices. • Notifies U.S. Post Office to forward all mail to trustee. • Opens a new bank acount (in the trustee’s name). • Compiles all financial records. • Obtains possession of all corporate records. An advisory committee of 3 - 11 unsecured creditors is appointed.

14. Role of the Trustee Has possession and control of the debtor’s assets. Can void property transfers made 90 days prior to the petition filing. Appointed by the court; approved by the creditors. Prepares the statement of realization and liquidation.

15. Statement of Realization and Liquidation Prepared by the trustee. Used to track the process of liquidating a company’s assets. Not required by GAAP. • Included Information • Account balances as of the date of the Order of Relief. • Cash receipts generated by sale of property. • Cash disbursements by the trustee. • Write-offs and recognition of previously unrecorded liabilities.

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

17. ReorganizationChapter 11 Bankruptcy • Workers get to keep their jobs. • Suppliers get to keep their customer. • Customers get to maintain their source of supply. A legal way to “salvage” a company rather than to liquidate it.

18. ReorganizationChapter 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 the company’s operations. • Plans for getting additional monetary resources. • Plans for changes in management of the company. • Plans to settle debts that existed when the order of relief was issued.

19. ReorganizationChapter 11 Bankruptcy • Acceptance of a reorganization plan requires approval of: • 2/3 of the $ amount and more than 1/2 of the creditors • 2/3 of each class of stockholders • If plan is turned down, the court can force its acceptance in a “cram down”. • As a final alternative, the court can convert a Chapter 11 Bankruptcy to a Chapter 7 Liquidation at any time.

20. ReorganizationChapter 11 Bankruptcy Financial Reporting During Reorganization • Gains/losses, revenues/expenses resulting from the reorganization process are reported separately. • Liabilities are restated. • Current/noncurrent classification not applicable.

21. Fresh Start Accounting Per SOP 90-7, when a company emerges from Chapter 11, fresh start accounting can be used if 2 conditions are met: • The FMV of the assets < the total of the allowed claims as of the order of relief. • The original owners are left with < 50% of the voting stock.

22. Fresh Start Accounting Fresh Start Accounting • Assets are restated to FMV. • Liabilities are stated at discounted present value. • R/E is stated at zero. • A balancing account is used; called Reorganization value in excess of amounts allocable to identifiable assets.

23. End of Chapter 13 Reorganize this, Hu-mon!