Bankrupty Liquidation and Reor

Larsen: Modern Advanced Accounting, Tenth Edition

IV. Accounting for Fiduciaries

14. Bankruptcy: Liquidation and Reorganization

The McGrawHill Companies, 2005

Bankruptcy: Liquidation andReorganization

Scope of ChapterBusiness failures are a common occurrence in the U.S. economy. Poor management, ex-cessive debt, and inadequate accounting are the most commonly cited causes of businessfailures. The situation that precedes the typical business failure is inability of a businessenterprise to pay liabilities as they become due. Unsecured creditors often resort to law-suits to satisfy their unpaid claims against a business enterprise. Secured creditors mayforce foreclosure proceedings for real property or may repossess personal property thatcollateralizes a security agreement. The Internal Revenue Service may seize the assetsof a business enterprise that has failed to pay FICA and income taxes withheld from itsemployees.

A business enterprise may be unable to pay its liabilities as they become due eventhough the current fair values of its assets exceed its liabilities. For example, an enterprisemay experience a severe cash shortage in times of price ination because of the lag betweenthe purchase or production of goods at inated costs and the recovery of the inated coststhrough increased selling prices.

More typical of the failing business enterprise than the conditions described in the fore-going paragraph is the state of insolvency. Insolvent is dened in the Bankruptcy Code asfollows:

insolvent means(A) with reference to an entity other than a partnership and a municipality, nancial condi-tion such that the sum of such entitys debts is greater than all of such entitys property, at afair valuation, exclusive of(i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such

entitys creditors; and(ii) property that may be exempted from property of the estate under . . . this title; and

(B) with reference to a partnership, nancial condition such that the sum of such partner-ships debts is greater than the aggregate of, at a fair valuation(i) all of such partnerships property, exclusive of property of the kind specied in subpara-

graph (A) (i) of this paragraph; and

Chapter Fourteen

607





608 Part Four Accounting for Fiduciaries

(ii) the sum of the excess of the value of each general partners nonpartnership property, ex-clusive of property of the kind specied in subparagraph (A) (ii) of this paragraph, oversuch partners nonpartnership debts;1

The terms insolvent and bankrupt often are used as interchangeable adjectives. Suchusage is technically incorrect; insolvent refers to the nancial condition of a person orbusiness enterprise, and bankrupt refers to a legal state. In this chapter, various legal andaccounting issues associated with bankruptcy liquidations and reorganizations are dis-cussed and illustrated.

The U.S. Constitution (Article 1, Section 8) authorizes Congress to establish uniform lawson the subject of bankruptcies throughout the United States. For the rst 89 years under theConstitution, the United States had a national bankruptcy law for a total of only 16 years.During the periods in which national bankruptcy laws were not in effect, state laws on in-solvency prevailed. In 1898 a Bankruptcy Act was enacted that, as amended, remained ineffect for 80 years. Enactment of the Bankruptcy Act caused state laws on insolvency to berelatively dormant. In 1978 the Bankruptcy Reform Act established the present BankruptcyCode; in 1980 the Bankruptcy Tax Act established a uniform group of income tax rules forbankruptcy and insolvency; and in 1994 the Bankruptcy Code was amended by the Bank-ruptcy Reform Act of 1994.

The U.S. Supreme Court may prescribe by general rules the various legal practices andprocedures under the Bankruptcy Code. Thus, the Federal Rules of Bankruptcy Procedureestablished by the Supreme Court constitute important interpretations of provisions of theBankruptcy Code.

The process of bankruptcy liquidation under Chapter 7 of the Bankruptcy Code involvesthe realization (sale) of the assets of an individual or a business enterprise and the distrib-ution of the cash proceeds to the creditors of the individual or enterprise. Creditors havingsecurity interests collateralized by specic assets of the debtor generally are entitled to ob-tain satisfaction of all or part of their claims from the assets pledged as collateral. TheBankruptcy Code provides for priority treatment for certain unsecured creditors; theirclaims are satised in full, if possible, from proceeds of realization of the debtors noncol-lateralized assets. Unsecured creditors without priority receive cash, in proportion to theamounts of their claims, from proceeds available from the realization of the debtors assets.Thus, there are four classes of creditors in a bankruptcy liquidation: fully secured creditors,partially secured creditors, unsecured creditors with priority, and unsecured creditorswithout priority.

Debtors (Voluntary) PetitionThe Bankruptcy Code provides that any person, except certain entities such as a rail-road, an insurance company, a bank, a credit union, or a savings and loan association,

1 Bankruptcy Code, sec. 101 (32).

THE BANKRUPTCY CODE

BANKRUPTCY LIQUIDATION





may le a petition in a federal bankruptcy court for voluntary liquidation under Chapter 7of the Code. The ofcial form for a debtors bankruptcy petition, also known as a vol-untary petition, must be accompanied by supporting exhibits of the petitioners debts andproperty. The debts are classied as follows: (1) creditors having priority; (2) creditorsholding security; and (3) creditors having unsecured claims without priority. The debtorsproperty is reported as follows: real property, personal property, and property claimed asexempt. Valuations of property are at market or current fair values. Also accompanyingthe debtors bankruptcy petition is a statement of nancial affairs (not to be confusedwith the accounting statement of affairs illustrated on page 614 of this chapter), whichcontains a series of questions concerning all aspects of the debtors nancial conditionand operations.

Creditors (Involuntary) PetitionIf a debtor other than a farmer, a nonprot organization, or one of the types precludedfrom ling voluntary petitions owes unpaid amounts to 12 or more unsecured creditorswho are not employees, relatives, stockholders, or other insiders, three or more of thecreditors having unsecured claims totaling $10,000 or more may le in a federal bank-ruptcy court a creditors petition for bankruptcy, also known as an involuntary petition.If fewer than 12 creditors are involved, one or more creditors having unsecured claims of$10,000 or more may le the petition. The creditors petition for bankruptcy must claimeither (1) the debtor is not paying debts as they come due or (2) within 120 days prior tothe date of the petition, a custodian was appointed for or had taken possession of thedebtors property.

Unsecured Creditors with PriorityThe Bankruptcy Code provides that the following unsecured debts are to be paid in full, inthe order specied if adequate cash is not available for all, out of a debtors estate beforeany cash is paid to other unsecured creditors:

1. Administrative costs.

2. Claims arising in the course of the debtors business or nancial affairs after the com-mencement of a creditors bankruptcy proceeding but before appointment of a trustee ororder for relief.

3. Claims for wages, salaries, and commissions, including vacation, severance, and sickleave pay not in excess of $4,000 per claimant, earned within 90 days before the date ofling the petition for bankruptcy or cessation of the debtors business.

4. Claims for contributions to employee benefit plans arising within 180 daysbefore the date of ling the petition for bankruptcy or cessation of the debtors busi-ness. The limit of such claims is $4,000 times the number of employees covered bythe plans, less the aggregate amount paid to the covered employees under priority3 above.

5. Claims by producers of grain against a grain storage facility or by shermen against ash storage or processing facility, not in excess of $4,000 per claimant.

6. Claims for cash deposited for goods or services for the personal, family, or householduse of the depositor, not in excess of $1,800 per claimant.

7. Claims for alimony, maintenance, or support of a spouse, former spouse, or child of thedebtor, under a separation agreement, divorce decree, or court order.

8. Claims of governmental entities for various taxes or duties, subject to varying timelimitations.

Chapter 14 Bankruptcy: Liquidation and Reorganization 609






Property Claimed as ExemptCertain property of a bankruptcy petitioner is not includable in the debtors estate. TheBankruptcy Code excludes from coverage of the Code the various allowances provided inthe laws of either the United States or the state of the debtors residence, whichever is morebenecial to the debtor. Typical of these allowances are residential property exemptionsprovided by homestead laws and exemptions for life insurance policies payable on death tothe spouse or a relative of the debtor. (Bills introduced in Congress in 2001 would modifythese allowances.)

Role of Court in LiquidationThe federal bankruptcy court in which a debtors or creditors petition for bankruptcy liq-uidation is led oversees all aspects of the bankruptcy proceedings.

One of the first acts of the court is either to dismiss the debtors or creditors bank-ruptcy petition or to grant an order for relief under the Bankruptcy Code. The filingof a debtors petition in bankruptcy is in effect an order for relief; in a creditors petition,order for relief is made by the court after a hearing at which the debtor may attemptto refute the creditors allegations that the debtor was not paying debts as they camedue. Any suits that are pending against a debtor for whom a debtors or creditors bank-ruptcy petition is filed generally are stayed until order for relief or dismissal of thepetition; after order for relief such suits are further stayed until the question of thedebtors discharge is determined by the court. Further, the court appoints an interimtrustee after the order for relief, to serve permanently or until a trustee is elected bythe creditors.

Role of CreditorsWithin a period of 10 to 30 days after an order for relief, the bankruptcy court must call ameeting of the creditors. At the meeting, the outsider creditors appoint a trustee to man-age the debtors estate. A majority vote in number and amount of claims of all unsecuredand nonpriority creditors present is required for actions by creditors.

Role of TrusteeThe trustee elected by the creditors or appointed by the court assumes custody of the debtorsnonexempt property. The principal duties of the trustee are to continue operating the debtorsbusiness if directed by the court, realize the free assets of the debtors estate, and pay cash tounsecured creditors. The trustee is responsible for keeping accounting records to enable theling of a nal report with the bankruptcy court.

The Bankruptcy Code empowers the trustee to invalidate a preference, dened as thetransfer of cash or property to an outsider creditor for an existing debt, made while thedebtor was insolvent and within 90 days of ling of the bankruptcy petition, providedthe transfer caused the creditor to receive more cash or property than would be received inthe bankruptcy liquidation. The trustee may recover from the creditor the cash or propertyconstituting the preference and include it in the debtors estate.

Discharge of DebtorOnce the debtors property has been liquidated, all secured and priority creditor claims havebeen paid, and all remaining cash has been paid to unsecured, nonpriority creditors, the





debtor may receive a discharge, dened as the release of the debtor from all unliquidateddebts except debts such as the following:

1. Taxes payable by the debtor to the United States or to any state or subdivision, includingtaxes attributable to improper preparation of tax returns by the debtor.

2. Debts resulting from the debtors obtaining money or property under false pretenses orrepresentations, or willful conversion of the property of others.

3. Debts not scheduled by the debtor in support of the bankruptcy petition, such creditorsnot being informed of the bankruptcy proceedings.

4. Debts arising from embezzlement or other fraudulent acts by the debtor acting in a du-ciary capacity.

5. Amounts payable for alimony, maintenance, or child support.

6. Debts for willful and malicious injuries to the persons or property of others.

7. Debts for nes, penalties, or forfeitures payable to governmental entities, other than fortax penalties.

8. With certain exceptions, debts for educational loans made, insured, or guaranteed bygovernmental entities or by nonprot universities or colleges. (In 1997, a National Bank-ruptcy Review Commission recommended discharge of educational loans other than formedical schools.)

A debtor will not be discharged if any crimes, misstatements, or other malicious actswere committed by the debtor in connection with the court proceedings. In addition, adebtor will not be discharged if the current bankruptcy petition was led within six yearsof a previous bankruptcy discharge to the same debtor.

Role of Accountant in Bankruptcy LiquidationThe accountants role in liquidation proceedings is concerned with proper reporting of thenancial condition of the debtor and adequate accounting and reporting for the trustee forthe debtors estate, as described in the following sections.

Financial Condition of Debtor Enterprise: The Statement of AffairsA business enterprise that enters bankruptcy liquidation proceedings is a quitting concern,not a going concern. Consequently, a balance sheet, which reports the nancial position ofa going concern, is inappropriate for an enterprise in liquidation.

The nancial statement designed for a business enterprise entering liquidation is thestatement of affairs (not to be confused with the legal bankruptcy form with a similar titledescribed on page 609). The purpose of the statement of affairs is to display the assets andliabilities of the debtor enterprise from a liquidation viewpoint, because liquidation is theoutcome of the Chapter 7 bankruptcy proceedings. Thus, assets displayed in the statementof affairs are valued at current fair values; carrying amounts of the assets are presented ona memorandum basis. In addition, assets and liabilities in the statement of affairs are clas-sied according to the rankings and priorities set forth in the Bankruptcy Code; the cur-rent/noncurrent classication used in a balance sheet for a going concern is not appropriatefor the statement of affairs.

Illustration of Statement of AffairsThe balance sheet of Sanders Company on June 30, 2006, the date that Sanders led adebtors (voluntary) bankruptcy petition, is as follows:







SANDERS COMPANYBalance Sheet

(prior to ling of debtors bankruptcy petition)June 30, 2006

Assets

Current assets:

Cash $ 2,700

Notes receivable and accrued interest, less allowance for doubtful notes, $6,000 13,300

Trade accounts receivable, less allowance for doubtful accounts, $23,240 16,110

Inventories, at rst-in, rst-out cost:

Finished goods 12,000

Goods in process 35,100

Material 19,600

Factory supplies 6,450

Short-term prepayments 950

Total current assets $106,210

Plant assets, at cost:

Land $ 20,000

Buildings (net) 41,250

Machinery (net) 48,800

Tools (net) 14,700

Net plant assets 124,750

Total assets $230,960

Liabilities and Stockholders Equity

Current liabilities:

Notes payable:

Pacic National Bank, including accrued interest (due June 30, 2007) $ 15,300

Suppliers, including accrued interest (due May 31, 2007) 51,250

Trade accounts payable 52,000

Salaries and wages payable 8,850

Property taxes payable 2,900

Interest payable on rst mortgage bonds 1,800

FICA and income taxes withheld and accrued 1,750

Total current liabilities $133,850

First mortgage bonds payable 90,000

Total liabilities $223,850

Stockholders equity:

Common stock, $100 par; 750 shares authorized, issued, and outstanding $ 75,000

Decit (67,890) 7,110

Total liabilities and stockholders equity $230,960





Other information available from notes to nancial statements and from estimates ofcurrent fair values of assets follows:

1. Notes receivable with a face amount plus accrued interest totaling $15,300, and a cur-rent fair value of $13,300, collateralize the notes payable to Pacic National Bank.

2. Finished goods are expected to be sold at a markup of 3313% over cost, with disposalcosts estimated at 20% of selling prices. Estimated cost to complete goods in processis $15,400, of which $3,700 would be cost of material and factory supplies used. Theestimated selling price of goods in process when completed is $40,000, with disposalcosts estimated at 20% of selling prices. Estimated current fair values for material andfactory supplies not required to complete goods in process are $8,000 and $1,000, re-spectively. All short-term prepayments are expected to be consumed in the course ofliquidation.

3. Land and buildings, which collateralize the rst mortgage bonds payable, have a currentfair value of $95,000. Machinery with a carrying amount of $18,200 and current fairvalue of $10,000 collateralizes notes payable to suppliers in the amount of $12,000, in-cluding accrued interest. The current fair value of the remaining machinery is $9,000,net of disposal costs of $1,000, and the current fair value of tools after the amounts usedto complete the goods in process inventory is $3,255.

4. Salaries and wages payable are debts having priority under the Bankruptcy Code.

5. Costs of administering the bankruptcy liquidation are estimated at $1,905.

The statement of affairs for Sanders Company on June 30, 2006, is as shown onpage 614.

The following points should be stressed in the review of the June 30, 2006, statement ofaffairs for Sanders Company:

1. The Carrying Amount columns in the statement of affairs serve as a tie-in to the bal-ance sheet of Sanders on June 30, 2006, as well as a basis for estimating expected lossesor gains on realization of assets.

2. Assets are assigned to one of three groups: pledged for fully secured liabilities, pledgedfor partially secured liabilities, and free. This grouping of assets facilitates the compu-tation of estimated amounts available for unsecured creditorsthose with priority andthose without priority.

3. Liabilities are grouped in the categories reported by a debtor in the exhibits supportinga debtors bankruptcy petition (see pages 608609): unsecured with priority, fully se-cured, partially secured, and unsecured without priority.

4. An offset technique used where the legal right of setoff exists. For example, amountsdue to fully secured creditors are deducted from the estimated current fair value ofthe assets serving as collateral; and unsecured liabilities with priority are deductedfrom estimated amounts available to unsecured creditors from the proceeds of free assetrealization.

5. An estimated settlement per dollar of unsecured liabilities without priority is computedby dividing the estimated amount available for unsecured, nonpriority creditors by thetotal unsecured liabilities, thus:

This computation enables the bankruptcy trustee to estimate the amount of cash that willbe available to unsecured, nonpriority creditors in a liquidation proceeding.

$60,960

$95,250 64 cents on the dollar







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Estimated Amounts to Be Recovered by Each Class of CreditorsBy reference to the statement of affairs on page 614, the accountant for the trustee in bank-ruptcy for Sanders Company may prepare the summary of estimated amounts to be recov-ered by each class of Sanderss creditors shown below:


Accounting and Reporting for TrusteeTraditionally, the accounting records and reports for trustees have been extremely detailedand elaborate. However, the provisions of the applicable Federal Rule of Bankruptcy Pro-cedure are general. Therefore, simple accounting records and reports such as the followingshould be adequate.

1. The accounting records of the debtor should be used during the period that a trustee car-ries on the operations of the debtors business.

2. An accountability technique should be used once the trustee begins realization of thedebtors assets. In the accountability method of accounting, the assets and liabilities forwhich the trustee is responsible are entered in the accounting records of the trustee attheir statement of affairs valuations, with a balancing debit to a memorandum-typeledger account with a title such as Estate Decit. The amount of the debit to EstateDecit is equal to the estimated deciency to unsecured creditors reported in the state-ment of affairs. Appropriate cash receipts and cash payments journal entries are madefor the trustees realization of assets and payment of liabilities. No gain or lossledger account is necessary because a business enterprise in liquidation does not requirean income statement. Differences between cash amounts realized or paid and carryingamounts of the related assets or liabilities are debited or credited to the Estate Decitledger account.

3. The interim and nal reports of the trustee to the bankruptcy court are a statement ofcash receipts and cash payments, a statement of realization and liquidation, and, forinterim reports, supporting exhibits of assets not yet realized and liabilities not yetliquidated.

Illustration of Accountability TechniqueAssume that Arline Wells, the trustee in the voluntary bankruptcy liquidation pro-ceedings for Sanders Company (see page 612), took custody of the assets of Sanders on

SANDERS COMPANYEstimated Amounts to Be Recovered by Creditors

June 30, 2006

EstimatedClass of Creditors Total Claims Computation Recovery

Unsecured with priority $ 15,405 100% $ 15,405Fully secured 91,800 100% 91,800Partially secured 27,300 $23,300 ($4,000 0.64) 25,860Unsecured without priority 91,250 64% 58,400

Totals $225,755* $191,465

*$15,405 $91,800 $15,300 $12,000 $39,250 $52,000 $225,755.

$95,000 $13,300 $10,000 ($76,365 $3,200) $191,465.






June 30, 2006. The accountant for the trustee prepared the following journal entry onJune 30, 2006.

When the trustee realizes assets of Sanders, the appropriate journal entry is a debitto Cash, credits to the asset ledger accounts, and a debit or credit to the Estate Decit ac-count for a loss or gain on realization, respectively. Costs of administering the estate thatexceed the $1,905 liability also are debited to the Estate Decit ledger account.

Statement of Realization and LiquidationThe traditional statement of realization and liquidation was a complex and not too readableaccounting presentation. A form of realization and liquidation statement that should bemore useful to the bankruptcy court than the traditional statement is as follows. This nan-cial statement is based on the assumed activities of the trustee for the estate of SandersCompany during the month of July 2006, including operating the business long enough tocomplete and sell the goods in process inventory.

SANDERS COMPANY, IN BANKRUPTCYArline Wells, Trustee

Journal EntryJune 30, 2006

Cash 2,700

Notes and Interest Receivable 13,300

Trade Accounts Receivable 16,110

Finished Goods Inventory 12,800

Goods in Process Inventory 20,300

Material Inventory 8,000

Factory Supplies 1,000

Land and Buildings 95,000

Machinery ($10,000 $9,000) 19,000

Tools 3,255

Estate Decit 34,290 (1)

Estimated Administrative Costs 1,905

Notes and Interest Payable ($15,300 $12,000 $39,250) 66,550

Trade Accounts Payable 52,000

Salaries and Wages Payable 8,850

Property Taxes Payable 2,900

FICA and Income Taxes Withheld and Accrued 1,750

Interest Payable on First Mortgage Bonds 1,800

First Mortgage Bonds Payable 90,000

To record current fair values of assets and liabilities of Sanders Company,in bankruptcy liquidation proceedings.

(1) Equal to estimated deciency to unsecured, nonpriority creditors in the statement of affairs on page 614.

Journal Entry forBankruptcy Trustee





An accompanying statement of cash receipts and cash payments for the month endedJuly 31, 2006, would show the sources of the $39,654 total realization proceeds, and thedates, check numbers, payees, and amounts of the $13,500 paid for liabilities with priorityand the $1,867 paid for administrative costs. Supporting exhibits would summarize assetsnot yet realized and liabilities not yet paid.

Liquidation involves realization of the assets of the debtors estate. In many cases, an in-solvent debtor may be restored to a sound nancial footing if it can defer payment of itsdebts. Chapter 11 of the Bankruptcy Code, dealing with reorganization, enables a debtor tocontinue operations under court protection from creditor lawsuits while it formulates a planto pay its debts. Reorganization is discussed in the next section.

Chapter 11 of the Bankruptcy Code provides for the court-supervised reorganization of adebtor business enterprise. Typically, a reorganization involves the reduction of amountspayable to some creditors, other creditors acceptance of equity securities of the debtor fortheir claims, and a revision of the par or stated value of the common stock of the debtor.

A debtors (voluntary) petition for reorganization may be led by a railroad or by anyperson eligible to petition for liquidation (see pages 608609) except a stockbroker or acommodity broker. Requirements for a creditors (involuntary) petition for reorganizationare the same as the requirements for a liquidation petition (see page 609).


BANKRUPTCY REORGANIZATION

Interim Statement ofRealization andLiquidation for Trusteein BankruptcyLiquidation

SANDERS COMPANY, IN BANKRUPTCYArline Wells, Trustee

Statement of Realization and LiquidationFor Month Ended July 31, 2006

Estate decit, June 30, 2006 $34,290Assets realized:

Current FairValues, Realization Loss or

June 30, 2006 Proceeds (Gain)

Trade accounts receivable $14,620 $12,807 $ 1,813Finished goods inventory 12,800 11,772 1,028Goods in process inventory 14,820 15,075 (255)

Totals $42,240 $39,654 2,586Liabilities with priority liquidated

at carrying amounts:Salaries and wages payable $ 8,850Property taxes payable 2,900FICA and income taxes

withheld and accrued 1,750Total liabilities with priority

liquidated $13,500

Administrative costs paid, $1,867 ($1,905 had been estimated) (38)

Estate decit, July 31, 2006 $36,838






Appointment of Trustee or ExaminerDuring the process of reorganization, management or owners of the business enterprisemay continue to operate the enterprise as debtor in possession. Alternatively, the bank-ruptcy court may appoint a trustee to manage the enterprise. A trustee is appointed becauseof fraud, dishonesty, incompetence, or gross mismanagement by current owners or man-agers, or to protect the interests of creditors or stockholders of the enterprise. In some re-organization cases not involving a trustee, the court may appoint an examiner to investigatepossible fraud or mismanagement by the current managers or owners of the enterprise; theappointment of an examiner is limited to enterprises having unsecured liabilities, other thanpayables for goods, services, or taxes, exceeding $5 million.

Among the powers and duties of the trustee are the following:

1. Prepare and le in court a list of creditors of each class and their claims and a list ofstockholders of each class.

2. Investigate the acts, conduct, property, liabilities, and business operations of the enter-prise, consider the desirability of continuing operations, and formulate a plan for suchcontinuance for submission to the bankruptcy judge if management of the debtor has notdone so.

3. Report to the bankruptcy judge any facts ascertained as to fraud against or mismanage-ment of the debtor enterprise.

Plan of ReorganizationThe plan of reorganization submitted by the management or the trustee to the bank-ruptcy court is given to the debtor enterprises creditors and stockholders, to the U.S.Secretary of the Treasury, and possibly to the SEC. The plan must include provisionsaltering or modifying the interests and rights of the creditors and stockholders of thedebtor enterprise, as well as a number of additional provisions. The SEC may reviewthe plan and may be heard in the bankruptcy courts consideration of the plan. Beforea plan of reorganization is confirmed by the bankruptcy court, the plan must be ac-cepted by a majority of the creditors, whose claims must account for two-thirds of thetotal liabilities, and by stockholders owning at least two-thirds of the outstanding capi-tal stock of each class. If one or more classes of stockholders or creditors has notaccepted a plan, the bankruptcy court may confirm the plan if the plan is fair andequitable to the nonacceptors. Conrmation of the plan of reorganization by the bank-ruptcy court makes the plan binding on the debtor enterprise, on all creditors and own-ers of the enterprise, and on any other enterprise issuing securities or acquiring propertyunder the plan.

Accounting for a ReorganizationThe accounting for a reorganization typically requires journal entries for adjustmentsof carrying amounts of assets; reductions of par or stated value of capital stock (withrecognition of resultant paid-in capital in excess of par or stated value); extensions of duedates and revisions of interest rates of notes payable; exchanges of equity securities fordebt securities; and the elimination of a retained earnings decit. The latter entry is as-sociated with fresh start reporting for a reorganized enterprise whose liabilities exceedthe reorganization value (essentially current fair value) of its assets.2 Because of

2 Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the BankruptcyCode (New York: AICPA, 1990), par. 36.





changes in the ownership of common stock of such an enterprise as a result of the reor-ganization, it is no longer controlled by its former stockholder group, and it essentially isa new reporting enterprise whose assets and liabilities should be valued at current fairvalues and whose stockholders equity consists only of paid-in capital.3

It is important for accountants to be thoroughly familiar with the plan of reorganiza-tion, in order to account properly for its implementation. Accountants must be carefulto avoid charging post-reorganization operations with losses that arose before the reor-ganization.

To illustrate the accounting for a reorganization, assume that Sanders Company (seepages 611615) led a petition for reorganization, rather than for liquidation, on June 30,2006, with Sanders management as debtor in possession. The plan of reorganization, whichwas approved by stockholders and all unsecured creditors and conrmed by the bankruptcycourt, included the following:

1. Deposit $25,000 with escrow agent, as soon as cash becomes available, to cover liabili-ties with priority and costs of reorganization proceedings.

2. Amend articles of incorporation to provide for 10,000 shares of authorized commonstock of $1 par. The new common stock is to be exchanged on a share-for-share basis forthe 750 shares of outstanding $100 par common stock.

3. Extend due date of unsecured notes payable to suppliers totaling $15,250 for four years,until May 31, 2011. Increase the interest rate on the notes from the stated rate of 14% to18%, the current fair rate of interest.

4. Exchange 1,600 shares of new $1 par common stock (at current fair value of $15 ashare) for unsecured notes payable to suppliers totaling $24,000.

5. Pay suppliers 70 cents per dollar of trade accounts payable owed.

The journal entries below and on page 620, numbered to correspond with the provisionsof the reorganization plan outlined above, were recorded by Sanders Company as cash be-came available from operations. Assuming that fresh start reporting is appropriate forSanders Company after the plan of reorganization has been carried out, the last journalentry on page 620 is appropriate for eliminating the $67,890 retained earnings decit ofSanders on June 30, 2006.


3 Ibid., par. 39.

SANDERS COMPANYJournal Entries

(1) Cash with Escrow Agent 25,000

Cash 25,000

To record deposit of cash with escrow agent under terms of bankruptcy reorganization.

Salaries and Wages Payable 8,850

Property Taxes Payable 2,900

FICA and Income Taxes Withheld and Accrued 1,750

Cash with Escrow Agent 13,500

To record escrow agents payment of liabilities with priority.

(continued)

Journal Entries forBankruptcyReorganization






The effect of the foregoing journal entries is to show a clean slate for Sanders Com-pany as a result of the approved bankruptcy reorganization and the write-off of the retainedearnings decit existing on the date of the petition for reorganization. The extension of duedates of some liabilities, conversion of other liabilities to common stock, and liquidation oftrade accounts payable at less than their face amount should enable Sanders to resume op-erations as a going concern. For a reasonable number of years following the reorganization,Sanders might date the retained earnings in its balance sheets to disclose that the earn-ings were accumulated after the reorganization.

Disclosure of ReorganizationThe elaborate and often complex issues involved in a bankruptcy reorganization are dis-closed in a note to the nancial statements for the period in which the plan of reorganiza-tion was carried out. Examples of recent such disclosures are included in the AICPAs 1994publication Illustrations of Financial Reporting by Entities in Reorganization under the

SANDERS COMPANY Journal Entries (concluded)

Costs of Bankruptcy Proceedings 11,000


To record escrow agents payment of costs of bankruptcy proceedings.

(2) Common Stock, $100 par 75,000

Common Stock, $1 par 750

Paid-in Capital in Excess of Par 74,250

To record issuance of 750 shares of $1 par common stock in exchange for 750 shares of $100 par common stock.

(3) 14% Notes Payable to Suppliers, due May 31, 2007 15,250

18% Notes Payable to Suppliers, due May 31, 2011 15,250

To record extension of due dates of notes payable to suppliers andincrease of interest rate to 18% from 14%.

(4) Notes Payable to Suppliers 24,000

Common Stock, $1 par 1,600


To record exchange of 1,600 shares of $1 par common stock for $24,000 face amount of notes payable, at current fair value of $15 a share.

(5) Trade Accounts Payable 52,000

Cash 36,400

Gain from Discharge of Indebtedness in Bankruptcy 15,600

To record payment of $0.70 per dollar of accounts payable to suppliers.


Gain from Discharge of Indebtedness in Bankruptcy 15,600

Costs of Bankruptcy Proceedings 11,000

Retained Earnings 67,890

To eliminate decit on June 30, 2006, and close bankruptcy gain and costs to Paid-in Capital in Excess of Par ledger account.

Journal Entry toEliminate Decit






Bankruptcy Code. In addition, the Summary of Signicant Accounting Policies note to -nancial statements of a reorganized enterprise might include disclosures such as the fol-lowing for Wang Laboratories, Inc., a publicly owned enterprise:

Bankruptcy-Related AccountingThe Company has accounted for all transactions related to the Chapter 11 case in accordancewith Statement of Position 90-7 (SOP 90-7), Financial Reporting by Entities in Reorgani-zation under the Bankruptcy Code, which was issued by the American Institute of CertiedPublic Accountants in November 1990. Accordingly, liabilities subject to compromise underthe Chapter 11 case have been segregated on the Consolidated Balance Sheet and are recordedfor the amounts that have been or are expected to be allowed on known claims rather than esti-mates of the amounts those claims are to receive under the Reorganization Plan. In addition,the Consolidated Statements of Operations and Consolidated Statements of Cash Flows forthe year ended June 30, 1993 separately disclose expenses and cash transactions, respectively,related to the Chapter 11 case (see Note C, Reorganization and Restructuring). In accordancewith SOP 90-7, no interest has been accrued on pre-petition, unsecured debt. Additionally, in-terest income earned by WLI subsequent to the ling of Chapter 11 is reported as a reductionof reorganization items. The reorganized Company will account for the Reorganization Planutilizing the Fresh-Start reporting principles contained in SOP 90-7.4

1. Dene insolvency as that term is used in the Bankruptcy Code for an entity other thana partnership.

2. What are Federal Rules of Bankruptcy Procedure?

3. Identify the various classes of creditors whose claims are dealt with in bankruptcyliquidations.

4. Describe the process of liquidation under Chapter 7 of the Bankruptcy Code.

5. Differentiate between a debtors petition and a creditors petition.

6. May any business enterprise le a debtors bankruptcy petition for liquidation?Explain.

7. Who may le a creditors petition for bankruptcy liquidation?

8. What is a statement of nancial affairs under the Bankruptcy Code?

9. List the unsecured debts having priority over other unsecured debts under the provi-sions of the Bankruptcy Code.

10. Describe the priority of claims for wages and salaries under the Bankruptcy Code.

11. Describe the authority of a bankruptcy trustee with respect to a preference.

12. What are the effects of a discharge in bankruptcy liquidation proceedings? Explain.

13. What use is made of the accounting nancial statement known as a statement ofaffairs? Explain.

14. Describe the accountability method of accounting used by a trustee in a bankruptcyliquidation.

15. For what types of bankruptcy reorganizations might an examiner be appointed by thebankruptcy court?

16. What is the role of the Securities and Exchange Commission in a bankruptcy reorga-nization?

4 AICPA, Accounting Trends & Techniques, 48th ed. (New York: 1994), p. 35.

ReviewQuestions






17. Must all classes of creditors accept a reorganization plan before the plan may be con-rmed by the bankruptcy court? Explain.

18. What is fresh-start reporting for a business enterprise reorganized under Chapter 11of the Bankruptcy Code, and under what circumstances is it appropriate?

Select the best answer for each of the following multiple-choice questions:

1. A category of assets that typically has zero in the Estimated Amount Available columnof a statement of affairs is:

a. Factory supplies inventoryb. Toolsc. Short-term prepaymentsd. None of the foregoing

2. In a bankruptcy proceeding, the term statement of affairs refers to:

a. A document containing a series of questions concerning all aspects of the debtorsnancial condition and operations.

b. A nancial statement prepared in lieu of a balance sheet.c. Both a and b.d. Neither a nor b.

3. The number of classes of creditors in a bankruptcy liquidation is:

a. Twob. Threec. Fourd. Five

4. The Paid-in Capital in Excess of Par ledger account of a debtor corporation undergo-ing bankruptcy reorganization typically is debited or credited for:

a. Costs of bankruptcy proceedings.b. Gain from discharge of indebtedness in bankruptcy.c. Retained earnings decit.d. All the foregoing items.e. None of the foregoing items.

5. The bankruptcy trustee for Insolvent Company sold assets having a carrying amountof $10,000 for $8,500 cash. The journal entry (explanation omitted) to record thesale is:

a. Cash 8,500Loss on Realization of Assets 1,500

Assets 10,000b. Cash 8,500

Estate Administration Expenses 1,500Assets 10,000

c. Cash 8,500Cost of Goods Sold 10,000

Sales 8,500Assets 10,000

Exercises(Exercise 14.1)






d. Cash 8,500Estate Decit 1,500

Assets 10,000

6. In a statement of affairs (nancial statement), assets pledged for partially secured lia-bilities are:

a. Included with assets pledged for fully secured liabilities.b. Offset against partially secured liabilities.c. Included with free assets.d. Disregarded.

7. Regis Company is being liquidated in bankruptcy. Unsecured creditors without prior-ity are expected to be paid 50 cents on the dollar. Sardo Company is the payee of a notereceivable from Regis in the amount of $50,000 (including accrued interest), which iscollateralized by machinery with a current fair value of $10,000. The total amount ex-pected to be realized by Sardo on its note receivable from Regis is:

a. $35,000b. $30,000c. $25,000d. $10,000e. Some other amount

8. In journal entries for a bankruptcy reorganization, the difference between the carryingamount of a liability of the debtor and the amount accepted by the creditor in full set-tlement of the liability is credited to:

a. Retained Earnings (Decit).b. Paid-in Capital in Excess of Par or Stated Value.c. Paid-in Capital from Reorganization.d. Cash with Escrow Agent.e. Some other ledger account.

9. With respect to the terms bankrupt and insolvent as adjectives:

a. Bankrupt refers to a legal state; insolvent refers to the nancial condition of a per-son or a business enterprise.

b. Bankrupt refers to the nancial condition of a person or a business enterprise;insolvent refers to a legal state.

c. Both bankrupt and insolvent refer to the nancial condition of a person or a busi-ness enterprise.

d. Bankrupt and insolvent properly may be used as interchangeable adjectives.

10. The accounting records of a trustee in a bankruptcy liquidation are maintained:

a. Under the accrual basis of accounting.b. Under the cost basis of accounting.c. Under an accountability technique.d. In accordance with the bankruptcy courts instructions.

11. Under the Bankruptcy Code, are creditors having priority:

a.b.c.d.

Secured Creditors? Unsecured Creditors?

Yes YesYes NoNo YesNo No






12. The period of time that must elapse before a debtor that has had a previous bankruptcydischarge may again be discharged is:

a. Four yearsb. Five yearsc. Six yearsd. Seven years

13. The sequence of listing (1) fully secured liabilities, (2) partially secured liabilities,(3) unsecured liabilities with priority, and (4) unsecured liabilities without priority inthe liabilities and stockholders equity section of a statement of affairs is:

a. (1), (2), (3), (4)b. (3), (1), (2), (4)c. (1), (3), (2), (4)d. (1), (3), (4), (2)

14. The following journal entry (explanation omitted) was prepared by an enterprise thathad led a debtors petition in bankruptcy:

Such a journal entry generally is related to:

a. A liquidation only.b. A reorganization only.c. Either a liquidation or a reorganization.d. Neither a liquidation nor a reorganization.

15. The estimated amount available for free assets in a statement of affairs for a businessenterprise undergoing bankruptcy liquidation is equal to the assets:

a. Carrying amounts less current fair values.b. Carrying amounts plus gain or less loss on realization.c. Carrying amounts plus loss or less gain on realization.d. Current fair values less carrying amounts.

16. A retained earnings decit of a business enterprise undergoing bankruptcy reorgani-zation typically is eliminated by its:

a. Offset against gain from discharge of indebtedness in bankruptcy.b. Inclusion with costs of bankruptcy proceedings.c. Offset against legal capital.d. Offset against additional paid-in capital.

17. On April 30, 2006, Carson Welles, trustee in bankruptcy liquidation for Lyle Company,paid $12,140 in full settlement of Lyles liability under product warranty, which hadbeen carried in Welless accounting records at $10,000. The appropriate journal entryfor Welles (explanation omitted) is:

a. Liability under Product Warranty 12,140Cash 12,140

b. Liability under Product Warranty 10,000Estate Decit 2,140

Cash 12,140c. Liability under Product Warranty 10,000

Product Warranty Expense 2,140Cash 12,140


Cash 100,000






d. Liability under Product Warranty 10,000Retained Earnings (Prior Period Adjustment) 2,140

Cash 12,140

The December 18, 2006, statement of affairs of Downside Company, which is in bankruptcyliquidation, included the following:

(Exercise 14.2)

(Exercise 14.3)

(Exercise 14.4)

Prepare a working paper to show the estimated amount of assets expected to be receivedby each of the four classes of creditors of Downside Company in its bankruptcy liquidation.

Amounts related to the statement of affairs of Foldup Company, in bankruptcy liquidationon April 30, 2006, were as follows:

Prepare a working paper to compute the total estimated deciency to unsecured, non-priority creditors, and the cents per dollar that such creditors may expect to receive fromFoldup Company.

Data from the April 30, 2006, statement of affairs of Windup Company, which was under-going bankruptcy liquidation, included the following:

Prepare a working paper to show how Windup Companys assets on April 30, 2006, areexpected to be apportioned to Windups creditors claims on that date.

CHECK FIGURETo partially securedliabilities, $48,000.

CHECK FIGUREEstimated deciency,$100,000.


Assets pledged for fully secured liabilities $100,000Assets pledged for partially secured liabilities 40,000Free assets 120,000Fully secured liabilities 80,000Partially secured liabilities 50,000Unsecured liabilities with priority 60,000Unsecured liabilities without priority 90,000

Assets pledged for fully secured liabilities $ 80,000Assets pledged for partially secured liabilities 50,000Free assets 280,000Fully secured liabilities 60,000Partially secured liabilities 80,000Unsecured liabilities with priority 40,000Unsecured liabilities without priority 330,000

Assets pledged for fully secured liabilities $70,000Assets pledged for partially secured liabilities 30,000Free assets 50,000Fully secured liabilities 60,000Partially secured liabilities 40,000Unsecured liabilities with priority 30,000Unsecured liabilities without priority 50,000






Components of the December 17, 2006, statement of affairs of Liquo Company, which wasundergoing liquidation under Chapter 7 of the Bankruptcy Code, included the following:

(Exercise 14.5)

Prepare a working paper dated December 17, 2006, to compute the amount expected tobe paid to each class of creditors of Liquo Company. The following column headings aresuggested: Class of Creditor, Total Claims, Computation, Estimated Amount. The total ofthe Estimated Amount column should equal total assets, $334,000.

Scott Company led a debtors bankruptcy petition on June 25, 2006, and its statement ofaffairs included the following amounts:

(Exercise 14.6)

Assuming that Scott Companys assets realized cash at the current fair values and thebusiness was liquidated by the bankruptcy trustee, prepare a working paper to computethe amount of cash that the partially secured creditors should receive.

The statement of affairs for Wick Corporation shows that approximately 78 cents on thedollar probably will be paid to unsecured creditors without priority. Wick owes Stark Com-pany $23,000 on a promissory note, plus accrued interest of $940. Inventories with a cur-rent fair value of $19,200 collateralize the note payable.

Prepare a working paper to compute the amount that Stark Company should receivefrom the trustee of Wick Corporation, assuming that actual payments to unsecured credi-tors without priority amount to 78 cents on the dollar. Round all amounts to the nearestdollar.

(Exercise 14.7)


CHECK FIGURECash received bypartially securedcreditors, $84,000.

CHECK FIGUREAmount to StarkCompany, $22,897.

Assets pledged for fully secured liabilities, at current fair value $150,000Assets pledged for partially secured liabilities, at current fair value 104,000Free assets, at current fair value 80,000Fully secured liabilities 60,000Partially secured liabilities 120,000Unsecured liabilities with priority 14,000Unsecured liabilities without priority 224,000

Carrying CurrentAmounts Fair Values

AssetsAssets pledged for fully secured liabilities $160,000 $190,000Assets pledged for partially secured liabilities 90,000 60,000Free assets 200,000 140,000

Totals $450,000 $390,000

LiabilitiesUnsecured liabilities with priority $ 20,000Fully secured liabilities 130,000Partially secured liabilities 100,000Unsecured liabilities without priority 260,000

Total $510,000






Decker Company led a debtors bankruptcy petition on August 15, 2006, and its statementof affairs included the following amounts:

(Exercise 14.8)

Assuming that Decker Companys assets realized cash at the current fair values and thebusiness was liquidated by the bankruptcy trustee, prepare a working paper to computethe amount of cash available to pay unsecured liabilities without priority.

Prepare a working paper to compute the estimated amount expected to be paid to eachclass of creditors, using the following data taken from the statement of affairs for KentCorporation:

CHECK FIGURECash available,$180,000.

(Exercise 14.9)

The following information for Progress Book Company on May 31, 2006, was obtained byan accountant retained by Progress Books creditors:

1. Furniture and xtures: Carrying amount, $70,000; current fair value, $60,500; pledgedon a note payable of $42,000 on which unpaid interest of $800 has accrued.

2. Book manuscripts owned: Carrying amount, $15,000; current fair value, $7,200; pledgedon a note payable of $9,000; interest on the note is paid to date.

3. Books in process of production: Accumulated cost (direct material, direct labor, andfactory overhead), $37,500; estimated sales value on completion, $60,000; additionalout-of-pocket costs of $14,200 will be required to complete the books in process.

Prepare the headings for the asset side of a statement of affairs for Progress Book Com-pany on May 31, 2006, and illustrate how each of the three items described is displayed inthe statement.

(Exercise 14.10)

CHECK FIGURETo partially securedcreditors, $57,200.

Carrying Current Amounts Fair Values

AssetsAssets pledged for fully secured liabilities $150,000 $185,000Assets pledged for partially secured liabilities 90,000 60,000Free assets 210,000 160,000

Totals $450,000 $405,000

LiabilitiesUnsecured liabilities with priority $ 35,000Fully secured liabilities 130,000Partially secured liabilities 100,000Unsecured liabilities without priority 270,000

Total $535,000

Assets pledged for fully secured liabilities (current fair value, $75,000) $ 90,000Assets pledged for partially secured liabilities (current fair value, $52,000) 74,000Free assets (current fair value, $40,000) 70,000Unsecured liabilities with priority 7,000Fully secured liabilities 30,000Partially secured liabilities 60,000Unsecured liabilities without priority 112,000






Edward Ross, the trustee in bankruptcy for Winslow Company, set up accounting recordsbased on the April 30, 2006, statement of affairs for Winslow. The trustee completed thefollowing transactions and events early in May 2006:

May 2 Sold for $10,000 cash the nished goods inventory with a statement of affairsvaluation of $10,500.

3 Paid wages with a statement of affairs valuation of $8,000.

4 Collected $6,000 on trade accounts receivable with a statement of affairs valu-ation of $6,200. The remainder was considered to be uncollectible.

7 Paid trustee fee for one week, $500. (Debit Estimated Administrative Costs.)

Prepare journal entries (omit explanations) for Edward Ross, trustee in bankruptcy forWinslow Company, for the transactions and events described above.

From the following traditional form of statement of realization and liquidation, preparea more concise statement of realization and liquidation similar to the one illustrated onpage 617.

(Exercise 14.11)

(Exercise14.12)

(Exercise 14.13) Following are selected provisions of the plan of reorganization for Kolb Company, which isemerging from Bankruptcy Code Chapter 11 reorganization on July 27, 2006:

(1) Amended articles of incorporation to provide for 100,000 shares of authorized com-mon stock, $5 par, to be exchanged on a share-for-share basis for 50,000 shares of out-standing no-par, no-stated-value common stock with a carrying amount of $600,000.

(2) Exchanged 10,000 shares of the new $5 par common stock for trade accounts payabletotaling $70,000.

(3) Paid 80 cents per dollar for full settlement of other trade accounts payable totaling$60,000.

CHECK FIGUREEstate decit, Jan. 31,$7,150.

REED COMPANY, IN BANKRUPTCYSelma Ross, Trustee

Statement of Realization and LiquidationFor Month of January 2006

Assets to be realized: Liabilities to be liquidated:Trade accounts receivable $ 7,500 Notes payable $ 5,000Inventories 12,500 Trade accounts payable 30,000Equipment 10,000 Interest payable 150

Subtotal $30,000 Subtotal $35,150Supplementary charges: Liabilities assumed:

Administrative costs 2,950 Interest payable 50Interest expense 50 Assets realized:

Liabilities liquidated: Trade accounts receivable 6,500Trade accounts payable 6,000 Inventories 14,500

Liabilities not liquidated: Assets not realized:Notes payable 5,000 Equipment 10,000Trade accounts payable 24,000 Net loss 2,000Interest payable 200

Total $68,200 Total $68,200






Prepare journal entries (omit explanations) for Kolb Company on July 27, 2006, to re-ect the foregoing elements of its plan of reorganization.

Among the provisions of the reorganization of Hayward Company under Chapter 11 of theBankruptcy Code were the following:

(1) Issued 1,000 shares of $5 par common stock in exchange for 1,000 shares of $100 parcommon stock outstanding.

(2) Issued 200 shares of $5 par common stock (current fair value $10 a share) for notespayable to suppliers with unpaid principal of $2,500 and accrued interest of $500.

(3) Paid $8,000 to suppliers in full settlement of trade accounts payable of $10,000.

Prepare journal entries (omit explanations) for Hayward Company for the foregoing pro-visions, all of which were completed on January 20, 2006.

The January 29, 1994, balance sheet of Hills Stores Company, a publicly owned enterprise,included the following asset:

(Exercise 14.14)

Cases(Case 14.1)

The Intangible Assets section of Hillss Summary of Signicant Accounting Policies noteto nancial statements read in part as follows:

Reorganization value in excess of amounts allocable to identiable assets is being amortizedover 20 years on a straight-line basis. Accumulated amortization was $29,395,000 at January29, 1994.

The reorganization value accounted for more than 19% of Hillss total assets of$907,621,000 on January 29, 1994.

InstructionsWhat is your opinion of the foregoing balance sheet display and related note disclosures?Explain, after researching the following:

AICPA Statement of Position 90-7, Financial Reporting by Entities in Reorganizationunder the Bankruptcy Code, paragraphs 9, 38, 61, and 62.

FASB Statement of Financial Accounting Concepts No. 6, Elements of FinancialStatements, paragraphs 25 through 31 and 171 through 177.

FASB Statement of Financial Accounting Standards No. 142, Goodwill and OtherIntangible Assets, paragraphs 1, 5, and 10.

FASB Statement of Financial Accounting Standards No. 87, EmployersAccountingfor Pensions, paragraphs 36, 37, and 38, and dissent of Robert T. Sprouse.

Reorganization value in excess of amounts allocable to identiable assets, net $176,718,000






In auditing the nancial statements of Delbert Company for the six months ended Decem-ber 31, 2006, you nd items a through e below had been debited or credited to the RetainedEarnings ledger account during the six months immediately following a bankruptcy reor-ganization, which was effective July 1, 2006:

a. Debit of $25,000 arising from an additional income tax assessment applicable to2005.

b. Credit of $48,000 resulting from gain on disposal of equipment that was no longerused in the business. This impaired equipment had been written down by a $50,000increase in the Accumulated Depreciation ledger account on July 1, 2006.

c. Debit of $15,000 resulting from the loss on plant assets destroyed in a re on November2, 2006.

d. Debit of $32,000 representing cash dividends declared on preferred stock.

e. Credit of $60,400, the net income for the six-month period ended December 31,2006.

InstructionsFor each of the foregoing items, state whether it is correctly debited or credited to theRetained Earnings ledger account. Give a brief reason for your conclusion.

You have been asked to conduct a training program explaining the preparation of a state-ment of affairs (nancial statement) for the staff of Bixby & Caneld, CPAs.

InstructionsExplain how each of the following is presented in a statement of affairs (nancial state-ment) for a corporation in bankruptcy liquidation proceedings:

a. Assets pledged for partially secured liabilities.

b. Unsecured liabilities with priority.

c. Stockholders equity.

On July 24, 2006, the date the plan of reorganization of Re-Org Company was approved bythe bankruptcy court, Re-Orgs stockholders equity was as follows:

(Case 14.2)

(Case 14.3)

Problems(Problem 14.1)

Included in Re-Orgs plan of reorganization were the following:

1. Authorize payment of $50,000 unrecorded bankruptcy administrative costs by escrowagent holding special Re-Org cash account.

2. Amend articles of incorporation to change common stock to $1 par from no-par, no-stated-value stock.

Common stock, no par or stated value; authorized 100,000 shares, issued and outstanding 60,000 shares $ 580,000

Decit (260,000)Total stockholders equity $ 320,000






3. Exchange 10% unsecured $120,000 promissory note payable to supplier (interest unpaidfor three months) for a 12%, two-year promissory note in the total amount of unpaid prin-cipal and accrued interest on the 10% note.

4. Pay suppliers 80 cents on the dollar (from Re-Org cash account) for their claims total-ing $100,000.

5. Eliminate decit against paid-in capital resulting from (2) and gain resulting from (4).

InstructionsAssuming the foregoing were completed on July 24, 2006, prepare journal entries (omitexplanations) for Re-Org Company on that date. Use the following ledger account titles:

The following information was available on October 31, 2006, for Dodge Company, whichcannot pay its liabilities when they are due:

(Problem 14.2)

Instructionsa. Prepare a statement of affairs for Dodge Company on October 31, 2006, in the form

illustrated on page 614.

b. Prepare a working paper to compute the estimated percentage of claims each groupof creditors should expect to receive if Dodge Company petitions for liquidation inbankruptcy.

Robaire Corporation was in nancial difculty because of declining sales and poor costcontrols. Its stockholders and principal creditors had asked for an estimate of the nancial

(Problem 14.3)


Cash Interest PayableCash with Escrow Agent 10% Note PayableCommon Stock, no par 12% Note PayableCommon Stock, $1 par Paid-in Capital in Excess of ParCosts of Bankruptcy Proceedings Retained Earnings (Decit)Gain from Discharge of Indebtedness in Trade Accounts Payable

Bankruptcy

Carrying Amounts

Cash $ 4,000Trade accounts receivable (net): Current fair value equal to carrying amount 46,000Inventories: Net realizable value, $18,000; pledged on $21,000 of notes

payable 39,000Plant assets: Current fair value, $67,400; pledged on mortgage note

payable 134,000Accumulated depreciation of plant assets 27,000Supplies: Current fair value, $1,500 2,000Wages payable, all earned during October 2006 5,800Property taxes payable 1,200Trade accounts payable 60,000Notes payable, $21,000 secured by inventories 40,000Mortgage note payable, including accrued interest of $400 50,400Common stock, $5 par 100,000Decit 59,400






results of the realization of the assets, the payment of liabilities, and the liquidation ofRobaire. Thus, the accountant for Robaire prepared the statement of affairs shown onpage 633.

On January 2, 2007, Robaire led a debtors petition for liquidation under the Bank-ruptcy Code. Charles Stern was appointed as trustee by the bankruptcy court to take cus-tody of the assets, make payments to creditors, and implement an orderly liquidation. Thetrustee completed the following transactions and events during January, 2007:

Jan. 2 Recorded the assets and liabilities of Robaire Corporation in a separate set ofaccounting records. The assets were recorded at current fair value, and all lia-bilities were recorded at the estimated amounts payable to the various groupsof creditors.

7 Disposed of the land and buildings at an auction for $52,000 cash and paid$42,550 to the mortgagee. The payment included interest of $50 that accruedin January.

10 Made cash payments as follows:

CHECK FIGURESb. Estate decit, Jan.31, $9,380; c. Trialbalance totals,$31,850.

31 Received cash from Jan. 8 to Jan. 31, 2007, as follows:

31 Made additional cash payments as follows:

Instructionsa. Prepare journal entries for the foregoing events and transactions of the trustee for

Robaire Corporation.

b. Prepare a statement of realization and liquidation for the trustee of Robaire Corporationfor the month of January 2007. Use the format illustrated on page 617.

c. Prepare a trial balance for the trustee of Robaire Corporation on January 31, 2007.

Wages payable $1,500FICA and income taxes withheld and accrued 800Completion of inventories 400Administrative costs of liquidation 600

Collection of trade accounts receivable at carrying amount,including $10,000 of assigned accounts $17,500

Sale of inventories 18,000Disposal of Public Service Company bonds 920

Administrative costs of liquidation $ 1,250Note payable to bank (from proceeds of collection of assigned

accounts receivable) 10,000Fifty cents on the dollar to unsecured creditors 30,500





Chapter 14 Bankruptcy: Liquidation and Reorganization 633R

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Javits Corporation advised you that it is facing bankruptcy proceedings. As the independentauditor for Javits, you knew of its nancial condition.

The unaudited balance sheet of Javits on July 10, 2006, was as follows:

(Problem 14.4)

Additional Information1. Cash included a $500 travel advance that had been spent.

2. Trade accounts receivable of $40,000 had been pledged as collateral for notes payableto banks in the amount of $30,000. Credit balances of $5,000 were netted in the ac-counts receivable total. All accounts were expected to be collected except those forwhich an allowance had been established.

3. Short-term investments (all acquired in May 2006), classied as trading, consistedof U.S. government bonds costing $10,000 and 500 shares of Owens Companycommon stock. The current fair value of the bonds was $10,000; the current fairvalue of the stock was $18 a share. The bonds had accrued interest receivable of$200. The short-term investments had been pledged as collateral for a $20,000 notepayable to bank.

4. Estimated realizable value of nished goods was $50,000 and of material was $30,000.For additional out-of-pocket costs of $10,000 the material would realize $59,900 asnished goods.

5. Short-term prepayments were expected to be consumed during the liquidation period.

6. The current fair values of plant assets were as follows: land, $25,000; buildings,$110,000; impaired machinery, $65,000.

CHECK FIGUREb. Estimateddeciency, $22,500.

JAVITS CORPORATIONBalance SheetJuly 10, 2006

Assets

Cash $ 12,000

Short-term investments, at cost 20,000

Trade accounts receivable, less allowance for doubtful accounts 90,000

Finished goods inventory 60,000

Material inventory 40,000

Short-term prepayments 5,000

Land 13,000

Buildings (net) 90,000

Machinery (net) 120,000

Goodwill (net) 20,000

Total assets $470,000

Liabilities and Stockholders Equity

Notes payable to banks $135,000

Trade accounts payable 94,200

Wages payable 15,000

Mortgage notes payable 130,000

Common stock 100,000

Retained earnings (decit) (4,200)

Total liabilities and stockholders equity $470,000






7. Trade accounts payable included $15,000 withheld FICA and income taxes and $6,000payable to creditors who had been reassured by the president of Javits that they wouldbe paid. There were unrecorded employers FICA taxes in the amount of $500.

8. Wages payable were not subject to any limitations under the Bankruptcy Code.

9. Mortgage notes payable consisted of $100,000 secured by land and buildings, and a$30,000 installment contract secured by machinery. Total unrecorded accrued interestfor these liabilities amounted to $2,400.

10. Probable judgment on a pending suit against Javits was estimated at $50,000.

11. Costs other than accounting fees to be incurred in connection with the liquidation wereestimated at $10,000.

12. You had not submitted an invoice for $5,000 for the April 30, 2006, annual audit ofJavits, and you estimate a $1,000 fee for liquidation work.

Instructionsa. Prepare correcting journal entries for Javits Corporation on July 10, 2006.

b. Prepare a statement of affairs for Javits Corporation on July 10, 2006. Amounts in thestatement should reect the journal entries in a.

The adjusted trial balance of Laurel Company on June 30, 2006, is as follows:(Problem 14.5)


LAUREL COMPANYAdjusted Trial Balance

June 30, 2006

Debit Credit

Cash $ 14,135Notes receivable 29,000Interest receivable 615Trade accounts receivable 24,500Allowance for doubtful accounts $ 800Inventories 48,000Land 10,000Building 50,000Accumulated depreciation of building 15,000Machinery and equipment 33,000Accumulated depreciation of machinery and equipment 19,000Furniture and xtures 21,000Accumulated depreciation of furniture and xtures 9,500Goodwill 9,600Note payable to City Bank 18,000Notes payable to Municipal Trust Company 6,000Notes payable to suppliers 24,000Interest payable on notes 1,280Trade accounts payable 80,520Wages payable 1,400FICA and income taxes withheld and accrued 430Mortgage bonds payable 32,000Interest payable on mortgage bonds 1,820Common stock 70,000Retained earningsdecit 39,900

Totals $279,750 $279,750






Additional Information1. Notes receivable of $25,000 were pledged to collateralize the $18,000 note payable to

City Bank. Interest of $500 was accrued on the pledged notes receivable, and interest of$600 was accrued on the $18,000 note payable to the bank. All the pledged notes re-ceivable were considered collectible. Of the remaining notes receivable, a $1,000 non-interest-bearing note was uncollectible. The note had been received for an unconditionalcash loan.

2. Trade accounts receivable included $7,000 from Boren Company, which currently wasbeing liquidated. Creditors were expected to realize 40 cents on the dollar. The al-lowance for doubtful accounts was adequate to cover any other uncollectible accounts.A total of $3,200 of the remaining collectible trade accounts receivable was pledged ascollateral for the notes payable to Municipal Trust Company of $6,000 with accrued in-terest of $180 on June 30, 2006.

3. Inventories, valued at rst-in, rst-out cost, were expected to realize 25% of cost on aforced liquidation sale after the write-off of $10,000 of obsolete stock.

4. Land and buildings, which had been appraised at 110% of their carrying amount, weremortgaged as collateral for the bonds. Interest of $1,820 was accrued on the bonds onJune 30, 2006. Laurel expected to realize 20% of the cost of its impaired machinery andequipment, and 50% of the cost of its impaired furniture and xtures after incurring re-nishing costs of $800.

5. Estimated costs of liquidation were $4,500. Depreciation and accruals had been adjustedto June 30, 2006.

6. Laurel had net operating loss carryovers for income tax purposes of $22,000 forthe year ended June 30, 2005, and $28,000 for the year ended June 30, 2006. Theincome tax rate expected to be in effect when the operating loss carryovers were usedwas 40%.

InstructionsPrepare a statement of affairs for Laurel Company on June 30, 2006.

Bilbo Corporation, which is in bankruptcy reorganization, had $105,000 of dividends in ar-rears on its 7% cumulative preferred stock on March 31, 2006. While retained earnings wereadequate to permit the payment of accumulated dividends, Bilbos management did notwant to weaken its working capital position. It also realized that a portion of the plant as-sets was no longer used by Bilbo. Therefore, management proposed the following plan ofreorganization, which was accepted by stockholders and conrmed by the bankruptcycourt, to be effective on April 1, 2006:

1. The preferred stock was to be exchanged for $300,000 face amount and current fairvalue of 15%, ten-year bonds. Dividends in arrears were to be settled by the issuance of12,000 shares of $10 par, 15%, noncumulative preferred stock having a current fairvalue equal to par.

2. Common stock was to be assigned a par of $50 a share.

3. Impaired goodwill was to be written off; impaired plant assets were to be writtendown, based on appraisal and estimates of current fair value, by a total of $103,200,consisting of a $85,400 increase in the Accumulated Depreciation ledger account bal-ance and a $17,800 decrease in plant assets; other current assets were to be writtendown by $10,460 to reduce trade accounts receivable and inventories to net realizablevalues.

(Problem 14.6)

CHECK FIGUREb. Total assets,$1,137,530.

Documents

Bankrupty Liquidation and Reor