McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20 Corporations in Financial Difficulty

20-2 Companies in Financial Difficulty A company in financial difficulty has a large number of alternatives, of which bankruptcy is only a final course. This chapter presents the range of major actions typically used by a company experiencing financial problems.

20-3 Reasons for Financial Difficulty Companies get into financial difficulty for a large variety of reasons: –Continued losses from operations –Overextended credit to customers –Poor management of working capital –Inadequate financing –Failure to react to changes in economic conditions

20-4 Liquidity Problems—A Vicious Cycle Failing to make a sufficient level of sales, a company cannot obtain adequate financing, then begins to miss debt payments, and the vicious cycle of financial difficulty is under way. At this point, outside creditors may decide to exercise their claims and demand payment of their receivables.

20-5 Alternative Courses of Action The debtor company has a number of alternative courses open to it: –Reach an agreement with its creditors to postpone required payments. –Turn its assets over to its creditors to liquidate. –Take the legal remedy of bankruptcy.

20-6 Other Reasons for Bankruptcy A company may petition the courts for bankruptcy for other reasons, such as to protect itself from an onslaught of legal suits. Several companies have also attempted to void union contracts by petitioning for bankruptcy. The courts are still defining the exact limits of bankruptcy, and each case must be decided individually.

20-7 Courses of Action Nonjudicial Actions: Formal agreements between the company and its creditors are legally binding, but are not administered by a court. Examples: Debt Restructuring and Voluntary Asset Assignment. Judicial Actions: Bankruptcy is a judicial action administered by bankruptcy courts and bankruptcy judges provided in the Bankruptcy Reform Act of 1978 (hereafter, Bankruptcy Reform Act).

20-8 The Bankruptcy Reform Act The Bankruptcy Reform Act provides for two major alternatives under the protection of the bankruptcy court. These two alternatives are often known by the chapters of the Bankruptcy Reform Act: – Chapter 11 Reorganization – Chapter 7 Liquidation.

20-9 Chapter 11 Reorganization Under a Chapter 11 reorganization, the debtor is provided judicial protection for a rehabilitation period during which it can eliminate unprofitable operations, obtain new credit, develop a new company structure with sustainable operations, and work out agreements with its creditors.

20-10 Chapter 7 Liquidation A Chapter 7 liquidation is often administered by a trustee appointed by the court. Under a Chapter 7 liquidation, the debtor’s assets are sold and its liabilities extinguished as the business is liquidated.

20-11 Reorganization versus Liquidation The major difference between a reorganization and a liquidation is that the debtor continues as a business after a reorganization, whereas the business does not survive a liquidation.

20-12 Creditor Accounting for Impaired Loans FASB 114 presents the creditor’s accounting and disclosure standards for impaired loans, including notes receivable. A loan is defined as being impaired when it is probable that the creditor will not be able to collect all amounts due under the loan agreement.

20-13 Measurement of Impaired Loans If the loan is collateral-dependent, that is, the creditor determines that foreclosure is probable, the loan value should be measured by using the fair value of the collateral. Otherwise, impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate at the point of origination of the loan.

20-14 Troubled Debt Restructuring The most common form of troubled debt restructuring is a modification of the debt terms to alleviate the short-term cash needs of the debtor. For example, the creditor may reduce the current interest rate, forgive some of the accrued interest or principal, or modify some other term of the debt agreement.

20-15 Troubled Debt Restructuring Another common form of troubled debt restructuring is the creditor’s acceptance of assets or equity with a fair value less than the amount of the debt. For example, the creditor may accept land with a fair value of $50,000 in exchange for extinguishing a debt of $65,000, because the creditor feels the $50,000 is the maximum amount it will be able to collect.

20-16 Restructuring Difference (Debtor) In order to calculate the restructuring difference (i.e., gain or loss on restructuring), the debtor compares the carrying value of the debt with the total future cash flows related to the debt, or with the fair value of the consideration exchanged in extinguishment of that debt (see FASB 15).

20-17 Restructuring Difference (Creditor) Under FASB 114, the creditor accounts for a troubled debt restructuring as an impairment of a loan. In order to calculate the restructuring difference (i.e., gain or loss on restructuring), the creditor compares the carrying value of the debt with the present value of the estimated total future cash flows, or with the fair value of the consideration exchanged in extinguishment of that debt.

20-18 Restructuring Gains The gain on the restructuring of debt is reported on the debtor’s income statement according to the criteria in APB 30. Stated otherwise, if the gain is material, is of an unusual nature, and has an infrequency of occurrence, then it is reported as an extraordinary item.

20-19 Restructuring Gains Note that FASB 145 rescinded FASB 4. FASB 4 had required extinguishment of debt gains to generally be reported as extraordinary items. Thus, these gains are now typically reported as part of continuing operations.

20-20 Restructuring Gains Not all negotiations of debt covenants are troubled debt restructurings; the restructuring must be a concession granted to a debtor in financial difficulties. Renegotiations between a debtor and a creditor because of changes in the competitive general economic environment are not troubled debt restructurings and are not included in FASB 15 and FASB 114.

20-21 Contingent Payments Some restructuring agreements contain provisions for contingent payments. For example, the agreement may specify that the debtor must pay an additional amount if its future net income exceeds a certain level. At the time of the restructuring agreement, contingent amounts should be included in the estimated total future cash payments by both the debtor and creditor if the conditions in FASB 5 have been met.

20-22 Chapter 11 Reorganization Chapter 11 of the of the Bankruptcy Reform Act allows for legal protection from creditors’ actions during a time needed to reorganize the debtor company and return its operations to a profitable level. Reorganizations are administered by the bankruptcy court, and trustees are often appointed by the court to direct the reorganization.

20-23 Chapter 11 Reorganization A company in financial distress petitions the bankruptcy court for protection form its creditors. If granted protection, the company receives an order of relief to suspend making any payments on its prepetition debt. The company continues to operate while it prepares a plan of reorganization, which serves as an operating guide during the reorganization. The proceeding includes the actions that take place from the time the petition is filed until the company completes the reorganization.

20-24 Chapter 11 Reorganization SOP 90-7 provides guidance for financial reporting for companies in reorganization. The financial statements issued by a company during Chapter 11 proceedings should distinguish transactions and events directly associated with the organization with those associated with ongoing operations. SOP 90-7 requires that financial statements clearly reflect the unique circumstances related to the organization.

20-25 Fresh Start Accounting A set of final financial statements is prepared just prior to emerging from reorganization. Thereafter, the company may use “Fresh Start Accounting” if both of the following conditions occur (see next slide).

20-26 Fresh Start Accounting (Ch. 11 Reorg.) 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. This implies that the prior shareholders have lost control of the emerging company.

20-27 Plan of Reorganization Most reorganization plans include detailed discussions of the following: –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.

20-28 Unsuccessful Reorganizations The major reason for unsuccessful reorganizations is continuing losses from operations and no reasonable likelihood of rehabilitation. Another common reason is the inability to consummate a reorganization plan because of the failure to dispose of an unprofitable subsidiary (etc.). The debtor company then moves from reorganization into liquidation.

20-29 Chapter 7 Liquidations Liquidations are administered by the bankruptcy courts. The intent in liquidation is to maximize the net dollar amount recovered from disposal of the debtor’s assets. Bankruptcy courts appoint accountants, attorneys, or experienced business managers as trustees to administer the liquidation. The liquidation process is often completed within 6 to 12 months, during which the trustees must make periodic reports to the bankruptcy court.

20-30 Classes of Creditors A very important aspect of liquidation is determining the legal rights of each creditor and establishing priorities for those rights. The Bankruptcy Reform Act specifies three classes of creditors, whose claims have the following priorities: (1) secured creditors, (2) creditors with priority, and (3) unsecured creditors. The priority of claims determines the order and source of payment to each creditor.

20-31 Secured 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. For example, a mortgage payable is secured by the company’s land and plant.

20-32 Creditors with Priority Creditors with a priority are unsecured creditors, that is, those having no collateral claim against specific assets, who have priority over other unsecured creditors. Creditors with priority are the first to be paid from any proceeds available to unsecured creditors. Any remaining monies are then distributed to the general unsecured creditors.

20-33 Summary--Creditors with Priority Costs of administering the bankruptcy, including accounting and legal costs for experts appointed by the bankruptcy court. Liabilities arising in the ordinary course of business during the bankruptcy proceedings. Certain wages, salaries, or commissions. Certain contributions to employee benefit plans. Certain deposits of customers. Unsecured tax claims of government units.

20-34 General Unsecured Creditors The lowest priority is given to claims by general unsecured creditors. These creditors are paid only after secured creditors and unsecured creditors with priority are satisfied to the extent of any legal limits. Often, the general unsecured creditors receive less than the full amount of their claim.

20-35 Statement of Affairs The accounting statement of affairs is the basic accounting report made at the beginning of the liquidation process to present the expected realizable amounts from disposal of the assets, the order of creditors’ claims, and the expected amount unsecured creditors will receive as a result of the liquidation.

20-36 Statement of Affairs The statement of affairs presents the balance sheet accounts in order of priority for liquidation. The statement of affairs presents estimated current fair values and expected gains or losses on the disposal of the assets.

20-37 Trustee Accounting and Reporting Bankruptcy courts appoint trustees to manage a company under Chapter 11 reorganizations in cases of management fraud, dishonesty, incompetence, or gross mismanagement. the trustee then attempts to rehabilitate the business.

20-38 Trustee Accounting and Reporting In Chapter 7 liquidations, the trustee normally has the responsibility to expeditiously liquidate the bankrupt company and pay creditors in conformity with the legal status of their secured or unsecured interests.

20-39 Receivership 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. A trustee who takes title to the debtor’s assets in a liquidation must make periodic financial report to the bankruptcy court, reporting on the progress of the liquidation and on the fiduciary relationship held.

20-40 Statement of Realization and Liquidation A monthly report, called a statement of realization and liquidation, is prepared for the bankruptcy court. It shows the results of the trustee’s fiduciary actions beginning at the point the trustee accepts the debtor’s assets. The statement has three major sections: Assets Supplementary items liabilities

20-41 Statement of Realization and Liquidation The statement presents the assets transferred to the trustee, the additional assets acquired by the trustee, and the ending balance of unrealized assets still to be converted into cash. The statement also reports on the debtor’s liabilities discharged by the trustee as well as the additional liabilities incurred by the trustee. Supplementary charges include the trustee’s administration fees and any cash expenses paid by the trustee. Supplementary credits may include any unusual revenue items.

20-42 Bankruptcy Provisions for Individuals In addition to Chapter 7 bankruptcies, individuals have the opportunity to use the provisions of Chapter 13 of the Bankruptcy Reform Act, entitled “Adjustment of Debts of an Individual with Regular Income.” An individual may file for bankruptcy only once every seven years.

20-43 You Will Survive This Chapter !!! The major difference between a reorganization (Chapter 11) and a liquidation (Chapter 7) is that the debtor continues as a business after a reorganization, whereas the business does not survive a liquidation. AVOID PERSONAL BANKRUPTCY !!! (Chapter 13 of the Bankruptcy Reform Act)

McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 20 End of Chapter