Chapter Thirteen Accounting for Legal Reorganization s and Liquidations McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Thirteen
Accounting forLegal
Reorganizations and
Liquidations
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Bankruptcy
A basic assumption of accounting is that a business is a going concern (will remain in business).
Occasionally, a business becomes insolvent (unable to pay debts as they come due).
An insolvent business can either cease to exist, or can seek a legal remedy called bankruptcy.
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Accounting for Legal Reorganizations and Liquidations
What happens to a business when it fails?
Who gets the assets?
If the assets are sold, who gets the money?
Are the creditors protected?
How is the business failure reported?
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Size of Recent American Bankruptcies
Total Assets Company Bankruptcy Date (in Billions)Lehman Brothers 07/15/2008 $691.1Washington Mutual 09/26/2008 327.9WorldCom 07/21/2002 103.9General Motors 06/01/2009 91.1Enron 12/02/2001 65.5Conseco 12/17/2002 61.4 Chrysler 04/30/2009 39.3Thornburg Mortgage 05/01/2009 36.5Pacific GE 04/06/2001 36.2 Texaco 04/12/1987 35.0
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Bankruptcy Reform Act of 1978
The Act strives to achieve two goals in connection with insolvency cases:
1) the fair distribution of assets to creditors, and
2) the discharge of an honest debtor from debt.
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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.
Bankruptcy Reform Act of 1978LO 2LO 2
Creditors file petition with the court.
Can force company into liquidation under Chapter 7 or receiving protection under Chapter 11.
Involuntary Bankruptcy Voluntary Bankruptcy
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Criteria for Forcing Involuntary Bankruptcy
When there are 12 or more unsecured creditors:
At least 3 must sign the petitionThose that sign must have total unsecured
debts of at least $14,425If there are fewer than 12:
Only 1 must signThe minimum debt limit remains $14,425(Debt limit balances are adjusted every
three years based on the Consumer Price Index)
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Court Response to the Petition
Neither 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 debtor’s inability to meet obligations as they come due (slowness of payment is NOT sufficient cause!!)
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Court Response to the Petition
If the court accepts the petition, it grants an order for relief.order for relief.
The order for relief halts all actions against the debtor.
The automatic stay prohibits creditors from collecting debts without the court’s permission
A trustee is appointed to oversee the bankruptcy process.
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Fully Secured
Partially Secured
Unsecured With Priority
Unsecured
Top Priority
Classification of Creditors
Each level must be paid in full prior to making distributions to the next level.
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1. Administrative costs related to liquidation
2. Debts arising between the filing date and the issuance of an order of relief.
3. Employee claims for wages earned and/or benefit plan contributions earned during the 180 days prior to filing (limit $11,725 per employee, each claim).
4. Customer deposits. Limited to $2,600 per customer.
5. Government claims for unpaid taxes.
Unsecured Liabilities Having Priority
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Reorganization or Liquidation?
How will the debtor be discharged from its obligations?
Under Chapter 7, the debtor’s assets will be liquidated and the proceeds distributed to creditors (based on their priority status) OR
Under Chapter 11, the debtor will be permitted to reorganize and continue operations.
(These “chapters” refer to the relevant sections of the Bankruptcy Reform Act)
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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 Affairs
Statement helps creditors decide between reorganization and liquidation for debtor.
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Liquidation – Chapter 7 Bankruptcy
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1. Interim 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.
2. An advisory committee of 3 - 11 unsecured creditors is appointed.
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Committee of Creditors
Consults with the trustee concerning estate administration
Makes recommendations regarding the trustee’s performance
Submits to the court questions affecting estate administration
(The selection of this committee is to help ensure fairness and to protect the creditor group’s interests.)
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Role of the Trustee
Charged with preserving the assets and preventing loss of the estate
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Trustee tracks the liquidation of a company’s assets (form not specified by GAAP).
Statement of Realization and Liquidation
Included Information
1. Account balances at the date on which the Order for Relief was filed.
2. Cash receipts generated by sale of property.
3. Cash disbursements by the trustee.
4. Write-offs and recognition of previously unrecorded liabilities.
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A legal way to “salvage” a company rather than liquidate it.
Reorganization -Chapter 11 Bankruptcy
The company is temporarily protected from its creditors.
Creditors are encouraged to negotiate new terms with the company.
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ReorganizationChapter 11 Bankruptcy
Workers keep their jobs.Suppliers keep their customers.Customers maintain their source of
supply.
Control of the company is normally maintained by the owners (“debtor in possession”)
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ReorganizationChapter 11 Bankruptcy
A plan of reorganization must be put forth within 120 days and approved within 180 days by the debtor in possession.
Examples include Plans: Proposing changes in company’s operations. For generating additional monetary
resources. For changes in management of the company. To settle debts that existed when the order
of relief was issued.
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ReorganizationChapter 11 Bankruptcy
Acceptance of a reorganization plan requires approval of:2/3 of the $ amount and more than 1/2 of
the creditors who cast votes2/3 of each class of stockholders who cast
votesConfirmation by the court
The 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.
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Financial Reporting During Reorganization
FASB’s 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 the reorganization are reported separately.
Liabilities are restated. Current versus noncurrent classification
not applicable.
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Fresh Start Reporting
When a company emerges from Chapter 11, GAAP permits fresh start reporting if two conditions are met:
The reorganization (or market) value of the assets is less than the total of the allowed claims as of the date of the order for relief plus any subsequent liabilities.
The previous owners are left with less than 50% of the voting stock.
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Fresh Start Accounting
Fresh Start AccountingAssets are restated to current market
value.Liabilities are stated at the discounted
present value of future cash payments.
Retained Earnings is set to zero.Normally, APIC is adjusted to
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Summary
Bankruptcy laws are intended to provide an orderly settlement to cases of insolvency, by assuring fair distribution of remaining assets while discharging the obligations of an honest debtor.
Bankruptcy may be voluntary or involuntary, and the result may be either liquidation (Chapter 7) or reorganization (Chapter 11).
Many companies emerging from liquidation are able to apply “fresh start” accounting.
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