To accompany Advanced Accounting, 11th edition by Beams, Anthony, Bettinghaus, and Smith Chapter 18...

Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

to accompanyAdvanced Accounting, 11th edition

by Beams, Anthony, Bettinghaus, and Smith

Chapter 18

Corporate Liquidations and Reorganizations

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Corporate Liquidations and Reorganizations: Objectives

1. Understand differences among types of bankruptcy filing.

2. Comprehend trustee responsibilities and accounting during liquidation.

3. Understand financial reporting during reorganization.

4. Understand financial reporting after emerging from reorganization, including fresh-start accounting.


1: TYPES OF BANKRUPTCIES


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Insolvency

Equity insolvency Inability to pay debts on time

May avoid bankruptcy proceedings Negotiate directly with creditors

Bankruptcy insolvency Having total debts in excess of the fair value

of assets May be liquidated, or Reorganized


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Types of Bankruptcies

Chapter 7: Liquidation Trustee appointed to sell assets of

business

Chapter 9: Adjustment of Debt of a Municipality

Chapter 11: Reorganization Debtor is expected to be rehabilitated

Chapter 12: Farmers

Chapter 13: Adjustment of Debts of an Individual


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Characteristics

Voluntary bankruptcy proceedings Filed by debtor

Involuntary bankruptcy proceedings Filed by creditor or group of creditors

Court action Dismiss a case Accept the petition Change form

Chapter 11 reorganization Chapter 7 liquidation


2: TRUSTEE RESPONSIBILITIES AND ACCOUNTING

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Duties of Debtor Corporation

In both liquidation and reorganization cases, the debtor corporation must File a list of creditors, a schedule of assets

and liabilities, and a statement of financial affairs

Cooperate with trustee Surrender property to the trustee, including

records Appear at court hearings


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Duties of Trustee

Trustee serves in liquidation cases Investigate debtor's financial affairs Provide information Examine, perhaps object to, creditor claims File report on trusteeship If authorized to operate debtor's business,

other period reports are required

In reorganization cases, in addition to above Filing reorganization plan or statement why

one cannot be filed


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Ranking of Claims: Liquidation


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Statement of Affairs

Legal document prepared for bankruptcy court

Assets at expected net realizable values Classified on basis of availability for classes

of creditors Liabilities are classified

Priority, fully secured, partially secured, unsecured

Historical values included for reference


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Trustee AccountingAt start of case, trustee creates a new set of books.During the case,

Records transactions Statement of cash receipts and disbursements Statement of changes in estate equity Balance sheet Statement of realization and liquidation

At close of case, Final settlement of claims Trustee is dismissed


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Debtor in Possession

Unless there is a reason to appoint a trustee, the debtor corporation’s management is permitted to continue to run the company while in bankruptcy.

The Debtor in Possession has the same responsibilities as a trustee in a reorganization case.


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Creditors’ CommitteeThe Creditors’ Committee is elected in a liquidation case, and is appointed in a reorganization case from the largest unsecured creditors. Makes decisions on behalf of all

creditors Reviews ongoing transactions of the

debtor in possession and can object Handles negotiations with any creditor

regarding settlement or continued business.


Benefits of Chapter 11

Benefits of being the Debtor in Possession include: Rejecting executory contracts Cancelling unexpired leases Legal protection from creditor action, such

as lawsuits or repossession of property

However, day-to-day operations may become more difficult as lenders, suppliers, customers, and employees are aware of the bankruptcy filing.

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Reorganization PlanA plan may be filed at the time of the bankruptcy filing (“prepackaged bankruptcy”) or by the debtor corporation within 120 days of filing. Other interested parties may file proposed plans after 120 days. Identify classes of claims Specify the expected payout of each class Claims within a given class must be treated

alike Define the expected requirements for

execution of the plan Must be fair and equitable

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3: FINANCIAL REPORTING DURING REORGANIZATION

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Chapter 11: Balance Sheet

Prepetition liabilities subject to compromise are reported as a separate line item in liabilities

Arose before filing Include unsecured and under-secured liabilities Likely to be paid at an amount less than face value

Prepetition secured liabilities and post petition liabilities reported in normal fashion

Prepetition claims discovered after filing Included at court-allowed amounts


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Chapter 11: Other Statements

Reorganization costs shown separately

Interest to be paid or probable amount Differences from contractual amounts

should be noted

Expected stock or stock equivalent issuances should be disclosed

Cash flow items related to reorganization shown separately


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Combined Financial Statements

Condensed combined financial statements are prepared for all entities in reorganization proceedings as supplementary information

Intercompany receivables and payables Write-down if necessary


4: EMERGING FROM REORGANIZATION

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Reorganization Value

Approximates fair value of entity without considering liabilities Discounted future cash flows of reorganized

business Consider business and financial risk

Reorganization value determines how much creditors recover

Emerging business will either use1. Fresh start reporting2. Report liabilities at present value and

forgiveness of debt as extraordinary item


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Fresh-Start Reporting

Fresh-Start Reporting recognizes that the emerging company is a new entity.

To qualify,1. Revaluation value immediately before the

reorganization plan is confirmed must be less than post-petition liabilities and allowed claims, and

2. Holders of existing voting shares receive less than 50% of emerging entity


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Apply Fresh Start ReportingAllocated reorganization value to identifiable assets

Unallocated amount is an intangible called “Reorganization value in excess of amounts allocated to identifiable assets”

Liabilities at current value at confirmation date Deferred tax benefits are first applied to reduce any

intangible asset recorded

Prepare final reports of old entity The effects of adjustments to asset and liability

accounts are shown, so that ending balance sheet of old entity = beginning balance sheet of new entity


Continued Reporting of Old Company

If a company does not qualify for Fresh-Start Reporting, then

Report liabilities at the appropriate interest rate under GAAP

Report debt forgiveness as an extraordinary item

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Reorganization Example

Tig files for protection under Chapter 11 on January 5, 2011. Accordingly, it reclassifies prepetition liabilities obtains short-term financing acquires additional equipment continues operations through June 30, 2012

when the plan is approved, with a reorganization value of $2,200

First, we'll look at the statements pre and post reorganization. Then we'll go through the entries and adjustments that occurred.


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Balance Sheet Assets

Filed

1/5/11FYE

12/31/11Before

6/30/12Re-

valuation

Fair value

6/30/12AFTER 6/30/12

Cash 50 150 300 0 300 300 Accounts receivable 500 350 335 0 335 335 Inventory 300 370 350 25 375 375 Other current assets 50 50 30 0 30 30 Land 200 200 200 100 300 300 Building, net 500 450 425 (75) 350 350 Equipment, net 300 330 290 (30) 260 260 Patent 200 150 125 (125) 0 0 Reorganization value in excess of identifiable assets 250 2,100 2,050 2,055 (105) 1,950 2,200


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Changes to Assets

Fair values and revaluation amounts are shown on 6/30/12 for comparison.Tig continues operations, records depreciation, and even acquires equipment from filing on 1/5/11 to reorganization on 6/30/12.

The reorganization revalues the assets to their fair value on that date. Patents are completely written off.

Tig records an intangible "Reorganization value in excess of identifiable assets" of $250. Not all reorganizations result in this intangible.


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Filed

1/5/11FYE

12/31/11Before

6/30/12AFTER 6/30/12

Short-term borrowing (post) 150 75 75 Accounts payable (pre/post) 600 100 125 125

Wages payable (post) 50 55 55

Taxes payable (pre) 150 150

Accrued bond interest (pre) 90

Note payable (pre) 260 Subordinated debt (post) 395 12% bonds payable – current (post) 100 12% bonds payable (post) 500

15% bonds payable (pre) 1,200

Liabilities subject to compromise 2,300 2,300

Capital stock (old) 500 500 500 Capital stock (new) 800 Deficit (700) (1,050) (1,000) 0 2,100 2,050 2,055 2,200

Balance Sheet - Liability & Equity


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Changes to LiabilitiesUpon filing on 1/5/11, Tig reclassifies the unsecured and partially secured liabilities at that point as Pre-petition Liabilities Subject to Compromise.

Pre-petition Liabilities Subject to Compromise are then reclassified or settled according to the plan.

Accounts payable on 12/31/11 does not include any of the $600 due prior to filing.

Taxes payable are still to be paid, and eventually recorded again in full.


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Changes to Equity

Some of the creditors receive stock in the reorganized firm. The old shareholders also receive stock, but now own only $100 of $800 of the stock at book value.

Although some APIC was recorded in reorganizing, it was subsequently eliminated. If it had been sufficient to wipe out the deficit, no intangible "reorganization value in excess of identifiable assets" would be recorded.

The Deficit is removed!


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Can Tig Use Fresh Start?

On 6/30/12 there were $255 in post-petition liabilities. All $2,300 pre-petition liabilities were allowed by the courts. Firm value is $2,200.

1. Liabilities exceed reorganization value2. Old shareholders retain less than 50%

Yes, fresh start is appropriate.

Post-petition liabilities $255 Allowed claims 2,300 Total liabilities $2,555 Less reorganization value (2,200)Excess liabilities $355


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Reorganization Plan: 6/30/12Pre-petition Liabilities and Equity New Agreements

Debt Dis-charge

15% partially secured bonds, $1200

$500 new stock, $500 senior 12% bonds, and another $100 bonds due 12/31/12 $100

Priority tax claims $150 To be paid cash once confirmed $0

Remaining unsecured claims, $950:$600 accounts payable $275 subordinated debt

and $140 new stock $185$90 accrued interest Forgiven $90$260 note $120 subordinated debt

and $60 new stock $80Total debt discharged $455

Old stock $100 new stock Equity


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Record New Debt Agreements

This entry reclassifies the pre-petition debt according to the reorganization plan.

Liabilities subject to compromise (pre) 2,300

Taxes payable 150

12% senior debt 500

12% senior debt - current 100

Subordinated debt 395

Common stock (new) 700

Gain on debt discharge 455

settlement of prepetition claims


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Give Shareholders New Shares

They will lose control since creditors have $700 of common stock.

Common stock (old) 500

Common stock (new) 100

Additional paid in capital 400

exchange of stock with owners


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Revalue Assets

A loss is recorded in revaluing the assets. Refer back to the Asset side of the balance sheet.

Inventory 25

Land 100

Loss on asset revaluation 105

Buildings, net 75

Equipment, net 30

Patent 125

revalue assets to fair value


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Calculate Balance in Retained Earnings (Deficit)

If sufficient APIC had existed, there would be no intangible asset, and excess APIC would remain on the balance sheet.

Deficit, 6/30/12 (1,000)


Loss on asset revaluation (105)

Final measure of deficit, 6/30/12 ($650)

Write-off Additional paid in capital 400 Reorganization value in excess of identifiable assets (intangible asset) ($250)


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Eliminate Deficit in Equity

The $1,000 deficit on 6/30/12 is adjusted for the gain on debt discharge and loss on asset revaluation. The net $650 deficit eliminates all of the APIC and creates a $250 intangible.

Reorganization value in excess of identifiable assets 250


Additional paid in capital 400

Loss on asset revaluation 105

Deficit 1,000


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Simplifying Assumptions

All transactions are recorded on 6/30/12.

Generally this takes some time. Creditors may have interest between

submission and approval of plan. All pre-petition debt is approved. The $2,200 reorganization value of the

firm probably used a discounted cash flow firm valuation model.


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Disclosures

Adjustments to historical values Assets Liabilities

Debt forgiveness

Prior retained earnings or deficit eliminated

Significant factors in determining the reorganization value


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To accompany Advanced Accounting, 11th edition by Beams, Anthony, Bettinghaus, and Smith Chapter 18...

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