© The McGraw-Hill Companies, Inc., 2004 Slide 13-1 McGraw-Hill/Irwin Chapter Thirteen Accounting for Legal Reorganizations and Liquidations

© The McGraw-Hill Companies, Inc., 2004 Slide 13-2 McGraw-Hill/Irwin 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 13-3 McGraw-Hill/Irwin What happens to a business when it fails? Who gets the assets? Are the creditors protected? How it the business failure reported? If the assets are sold, who gets the money?

© The McGraw-Hill Companies, Inc., 2004 Slide 13-4 McGraw-Hill/Irwin 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 13-5 McGraw-Hill/Irwin Bankruptcy Reform Act of 1978 Two basic forms of filings Voluntary Bankruptcy Involuntary Bankruptcy

© The McGraw-Hill Companies, Inc., 2004 Slide 13-6 McGraw-Hill/Irwin 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. 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. Bankruptcy Reform Act of 1978

© The McGraw-Hill Companies, Inc., 2004 Slide 13-7 McGraw-Hill/Irwin 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. 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. Bankruptcy Reform Act of 1978

© The McGraw-Hill Companies, Inc., 2004 Slide 13-8 McGraw-Hill/Irwin Criteria for Forcing Involuntary Bankruptcy

© The McGraw-Hill Companies, Inc., 2004 Slide 13-9 McGraw-Hill/Irwin Court Response to the Involuntary Petition order of relief 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Fully Secured Partially Secured Unsecured With Priority Unsecured Top Priority Classification of Creditors Common and preferred stockholders get what’s left over. Each level must be paid in full prior to making distributions to the next level.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin 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. Unsecured Creditors with Priority

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Assets labeled as: Pledged with fully secured creditors. Pledged with partially secured creditors. Available for priority liabilities and unsecured creditors. 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. Liabilities with priority. Fully secured creditors. Fully secured creditors. Partially secured creditors. Partially secured creditors. Unsecured creditors. Unsecured creditors. Debts labeled as: Liabilities with priority. Liabilities with priority. Fully secured creditors. Fully secured creditors. Partially secured creditors. Partially secured creditors. Unsecured creditors. Unsecured creditors. Statement of Financial Affairs Prepared at the start of the proceedings. Prepared at the start of the proceedings. Helps the creditors to decide whether to push for reorganization or liquidation. Helps the creditors to decide whether to push for reorganization or liquidation. Prepared at the start of the proceedings. Prepared at the start of the proceedings. Helps the creditors to decide whether to push for reorganization or liquidation. Helps the creditors to decide whether to push for reorganization or liquidation.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin 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. 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 unsecured creditors is appointed.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Appointed by the court; approved by the creditors. Has possession and control of the debtor’s assets. Can void property transfers made 90 days prior to the petition filing. Prepares the statement of realization and liquidation. Role of the Trustee

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Prepared by the trustee. Used to track the process of liquidating a company’s assets. Not required by GAAP. Statement of Realization and Liquidation Included Information 1.Account balances as of the date of the Order of Relief. 2.Cash receipts generated by sale of property. 3.Cash disbursements by the trustee. 4.Write-offs and recognition of previously unrecorded liabilities. Included Information 1.Account balances as of the date of the Order of Relief. 2.Cash receipts generated by sale of property. 3.Cash disbursements by the trustee. 4.Write-offs and recognition of previously unrecorded liabilities.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin A legal way to “salvage” a company rather than to liquidate it. Reorganization Chapter 11 Bankruptcy The company is temporarily protected from its creditors. Creditors are encouraged to negotiate new terms with the company.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Reorganization Chapter 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Reorganization Chapter 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Reorganization Chapter 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Reorganization Chapter 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. Financial Reporting During Reorganization Gains/losses, revenues/expenses resulting from the reorganization process are reported separately. Liabilities are restated. Current/noncurrent classification not applicable.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin 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. 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.

© The McGraw-Hill Companies, Inc., 2004 Slide McGraw-Hill/Irwin Reorganize this, Hu-mon! End of Chapter 13