Advanced Accounting by Hoyle et al, 6th Edition

Chapter ThirteenAccounting forLegal Reorganizations and Liquidations

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Learning Objective 13-2Explain the difference betweena voluntary and involuntarybankruptcy.13-4Explain the difference between a voluntary and involuntary bankruptcy.Learning Objective 13-3Identify the various types ofcreditors as they are labeledduring a bankruptcy.13-7Identify the various types of creditors as they are labeled during a 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.BankruptcyCreditors file petition with the court. Can force company into liquidation under Chapter 7 or receiving protection under Chapter 11.Involuntary BankruptcyVoluntary Bankruptcy13-5Involuntary BankruptcyCreditors file petition with the court. Can force company into liquidation under Chapter 7 or receiving protection under Chapter 11.Voluntary BankruptcyCompany 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 PetitionNeither 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 debtors 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.

13-6Court Response to the PetitionNeither 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 debtors inability to meet obligations as they come due (slowness of payment is NOT sufficient cause!!)

Fully SecuredPartially SecuredUnsecuredClassification of Creditors13-8Net realizable value of the collateral exceeds the amount of the obligation. These creditors are completely protected by the pledged property. The value of the collateral covers only a portion of the obligation. The remainder is considered unsecured.All other liabilities are unsecured; creditors have no legal right to any of the debtors specific assets. They are entitled to share only in any funds that remain after all secured claims have been settled. 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 debtors insolvency, these creditors will not sufferloss; they are completely protected by the pledged property. Any money received from theasset 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 portionof the obligation. The remainder is considered unsecured; the creditor risks losingsome or all of this additional amount. For example, a bank might have a $90,000 loan duefrom 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 thedebtors specific assets. They are entitled to share only in any funds that remain after allsecured claims have been settled. Obviously, unsecured creditors are in a precarious position.Unless a debtors assets greatly exceed secured liabilities (which is unlikely in mostinsolvency cases), these creditors can expect significant losses if liquidation proves to benecessary. Hence, one of the most important aspects of the bankruptcy laws is the rankingof unsecured claims.Learning Objective 13-4Describe the difference betweena Chapter 7 bankruptcy and aChapter 11 bankruptcy.13-9Describe 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 debtors assets will be liquidated and the proceeds distributed to creditors (based on their priority status) ORUnder Chapter 11, the debtor will be permitted to reorganize and continue operations.(These chapters refer to the relevant sections of the Bankruptcy Reform Act)

13-10How will the debtor be discharged from its obligations?Under Chapter 7, the debtors assets will be liquidated and the proceeds distributed to creditors (based on their priority status) ORUnder Chapter 11, the debtor will be permitted to reorganize and continue operations.(These chapters refer to the relevant sections of the Bankruptcy Reform Act)

Learning Objective 13-5Account for a company as it enters bankruptcy13-11Account for a company as it enters bankruptcyStatement of Financial Affairs13-12To begin bankruptcy proceedings, the debtor normally prepares a statement of financial affairs. This schedule provides information on the companys 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 offinancial affairs. This schedule provides information about the companys current financialposition 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. 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 of Financial AffairsDebtors assets and liabilities are reported according to the classifications relevant to a liquidation.13-13Statement 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.

Learning Objective 13-6Account for the liquidation ofa company in bankruptcy especially when using the liquidation basis of accounting. 13-14Account for the liquidation of a company in bankruptcy especially when using the liquidation basis of accounting.

Liquidation - Chapter 7 Bankruptcy13-15Interim 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 groups interest.Selection of committee helps ensure fairness and protect the creditor groups interests.Consults with trustee concerning estate administrationMakes recommendations regarding trustees performanceSubmits questions affecting estate administration to courtInterim 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 groups interest.

April 2013 - FASB issued Accounting Standards Update No. 201307: 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 andthe 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.

13-16Liquidation Basis of AccountingApril 2013 - FASB issued Accounting Standards Update No. 201307: 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.

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.Liquidation Basis of Accounting13-17From that time forward, financial reporting for the liquidating entity must include a statement ofchanges in net assets in liquidation to report all changes during the period of reporting in the net assetsavailable for distribution to investors and other claimants. Because the company is going out ofbusiness, 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 interestedparties to gain information about the net assets that are available for distribution.Learning Objective 13-7List the provisions that areoften found in a bankruptcyreorganization plan.13-18List the provisions that are often found in a bankruptcy reorganization plan. Reorganization -Chapter 11 BankruptcyThe 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.

13-19ReorganizationChapter 11 BankruptcyControl 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 BankruptcyAcceptance of reorganization plan requires approval by:

Two-thirds of the dollar amount and more than one-half of the creditors who voteTwo-thirds of each class of stockholders who vote Confirmation by the courtThe 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.13-20ReorganizationChapter 11 BankruptcyAcceptance of a reorganization plan requires approval of:Two-thirds of the dollar amount and more than one-half of the creditors who cast votesTwo-thirds of each class of stockholders who cast votes Confirmation by the courtThe 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.

Learning Objective 13-8Account for a company as itmoves through reorganization.13-21Account for a company as it moves through reorganization.Financial Reporting During ReorganizationFASBs Accounting Standards Codification Topic 852, Reorganizations, requires financial statements be prepared:During the reorganization andWhen 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.

13-22Financial Reporting During ReorganizationFASBs Accounting Standards Codification Topic 852, Reorganizations, requires financial statements be preparedDuring the reorganization andWhen entity emerges from reorganization.Financial Reporting During 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, traditionalgenerally accepted accounting principles continue to apply. Assets, for example,should still be reported at their book values. However, a successful reorganization planwill 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 ofthe granting of the order for relief fall into this category. Fully secured liabilities andall debts incurred subsequent to that date are not subject to compromise and must bereported in a normal manner as either a current or noncurrent liability.Liabilities that are subject to compromise must be shown at the expected amount ofallowable 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 13-9Describe the financial reporting for a company that successfully exits bankruptcy as a reorganized entity.13-23Describe the financial reporting for a company that successfully exits bankruptcy as a reorganized entity.Fresh Start ReportingWhen 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.

13-24 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, allliabilities (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.