1. Copyright © 2016 by McGraw-Hill Education, All rights reserved. McGraw-Hill Education Chapter 20 Corporations in Financial Difficulty

2. Learning Objective 20-1 2 Understand the courses of action available to financially distressed firms.

3. Overview  A company in financial difficulty has a large number of alternatives. Bankruptcy is only a final course.  A company may petition the courts for bankruptcy to protect itself from an onslaught of legal suits. Some have also attempted to void union contracts by petitioning for bankruptcy. U.S. auto industry? 3

4. Courses of Action  Nonjudicial Actions Formal agreements between the company and its creditors are legally binding but are not administered by a court.  Bankruptcy is the final step for a financially distressed business. 4

5. Nonjudicial Actions  Debt Restructuring Arrangements Extension of due dates of its debt. Decrease of the interest rate on the debt. Modification of other terms of the debt contract. Composition agreement Creditors agree to accept less than the face amount of their claims. 5

6. Nonjudicial Actions  Creditors’ committee management Creditors may agree to “assist” the debtor in managing the most efficient payment of its claims. Most creditors’ committees are advisory. Counsel closely with the debtor. The creditors do not want to assume additional liabilities and problems of the debtor’s actual operation. Usually initiated with a plan of settlement proposed by the debtor. 6

7. Nonjudicial Actions  Transfer of assets Debtors may transfer assets to obtain quick cash. Example: factoring trade receivables at a discount. The contract may specify that the receivables be sold “with recourse” or “without recourse.” A transfer of financial assets is considered a sale only if the transferor has surrendered control over the transferred assets. ASC 860 provides the accounting and reporting guidelines for these transfers. It requires that separately recognized servicing assets or liabilities in transactions such as these asset transfers be initially measured at fair value. 7

8. Judicial Actions  Bankruptcy is a judicial action administered by bankruptcy courts and bankruptcy judges using the guidance provided in Title 11 of the United States Bankruptcy Code. 8 Chapters of the Bankruptcy Code Chapter 1General Provisions Chapter 3Case Administration Chapter 5Creditors, the Debtor, and the Estate Chapter 7Liquidation Chapter 9Adjustment of Debts of a Municipality Chapter 11Reorganization Chapter 12Adjustment of Debts of a Family Farmer with Regular Annual Income Chapter 13Adjustment of Debts of an Individual with Regular Income

9. Judicial Actions  Either the debtor or its creditors may decide that a judicial action is best. The debtor may file a voluntary petition seeking judicial protection in the form of an order of relief against the initiation or continuation of legal claims by the creditors against the debtor. Creditors may file an involuntary petition against the debtor. Certain conditions must exist before creditors may file a petition. 9

10. Practice Quiz Question #1 Which of the following is usually NOT one of the debt restructuring arrangements available to companies in distress? a.Extension of due dates. b.Extension of additional loans from the same lenders to pay off current debt. c.A decrease in interest rates. d.Modification of debt terms. e.None of the above. Which of the following is usually NOT one of the debt restructuring arrangements available to companies in distress? a.Extension of due dates. b.Extension of additional loans from the same lenders to pay off current debt. c.A decrease in interest rates. d.Modification of debt terms. e.None of the above. 10

11. Practice Quiz Question #2 Which of the following statements is true? a.A Chapter 11 bankruptcy leads to the liquidation of the corporation. b.A Chapter 7 bankruptcy leads to the reorganization of the corporation’s debt. c.A Chapter 11 bankruptcy leads to the reorganization of the corporation’s debt. d.A Chapter 7 bankruptcy leads to the adjustments of debt for an individual. Which of the following statements is true? a.A Chapter 11 bankruptcy leads to the liquidation of the corporation. b.A Chapter 7 bankruptcy leads to the reorganization of the corporation’s debt. c.A Chapter 11 bankruptcy leads to the reorganization of the corporation’s debt. d.A Chapter 7 bankruptcy leads to the adjustments of debt for an individual. 11

12. Learning Objective 20-2 12 Understand Chapter 11 reorganizations and be able to prepare financial statements for debtors-in- possession as well as a plan of recovery.

13. Chapter 11 Reorganizations  Allows time needed to reorganize the debtor company and return its operations to a profitable level.  Bankruptcy court administers reorganizations. Can appoint trustees to direct the reorganization.  Temporary protection from creditors.  If granted protection, the company receives an order of relief to suspend making any payments on its prepetition debt. 13

14. Chapter 11 Reorganizations  The company continues to operate while it prepares a plan of reorganization.  The proceeding includes the actions that take place from the time the petition is filed until the company completes the reorganization.  A disclosure statement is transmitted to all creditors and other parties eligible to vote on the plan of reorganization.  The bankruptcy court then evaluates the responses to the plan from creditors and other parties and either confirms the plan of reorganization or rejects it. 14

15. ASC 852  Provides guidance for financial reporting for companies in reorganization.  Financial statements issued by a company during Chapter 11 proceedings should distinguish between Transactions and events directly associated with the reorganization and Those associated with ongoing operations. 15

16. Fresh Start Accounting  ASC 852 states that fresh start reporting should be used as of the confirmation date of the plan of reorganization if both the following conditions occur: 1.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. 2.Holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging company. 16

17. Fresh Start Accounting  Compute the reorganization value of the emerging entity’s assets. This represents the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the entity’s assets.  The reorganization value is then allocated to the assets using the allocation of value method prescribed in ASC 805. 17

18. Fresh Start Accounting  A reorganization value in excess of amounts assignable to identifiable assets is reported as an intangible asset.  The emerging company’s liabilities are recorded at the present values of the amounts to be paid.  Any retained earnings or deficits are eliminated.  A set of final operating statements is prepared just prior to emerging from reorganization.  In essence, the company is a new reporting entity after reorganization. 18

19. Fresh Start Accounting  Companies not qualifying for fresh start accounting should: Determine whether assets are impaired. Report liabilities at the present values of the amounts to be paid. Any gain or loss on the revaluation of the liabilities can be extraordinary or ordinary. Unusual and infrequent = extraordinary. 19

20. Fresh Start Accounting  Companies not qualifying for fresh start accounting should: Recognize a liability for a cost associated with an exit or disposal activity when the liability is incurred, not at the earlier time the company makes a commitment to an exit plan. Long-lived assets are divided between 1.Those to be held and used. 2.Those to be sold. 20

21. Plans of Reorganization  Most plans of reorganization include detailed discussions of the following: 1.Disposing of unprofitable operations. 2.Restructuring of debt with specific creditors. 3.Revaluation of assets and liabilities. 4.Reductions or eliminations of claims of original stockholders and issuances of new shares to creditors or others. 21

22. Practice Quiz Question #3 Which of the following statements is true about fresh start accounting? a.Fresh start accounting focuses on pre- bankruptcy book values. b.Fresh start accounting allows management to revalue assets to any value they feel is “fair and normal.” c.Fresh start accounting is no longer legal in the U.S. d.Fresh start accounting focuses the fair value of assets a willing buyer would pay to acquire them. Which of the following statements is true about fresh start accounting? a.Fresh start accounting focuses on pre- bankruptcy book values. b.Fresh start accounting allows management to revalue assets to any value they feel is “fair and normal.” c.Fresh start accounting is no longer legal in the U.S. d.Fresh start accounting focuses the fair value of assets a willing buyer would pay to acquire them. 22

23. Illustration of a Reorganization 23 are classified as Consider the following scenario: Peerless Products Corporation’s management petitions the bankruptcy court for a Chapter 11 reorganization to obtain relief from debt payments and time to rehabilitate the company and return to profitable operations. The following timeline presents the dates relevant for this example:

24. Balance Sheet on the Date of Corporate Insolvency 24

25. Plan of Reorganization 25 Peerless files the plan of reorganization (shown below) with audited financial statements and other disclosures requested by the bankruptcy court:

26. Reporting for Companies in Reorganization Proceedings  ASC 852 prescribes the reporting guidelines for companies in reorganization proceedings.  The reorganization amounts must be reported separately from other operating amounts.  The “Debtor-in-Possession” indicates that Peerless continues to manage its own assets rather than have a court-appointed trustee manage them. 26

27. Balance Sheet for a Company in Reorganization Proceedings 27

28. Income Statement for a Company in Reorganization Proceedings 28 are classified as

29. Statement of Cash Flows for a Company in Reorganization Proceedings 29 are classified as

30. Recovery Analysis for Plan of Reorganization 30 are classified as After the bankruptcy court approves the plan of reorganization as filed, Peerless carries out the plan as shown in this recovery analysis:

31. Reorganization Value  Reorganization value is the fair value of the entity’s assets.  Typical methods of determining reorganization value are discounting future cash flows or appraisals.  After extensive analysis, a reorganization value of $195,000 is determined for Peerless’ assets. 31 are classified as

32. Postreorganization Capital Structure 32 are classified as After intensive study of risk-equivalent companies, the profit potential of the emerging company, and the present value of future cash flows, the capital structure of the emerging company is established as follows:

33. Illustration of Reorganization 33 are classified as Journal entry to record the debt restructuring and the gain on the discharge of debt:

34. Illustration of Reorganization 34 Journal entry to record the exchange of stock for stock:

35. Effect of Plan of Reorganization on Company’s Balance Sheet 35 are classified as

36. Illustration of Reorganization 36 The following table compares the company’s book values and fair values:

37. Illustration of Reorganization 37 are classified as Journal entry to record the fresh start revaluation of assets and elimination of the deficit:

38. Chapter 11 Reorganizations PRACTICE: E20-2

39. Plan of Reorganization EliminationReduction$2 par of Debt SurvivingofCommonStockTotalRecovery and EquityDebtAssets% Value$% Post-petition liabilities (30,000) 100% Claims/Interest: Accounts Payable(80,000) 8,000 (72,000) 90 Notes Payable, 10%(150,000)25,000 (125,000) 83 Related Int. Payable(16,000)16,000 -0- 0 Bonds Payable, 12%(200,000) 100 Related Interest Payable (24,000) 18,000 (6,000) 25 Total(470,000)67,000 Common shareholders: Common Stock(100,000) 100% (200,000) Additional Paid-In(200,000)171,000 (29,000) Retained Earnings Deficit 178,000 (178,000) Total(622,000) (40,000)(230,000)(203,000)100% (229,000)(662,000)

40. (1)Accounts Payable80,000 Notes Payable, 10%150,000 Interest Payable40,000 Cash6,000 Accounts Receivable (net)72,000 Land85,000 Gain on Disposal of Land40,000 Gain on Discharge of Debt67,000 Record discharge of debt. Journal Entries to Record Reorganization

41. (1)Accounts Payable80,000 Notes Payable, 10%150,000 Interest Payable40,000 Cash6,000 Accounts Receivable (net)72,000 Land85,000 Gain on Disposal of Land40,000 Gain on Discharge of Debt67,000 Record discharge of debt. (2)Common Stock ($1 par)100,000 Additional Paid-In Capital171,000 Gain on Disposal of Land40,000 Gain on Discharge of Debt67,000 Common Stock ($2 par)200,000 Retained Earnings178,000 Record change in par value of stock and elimination of deficit. Journal Entries to Record Reorganization

42. Learning Objective 20-3 42 Understand Chapter 7 liquidations and be able to prepare a statement of affairs.

43. Chapter 7 Liquidations  Liquidations are administered by the bankruptcy courts in the interests of the corporation’s creditors and shareholders.  The intent in liquidation is to maximize the net dollar amount recovered from disposal of the debtor’s assets. 43

44. Classes of 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.  Creditors with priority Unsecured creditors having no collateral claim against specific assets but have priority over other unsecured creditors. 44

45. Classes of Creditors  General unsecured creditors The lowest priority is given to these claims. Paid only after secured creditors and unsecured creditors with priority are satisfied. Often receive less than the full amount of their claim. 45

46. Statement of Affairs  The accounting statement of affairs is the basic accounting report made at the beginning of the liquidation process.  Presents the expected realizable amounts from Disposal of the assets. The order of creditors’ claims. The expected amount that unsecured creditors will receive as a result of the liquidation.  A different report, also entitled the “Statement of Affairs,” is a list of questions the debtor must answer as part of the bankruptcy petition. 46

47. Statement of Affairs  An important planning report for a company’s anticipated liquidation.  The statement of affairs presents book values of the debtor company’s balance sheet accounts. estimated fair market values of the assets. order of the claims. estimated deficiency to the general unsecured creditors. 47

48. Practice Quiz Question #4 Which of the following is NOT one of the classes of creditors that could be paid in a Chapter 7 liquidation? a.Secured creditors. b.Unsecured creditors. c.Creditors in jeopardy. d.Creditors with priority. Which of the following is NOT one of the classes of creditors that could be paid in a Chapter 7 liquidation? a.Secured creditors. b.Unsecured creditors. c.Creditors in jeopardy. d.Creditors with priority. 48

49. Chapter 7 Liquidations PRACTICE: E20-4

50. E20-4 Solution

53. Chapter 7 Liquidations PRACTICE: P20-7

54. P20-7 Solution 54

55. P20-7 Solution 55

56. Liabilities and Equities Estimated BookAmount ValueUnsecured (1)Fully secured creditors: $ 44,000 12% note payable and interest$ 44,000 234,600 Mortgages payable and interest 234,600 $278,600 (2)Partially secured creditors: 29,400 10% note payable and interest$ 29,400 Less: Marketable securities (22,000)$ 7,400 105,000 Accounts payable$105,000 Less: Inventory (75,000)30,000 (3)Creditors with priority: -0- Estimated liquidation expenses$ 13,000 20,000 Wages payable20,000 12,000 Taxes payable 12,000 $ 45,000 (4)Unsecured creditors: 160,000 Accounts payable160,000 212,000 Notes payable212,000 17,000 Interest payable17,000 (5)Stockholders' equity: 240,000 Common stock (203,000) Retained earnings (deficit) $871,000 $426,400 b. % to unsecured creditors: $343,900= 80.65% $426,400

57. Learning Objective 20-4 57 Understand trustee accounting and reporting.

58. Trustee Accounting and Reporting  Under a Chapter 11 reorganization, bankruptcy courts appoint trustees to manage a company in cases of Management fraud Dishonesty Incompetence Gross mismanagement  The trustee then attempts to rehabilitate the business. 58

59. Trustee Accounting and Reporting  In Chapter 7 liquidations, the trustee expeditiously Liquidates the bankrupt company and Pays creditors in conformity with the legal status of their secured or unsecured interests.  In some cases, the court appoints a trustee to operate the company for a short time in an effort to obtain a better price for the company in entirety rather than selling it piecemeal. 59

60. Trustee Accounting and Reporting  Trustees examine the proof of all creditors’ claims against the debtor company.  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. 60

61. Trustee Accounting and Reporting  The general form of the trustee’s opening entry, accepting the assets of the debtor company is as follows: 61 AssetsXXX Debtor Company – In ReceivershipXXX

62. Trustee Accounting and Reporting  Statement of realization and liquidation A monthly report prepared for the bankruptcy court. Shows the results of the trustee’s fiduciary actions. Has three major sections: assets, supplementary items, and liabilities. 62

63. Additional Considerations  Sections of the statement of realization and liquidation 63

64. Illustration of Trustee Accounting and Reporting Consider the following example:  On December 31, 20X6, D. Able was appointed trustee in charge of liquidating Peerless Products Corporation.  Able will be allowed to operate the company for a short period of time to determine whether it can be sold in entirety as opposed to piecemeal.  During this time, the trustee must reduce Peerless’ current short- term debts.  If a sale in entirety is infeasible, Able is directed to liquidate the company.  Able accepts the assets on December 31, 20X6, and makes several transactions during January 20X7.  See Figure 20-9 to see the entries made on Peerless’ and the trustee’s books. 64

65. Illustration of Trustee Accounting and Reporting 65

66. Illustration of Trustee Accounting and Reporting 66

67. Illustration of Trustee Accounting and Reporting 67

68. Practice Quiz Question #5 Which of the following is NOT true about bankruptcy trustees? a.Trustees are often appointed in a Chapter 11 bankruptcy when management cannot be trusted. b.Trustees can be considered voluntary employees of the company. c.In a Chapter 7 bankruptcy, the trustee liquidates the company and pays the creditors. d.In a Chapter 11 bankruptcy, the trustee attempts to rehabilitate the business. Which of the following is NOT true about bankruptcy trustees? a.Trustees are often appointed in a Chapter 11 bankruptcy when management cannot be trusted. b.Trustees can be considered voluntary employees of the company. c.In a Chapter 7 bankruptcy, the trustee liquidates the company and pays the creditors. d.In a Chapter 11 bankruptcy, the trustee attempts to rehabilitate the business. 68

69. Conclusion The End