Prepared by Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R 17 Shareholders’ Equity: Retained Earnings

Appendix 17A Financial Reorganization

Study Objectives 1.Describe the accounting for a financial reorganization

When a corporation incurs consistent losses, Retained Earnings carries a debit balance This prevents the declaration and payment of dividends The debit balance (deficit) in the Retained Earnings must first be cleared before dividends can be paid out Financial Reorganization

The enterprise may be on the verge of an “upswing” due perhaps to a new market, new technology, or the like In these cases, new funds are usually needed to ensure the success of the corporation With a substantial debit balance in Retained Earnings, the corporation may not be able to pay out dividends for some time Financial Reorganization

Market value of the shares is effected, which limits the amount of funds the corporation may be able to raise (debt or equity issue) ultimately determines the success or failure of the turnaround To allow the corporation a chance to succeed, it may go through the formal procedure of a financial reorganization

The difference in accounting treatment when dealing with reorganization is determined by the nature of the reorganization Change in control No change in control Accounting for Financial Reorganization

When a change in control has occurred a comprehensive revaluation of assets and liabilities takes place Objectives (steps) are: 1.Bring the deficit (Retained Earnings) to zero 2.Record the negotiated changes in debt and equity interests 3.Assets and liabilities reflect appropriate values Accounting for Financial Reorganization

Using E17-17 as a working example: Sudbury Corporation would qualify as a “change in control” and comprehensive revaluation based on: The same party does not control the enterprise both before and after the reorganization In this case, the note holder becomes the sole shareholder The new costs are reasonably determinable The asset and liability values were determined in bargained transactions among the relevant parties Accounting for Financial Reorganization – Change in Control

The journal entries required immediately prior to the reorganization are: Equipment100,000 Retained Earnings280,000 Accounts Receivable 140,000 Inventory 160,000 Intangibles 80,000 To adjust asset value prior to financial reorganization. Accounting for Financial Reorganization – Change in Control

Accounts Payable (450,000*80%)360,000 Retained Earnings (450,000*30%)135,000 Long-Term Note Payable (450,000*50%)225,000 To record revaluation of current liabilities as negotiated with creditors. Notes Payable605,000 Common Shares605,000 To record exchange of note payable for common shares, as negotiated. Accounting for Financial Reorganization – Change in Control

Common Shares50,000 Retained Earnings50,000 To record cancellation of existing common shares held. Common Shares230,000 Retained Earnings230,000 To clear final deficit balance in Retained Earnings. (Note: the company has no Contributed Surplus account to use up) Accounting for Financial Reorganization – Change in Control

As a result of these entries, the balance sheet for Sudbury Corporation immediately after these entries (and the formal reorganization) occur will contain the following:

Accounting for Financial Reorganization – Change in Control

When there is no change in control, GAAP restricts the reorganization to the following: Asset values cannot be increased Nonrecorded assets cannot be recorded Debt and equity interests, net asset write- down and Retained Earnings (Deficit) are adjusted Accounting for Financial Reorganization – No Change in Control

Disclosure Requirements In the period of reorganization a.Date of reorganization b.Description of the reorganization c.Amount of change in each major class of asset, liability and equity Subsequent periods – at least 3 years a.Date of reorganization b.Revaluation amount and account recorded in c.Amount of reclassified deficit and account recorded in d.Measurement bases for revalued assets and liabilities

COPYRIGHT Copyright © 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.