©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Corporate Liquidations and Reorganizations Chapter 17

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 1 Understand differences among types of bankruptcy filings.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Bankruptcy Reform Act of 1978 Prior to 1898, state government legislation governed bankruptcy procedures. The 1898 Bankruptcy Act, a federal law, preempted the state legislation. The 1898 Act was repealed when Congress enacted the Bankruptcy Reform Act of 1978.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Bankruptcy Law The bankruptcy law facilitates debt relief to individuals and corporations under various provisions, called chapters.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Types of Bankruptcies Chapter 7 – Liquidation  A trustee is appointed to sell off assets of the individual or company and pay claims to creditors. Description Type Chapter 9 – Adjustments of debts of a municipality  Municipalities (not covered here).

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Types of Bankruptcies Chapter 11 – Reorganization  A debtor corporation is expected to be rehabilitated and the reorganization of the corporation is anticipated.  Either a trustee is appointed or the company performs the duties of a trustee (debtor in possession).  A plan of reorganization is negotiated. Description Type

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Types of Bankruptcies Description Chapter 12 – Farmers  Family farmers with regular income (not covered here). Type Chapter 13 – Adjustments of debts of an individual with regular income  Exclusively applies to individuals, including sole proprietorships.  Unsecured debts less than $250,000 and secured debts less than $750,000 (not covered here).

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Payment of Claims I.Secured Claims Claims secured by valid liens. II.Unsecured Priority Claims 1.Administrative expenses incurred in preserving and liquidating the estate. 2.Claims incurred between the date of filing and the date an interim trustee is appointed. 3.Claims for wages, salaries, and commissions. 4.Claims for contributions to employee benefit plans. 5.Claims of individuals regarding property or services. 6.Claims of governmental units (taxes, duties, etc.).

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Payment of Claims III.Unsecured Nonpriority Claims 1.Allowed claims that were timely filed. 2.Allowed claims where proof of claims was filed late. 3.Allowed claims for any fine, penalty, or forfeiture, or for charges arising prior to the order for relief. 4.Claims for interest on the unsecured priority claims or the unsecured nonpriority claims. IV.Stockholders’ Claims Remaining assets are returned to the debtor corporation or its stockholders.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 2 Comprehend trustee responsibilities and accounting during liquidation.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Duties of the Trustee in Liquidation Cases The filing of a case creates an estate. The trustee takes possession of the estate, converts the assets into cash, and distributes the proceeds according to the priority of claims, as directed by the bankruptcy court.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Statement of Affairs This statement is a legal document prepared for the bankruptcy court. It emphasizes liquidation value.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Trustee Accounting The Bankruptcy Act does not cover procedural accounting details.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Trustee Accounting Statement of Cash Receipts and Disbursements Statement of Changes in Estate Equity Balance Sheet Statement of Realization and Liquidation

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 3 Understand financial reporting during reorganization.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Reorganization Less than 30% of business bankruptcy cases are filed under Chapter 11 each year. A Chapter 11 reorganization case is initiated voluntarily or involuntarily.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Trustee or Debtor in Possession A private trustee may be appointed. The debtor corporation may continue in possession.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn The Duties of a Trustee Including the Following: – Being accountable for the debtor’s property – Filing a list of creditors, schedules of assets and liabilities, and a financial statement – Furnishing information to the court – Examining creditor claims for authenticity – Filing a reorganization plan – Filing final papers on the trusteeship

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Committee Representation Creditors’ committees are responsible for protecting the interests of the creditors they represent.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Operating Under Chapter 11 Protection of the debtor in possession allowing possible cost reductions Losing the confidence of its lenders, suppliers, customers, and employers Possible Benefits Disadvantages

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn The Plan of Reorganization Must: – Identify class of claims – Specify any class of claims that is not impaired – Specify any class of claims that is impaired – Treat all claims within a particular class alike – Provide adequate means for the plan’s execution – Prohibit the issuance of nonvoting securities

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Financial Reporting During Reorganization The reorganization process can take several years. The corporation must still prepare financial statements and filings for the SEC during this time period and after it emerges from reorganization.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Effects of Chapter 11 on the Balance Sheet Unsecured liabilities and undersecured liabilities incurred before the company entered Chapter 11 are prepetition liabilities subject to compromise.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Effects of Chapter 11 on the Income Statement Professional fees and similar expenses related directly to the Chapter 11 proceedings are expensed as incurred. Reorganization items should be reported.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Effects of Chapter 11 on the Statement of Cash Flows Cash flow items relating to reorganization are disclosed separately from cash flow items relating to the ongoing operations of the business.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Supplementary Combined Financial Statements SOP 90-7 requires that condensed combined financial statements for all entities in reorganization proceedings be presented as supplementary financial information.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 4 Understand financial reporting after emerging from reorganization including fresh-start accounting.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Financial Reporting for the Emerging Company Ordinarily, a corporate reorganization involves a restructuring of liabilities and capital accounts and a revaluation of assets. For many companies, their reorganization plan includes the sale of the company.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Reorganization Value Generally, the reorganization value is determined by discounting future cash flows for the reconstituted business… plus the expected proceeds from sale of assets not required in the new business.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Fresh-Start Reporting Fresh-start reporting results in a new reporting entity with no retained earnings or deficit balance. The SOP provides two conditions that must be met for fresh-start reporting:

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Fresh-Start Reporting 1.The reorganization value of the emerging entity’s assets immediately before the date of confirmation of the reorganization plan is less than the total of all postpetition liabilities and allowed claims. 2.Holders of existing voting shares immediately before confirmation of the reorganization plan receive less than 50% of the emerging entity.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Fresh-Start Reporting Results in a New Reporting Entity – Allocating the reorganization value to identifiable assets – Reporting liabilities – Final statement of old entity – Disclosures in initial financial statements of new entity – Comparative financial statements

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Reporting by Entities That Do Not Qualify for Fresh-Start Reporting Liabilities are reported at present values using appropriate interest rates. Forgiveness of debt should be reported as an extraordinary item. Quasi-reorganization accounting is not used.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Illustration of a Reorganization Case Tiger Corporation files for protection from creditors under Chapter 11 on January 5, During 2003, no prepetition liabilities are paid and no interest is accrued on the bank note or the bonds payable.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Illustration of a Reorganization Case The bankruptcy court allows Tiger to invest $100,000 in new equipment in August The new equipment has a useful life of five years, and is depreciated over a five year period to the nearest half-year.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Illustration of a Reorganization Case Building depreciation:$50,000 per year Old equipment:$60,000 per year Patent amortization:$50,000 per year

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Illustration of a Reorganization Case (Tiger Balance Sheet) Current assets Cash$ 50,000 Accounts receivable, net 500,000 Inventory 300,000 Other current assets 50,000$ 900,000 Plant assets Land$200,000 Building, net 500,000 Equipment, net 300,000 Patent 200,000 1,200,000 $2,100,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Illustration of a Reorganization Case (Tiger Balance Sheet) Current liabilities Accounts payable$600,000 Taxes payable 150,000 Accrued interest on bonds 90,000 Note payable to bank 260,000$1,100,000 15% bonds payable (partially secured) 1,200,000 Stockholders’ deficit Capital stock 500,000 Deficit–700,000 – 200,000 $2,100,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Reclassification of Liabilities Subject to Compromise (000) Accounts Payable 600 Taxes Payable 150 Accrued Interest on 15% Bonds 90 Note Payable to Bank % Bonds Payable (partially secured)1,200 Liabilities Subject to Compromise2,300 To reclassify liabilities subject to compromise

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Income and Retained Earnings Statement for the Year 2003 Sales$ 1,000,000 Cost of sales (430,000) Wages and salaries (250,000) Depreciation and amortization (170,000) Other expenses (50,000) Earnings before reorganization items 100,000 Professional fees related to bankruptcy (450,000 Net loss (350,000) Beginning deficit (700,000) Deficit December 31, 2003$(1,050,000)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Tiger Balance Sheet at December 31, 2003 Current assets Cash$150,000 Accounts receivable, net 350,000 Inventory 370,000 Other current assets 50,000$ 920,000 Plant assets Land$200,000 Building, net 450,000 Equipment, net 330,000 Patent 150,000 1,130,000 $2,050,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Tiger Balance Sheet at December 31, 2003 Current liabilities Short-term borrowings$ 150,000 Accounts payable 100,000 Wages and salaries payable 50,000$ 300,000 Liabilities subject to compromise 2,300,000 Stockholders’ deficit Capital stock 500,000 Deficit–1,050,000 – 550,000 $2,050,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn The Reorganization Plan 1.Tiger’s 15% bonds payable were secured with the land and building. The bondholders agree to accept $500,000 new common stock, $500,000 senior debt of 12% bonds and $100,000 cash payable 12/31/03. 2.The priority tax claims of $150,000 will be paid in cash as soon as the reorganization plan is confirmed. 3.The remaining unsecured, nonpriority, prepetition claims of $950,000 will be settled as follows:

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn The Reorganization Plan a. Creditors represented by the accounts payable will receive $275,000 subordinated debt and $140,000 common stock. b. The $90,000 accrued interest on the 15% bonds will be forgiven. c.The $260,000 note payable to the bank will be exchanged for $120,000 subordinated debt and $60,000 common stock. 4.Equity holders will exchange their stock for $100,000 common stock of the emerging company.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Fresh-Start Reporting The reorganization value is compared with the total postpetition liabilities and court-allowed claims at June 30 to determine if fresh-start reporting is appropriate. Postpetition liabilities$ 255,000 Allowed claims subject to compromise 2,300,000 Total liabilities on June 30, ,555,000 Less: Reorganization value–2,200,000 Excess liabilities over reorganization value$ 355,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Proposed Reorganized Capital Structure Postpetition liabilities$ 255,000 Taxes payable 150,000 Current portion of senior debt, due December ,000 Senior debt, 12% bonds 500,000 Subordinated debt 395,000 Common stock 800,000 $2,200,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Comparative Balance Sheets at June 30, 2004 (000) Assets Cash Accounts receivable Inventory Other current assets Land Building Equipment Patent Reorganization excess $ — $2,055 a 25 b 100 f 250 c 75 d 30 c 125 $ — 250 $2,200 Preconfirmation Balance Sheet Adjustments DebitsCredits Reorganized Balance Sheet

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Comparative Balance Sheets at June 30, 2004 (000) Equities (claims) Short-term bank loan Accounts payable Wages payable Prepetition claims Accounts payable, old Taxes payable Interest Bank note 15% bonds payable $ ,200 h 600 i 90 j 260 g1,200 $ — 150 — Preconfirmation Balance Sheet Adjustments DebitsCredits Reorganized Balance Sheet

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Comparative Balance Sheets at June 30, 2004 (000) Stockholders’ Equity Capital stock, old Deficit 500 (1,000) k 500 c 75 d 30 e 125 a 25 b 100 f 250 g 100 h 185 i 90 j 80 k 400 ———— Preconfirmation Balance Sheet Adjustments DebitsCredits Reorganized Balance Sheet

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Comparative Balance Sheets at June 30, 2004 (000) New Equities Current portion, bonds 12% senior debt Subordinated debt Common stock, new Retained earnings, new — $2,055 g 100 g 500 h 275 j 120 g 500 h 140 j 60 k $2,200 Preconfirmation Balance Sheet Adjustments DebitsCredits Reorganized Balance Sheet

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn End of Chapter 17