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.

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

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. The Bankruptcy Reform Act of 1978 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. 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.

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

Involuntary Bankruptcy Creditors file petition with the court. Can force company into liquidation under Chapter 7 or receiving protection under Chapter 11. 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. Involuntary Bankruptcy Creditors file petition with the court. Can force company into liquidation under Chapter 7 or receiving protection under Chapter 11. Voluntary Bankruptcy 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.

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. 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!) If the court accepts the petition, it grants an order for relief that halts all actions against the debtor. A trustee is appointed to oversee the bankruptcy process. 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!!)

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

Classification of Creditors Net realizable value of the collateral exceeds the amount of the obligation. These creditors are completely protected by the pledged property. Fully Secured Partially Secured Unsecured The value of the collateral covers only a portion of the obligation. The remainder is considered unsecured. Some debts are identified as fully secured to indicate that the net realizable value of the collateral exceeds the amount of the obligation. Despite the debtor’s insolvency, these creditors will not suffer loss; they are completely protected by the pledged property. Any money received from the asset that is in excess of the balance of the debt is then used to pay unsecured creditors. Conversely, a liability is partially secured if the value of the collateral covers only a portion of the obligation. The remainder is considered unsecured; the creditor risks losing some or all of this additional amount. For example, a bank might have a $90,000 loan due from an insolvent party that is protected by a lien attached to land valued at $64,000. This debt is only partially secured; the asset would not satisfy $26,000 of the balance. This residual portion is reported to the court as unsecured. All other liabilities are unsecured; these 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. Obviously, unsecured creditors are in a precarious position. Unless a debtor’s assets greatly exceed secured liabilities (which is unlikely in most insolvency cases), these creditors can expect significant losses if liquidation proves to be necessary. Hence, one of the most important aspects of the bankruptcy laws is the ranking of unsecured claims. 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.

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

Account for a company as it enters bankruptcy Learning Objective 13-5 Account for a company as it enters bankruptcy 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. At the start of bankruptcy proceedings, the debtor normally prepares a statement of financial affairs. This schedule provides information about the company’s current financial position and helps all parties as they consider what actions to take. It is especially important in assisting unsecured creditors as they decide whether to push for reorganization or liquidation.

Statement of Financial Affairs Debtor’s assets and liabilities are reported according to the classifications relevant to a 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 helps creditors decide between reorganization and liquidation for debtor. 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.

Account for the liquidation of Learning Objective 13-6 Account for the liquidation of a company in bankruptcy especially when using the liquidation basis of accounting. 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. Compiles all financial records. Obtains possession of all corporate records. A committee of 3 - 11 unsecured creditors is appointed to help protect the group’s interest. Selection of committee helps ensure fairness and protect the creditor group’s interests. Consults with trustee concerning estate administration Makes recommendations regarding trustee’s performance Submits questions affecting estate administration to court 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 3 - 11 unsecured creditors is appointed to help protect the group’s interest.

Liquidation Basis of Accounting April 2013 - FASB issued Accounting Standards Update No. 2013‐07: “Liquidation Basis of Accounting,” which is to take affect for annual reporting periods beginning after December 15, 2013. 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 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. April 2013 - FASB issued Accounting Standards Update No. 2013‐07: “Liquidation Basis of Accounting,” which is to take affect for annual reporting periods beginning after December 15, 2013. FASB addresses four essential questions about a company being liquidated.

Liquidation Basis of Accounting 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. From that time forward, financial reporting for the liquidating entity must include a statement of changes in net assets in liquidation to report all changes during the period of reporting in the net assets available for distribution to investors and other claimants. Because the company is going out of business, an income statement or a statement of comprehensive income probably serves little purpose. In addition, the company must issue a statement of net assets in liquidation to allow all interested parties to gain information about the net assets that are available for distribution.

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

Reorganization - Chapter 11 Bankruptcy The company is temporarily protected from its creditors. Creditors are encouraged to negotiate new terms with the company. Control of the company is normally maintained by the owners (“debtor in possession”) Workers keep their jobs. Suppliers keep their customers. Customers maintain their source of supply. A plan of reorganization must be put forth within 120 days and approved within 180 days by the debtor in possession. Reorganization Chapter 11 Bankruptcy Control of the company is normally maintained by the owners (“debtor in possession”) Creditors often take over as new owners. Workers keep their jobs. Suppliers keep their customers. Customers maintain their source of supply.

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. Reorganization Chapter 11 Bankruptcy Acceptance of a reorganization plan requires approval of: Two-thirds of the dollar amount and more than one-half of the creditors who cast votes Two-thirds of each class of stockholders who cast votes 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.

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

Financial Reporting During Reorganization FASB’s Accounting Standards Codification Topic 852, Reorganizations, requires financial statements be prepared: During the reorganization and When entity emerges from reorganization. Gains, losses, revenues and expenses of reorganization are reported separately from normal operations on the income statement. Assets are still reported at book value. Liabilities are shown as current versus non-current Except for liabilities subject to reduction - reported separately at the amount of the claims. Financial Reporting During Reorganization FASB’s Accounting Standards Codification Topic 852, Reorganizations, requires financial statements be prepared During the reorganization and When entity emerges from reorganization. Gains, losses, revenues and expenses of the reorganization are reported separately. 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 the bankruptcy is reported separately as a reorganization item. A new entity is not created when a company moves into reorganization. Therefore, traditional generally accepted accounting principles continue to apply. Assets, for example, should still be reported at their book values. However, a successful reorganization plan will likely reduce payments to be made on many liabilities. In addition, because of the order for relief, the current/noncurrent classification system is no longer applicable; payments may be delayed for years. Thus, in reporting the liabilities of a company in reorganization, debts subject to compromise (possible reduction by the court through acceptance of a reorganization plan) must be disclosed separately. Unsecured and partially secured obligations existing as of the granting of the order for relief fall into this category. Fully secured liabilities and all debts incurred subsequent to that date are not subject to compromise and must be reported in a normal manner as either a current or noncurrent liability. Liabilities that are subject to compromise must be shown at the expected amount of allowable claims rather than an estimated settlement amount. Thus, the company does not have to anticipate the payment required by a final plan but simply discloses the amount of these claims

Learning Objective 13-9 Describe the financial reporting for a company that successfully exits bankruptcy as a reorganized entity. 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. Original owners are left with less than 50% of voting stock. Assets are restated to individual current value. Liabilities (except deferred income taxes) are stated at present value of future cash payments. Normally, APIC is adjusted to balance. Retained Earnings is set to zero. According to U.S. GAAP, such assets and liabilities should be adjusted to fair value if two criteria are met: 1. The total reorganization (or fair) value of the assets of the emerging company is less than the total of the allowed claims as of the date of the order for relief plus liabilities incurred subsequently. 2. The previous owners of the voting stock are left with less than 50 percent of the voting stock of the company when it emerges from bankruptcy. Reporting liabilities following a reorganization also creates a concern because many Of these balances will be reduced and the payment period extended. Consequently, all liabilities (except for deferred income taxes) are reported at the present value of the future cash payments. In making the necessary asset adjustments to fresh start accounting, Additional Paid-In Capital is normally increased or decreased. However, any write-down of a liability creates a recognized gain. Finally, because the company is viewed as a new entity, it must leave reorganization with a zero balance reported for retained earnings.