CHAPTER 19 BANKRUPTCY REORGANIZATI ONS AND LIQUIDATIONS

CHAPTER 19

BANKRUPTCY REORGANIZATI

ONS

AND LIQUIDATIONS

FOCUS OF CHAPTER 19

• Bankruptcy Statutes• Bankruptcy Reorganizations• Liquidations• Accounting by Trustees

Bankruptcy Statutes: Their Significance

• Under the bankruptcy statutes, a company is placed under the protection of the bankruptcy court. This means that:– Creditors are prevented from taking

legal action individually otherwise available to them.

– Creditors’ legal rights are thus suspended for an indefinite period.

Bankruptcy Statutes: Their Significance

• When a corporation is in bankruptcy proceedings, the bankruptcy judge controls the company.

• A subsidiary in bankruptcy proceedings cannot be consolidated by its parentbecause the parent has lost control.

Bankruptcy Statutes: Applicability

• The bankruptcy statutes apply to:– Individuals.– Partnerships.– Corporations.– Municipalities.

Bankruptcy Statutes: Applicability

• The bankruptcy statutes do not apply to:– Insurance companies.– Certain financial institutions, such as

banks and savings and loans, which are subject to alternative regulations.

Bankruptcy Statutes: Types of Petitions

• A company can file for bankruptcy protection by filing a voluntary petition.

• A company’s creditors can file an involuntary petition if the debtor:– Is generally NOT paying its debts as they

become due or– Has appointed a custodian or given

possession of its property to a custodian.

Bankruptcy Statutes: Creditors With Priority

• A special class of creditors created by the bankruptcy statutes is called “creditors with priority.”

• These creditors are given statutory priority over the claims of other unsecured creditors with regard to payment.

Bankruptcy Statutes: Creditors With Priority

• Creditors Claims With Priority:– Administrative expenses related to the

bankruptcy proceeding (postpetition claims).

– Wages, salaries, and commissions earned within 90 days before the bankruptcy filing (up to $4,000 per employee).

– Employee benefit plan claims (specified).– Deposits by individuals.– Taxes.

Bankruptcy Statutes: Chapter 7 Vs. Chapter 11

• Chapter 7 of the Bankruptcy Statutes:– Deals with liquidations:

• Sell the assets, pay the creditors, close down the business.

• Chapter 11 of the Bankruptcy Statutes:– Deals with reorganizations:

• Certain debts are forgiven & the company is able to get a “fresh start.”

Bankruptcy Statutes: Chapter 11 Vs. Troubled Debt Restructuring

• Filing for bankruptcy reorganization is a last resort short of liquidation.

• Most companies prefer to attempt a troubled debt restructuring outside of the bankruptcy court. Advantages are:– Can be done in far less time.– Avoids the stigma of having gone through

bankruptcy proceedings.

Chapter 11 BankruptcyReorganizations: Management’s Role

• In a Chapter 11 bankruptcy filing, the debtor’s management usually:– Continues to manage and operate the

company.– Develops a plan of reorganization, to

be submitted to creditors and the bankruptcy court.

Chapter 11 BankruptcyReorganizations: Debt Forgiveness

• If the creditors approve of any plan of reorganization, certain debt is forgiven.– Formally, this is referred to as a

“discharge of indebtedness.”• Certain debt cannot be discharged under

the bankruptcy statutes, such as:– Taxes– Debt incurred under false pretenses.

Chapter 11 BankruptcyReorganizations: Accounting Issues

• The Accounting Issues:– How to calculate whether any debt has

been forgiven.• This issue includes whether interest

should be imputed.– How to report a forgiveness of debt.

Chapter 11 BankruptcyReorganizations: Accounting Issues

• These are the identical issues that exist in troubled debt restructurings, which are governed by FAS 15.

• However, the AICPA’s SOP 90-7, which applies exclusively to bankruptcy reorganizations applies—NOT FAS 15.

Chapter 11 BankruptcyReorganizations: SOP 90-7

• The central idea of SOP 90-7 is that the entity that emerges from Chapter 11 be deemed a new entity for which fresh-start financial statements should be prepared.

• No beginning retained earnings or deficit (deficits usually exist) is reported.

• A small percentage of entities emerging from Chapter 11 will not qualify for fresh-start accounting under SOP 90-7.


• Under SOP 90-7, comparative financial statements that straddle a confirmation date cannot be presented because it would be an inappropriate comparison of:– A former entity and– A new entity.


• Under SOP 90-7, any forgiveness of debt (“discharge of indebtedness”) is:– Calculated by determining the present

value of amounts to be paid using appropriate current interest rates.

– Reported as an extraordinary item in the predecessor entity’s final statement of operations.


• Under SOP 90-7, all assets are restated to reflect their fair value at the date of reorganization. Three steps are required:– Determining the “reorganization value”

of the entity—an amount that approximates what a “willing buyer” would pay for the assets of the emerging entity immediately after the restructuring.

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– Allocating the reorganization value to the entity’s tangible and intangible assets.

– Reporting any unallocated value as goodwill (subsequently to be evaluated periodically for impairment).

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• Under SOP 90-7, the “old entity” prior to

the confirmation date is to report:– Bankruptcy related losses and

expenses in a separate “REORGANIZATIONS ITEMS” category in its statement of operations.


• Also under SOP 90-7, the “old entity” prior to the confirmation date is to report IN ANY BALANCE SHEETS ISSUED, its liabilities in the following specified categories:– PRE PETITION liabilities subject to

compromise, – PRE PETITION liabilities not subject to

compromise (priority), and – POST PETITION liabilities (priority).

Chapter 7 Bankruptcy Liquidations

• In a Chapter 7 filing (for liquidation). the court usually appoints a trustee to liquidate the company.

• Trustees have the power to void fraudulent and preferential transfers made by the debtor within certain specified periods preceding the filing date.

Chapter 7 Bankruptcy Liquidations

• In a Chapter 7 filing, a special statement (called the “statement of affairs”) is prepared on a “quitting concern” basis.

• This statement provides information concerning how much money each class of creditors can expect to receive on liquidation of the company.– This is a pro forma (“as if ”) statement.

Accounting By Trustees

• If the court or creditors desire information that discloses the trustee’s responsibility for the book balances existing when the trustee was appointed, a statement of realization and liquidation can be prepared.– This is a historical statement in its

entirety (nothing pro forma about it).

Review Question #1

Which accounts are adjusted to a zero balance in a bankruptcy reorganization that qualifies for fresh start accounting?

A. Accumulated depreciation. B. Additional Paid-in Capital. C. Retained Earnings. D. Accumulated Deficit. E. None of the above.

Review Question #1With Answer

Which accounts are adjusted to a zero balance in a bankruptcy reorganization that qualifies for fresh start accounting?

A. Accumulated depreciation. B. Additional Paid-in Capital. C. Retained Earnings. D. Accumulated Deficit. E. None of the above.

Review Question #2

Which classifications are NOT used in a debtor’s balance sheet issued prior to adopting fresh start accounting in a bankruptcy reorganization? A. Prepetition liabilities—subject to compromise.B. Prepetition liabilities—not subject to

compromise.C. Postpetition liabilities—subject to compromise.D. Postpetition liabilities—not subject to

compromise.


Which classifications are NOT used in a debtor’s balance sheet issued prior to adopting fresh start accounting in a bankruptcy reorganization? A. Prepetition liabilities—subject to compromise.B. Prepetition liabilities—not subject to

compromise.C. Postpetition liabilities—subject to compromise.D. Postpetition liabilities—not subject to

compromise.

Review Question #3

How is a discharge of indebtedness in a bankruptcy reorganization that qualifies for fresh start accounting reported?

A. Extraordinary item in old entity’s statements.

B. Extraordinary item in new entity’s statements.

C. A credit to Additional Paid-in Capital.

D. A credit directly to Retained Earnings.

E. An item in Other Comprehensive Income.


How is a discharge of indebtedness in a bankruptcy reorganization that qualifies for fresh start accounting reported?

A. Extraordinary item in old entity’s statements.

B. Extraordinary item in new entity’s statements.

C. A credit to Additional Paid-in Capital.

D. A credit directly to Retained Earnings.

E. An item in Other Comprehensive Income.

End of Chapter 19

Time to Clear Things Up—Any Questions?

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CHAPTER 19 BANKRUPTCY REORGANIZATI ONS AND LIQUIDATIONS