CHAPTER
19
BANKRUPTCY
REORGANIZATI
ONS
AND
LIQUIDATIONS
FOCUS OF CHAPTER 19
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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 parent
because 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 Bankruptcy
Reorganizations: 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 Bankruptcy
Reorganizations: 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 Bankruptcy
Reorganizations: 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 Bankruptcy
Reorganizations: 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 Bankruptcy
Reorganizations: 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.
Chapter 11 Bankruptcy
Reorganizations: 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.
Chapter 11 Bankruptcy
Reorganizations: SOP 90-7
• 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.
Chapter 11 Bankruptcy
Reorganizations: SOP 90-7
• Under SOP 90-7, all assets are restated to
reflect their fair value at the date of
reorganization. Three steps are required:
#1 – 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.
Chapter 11 Bankruptcy
Reorganizations: SOP 90-7
#2 – Allocating the reorganization value to
the entity’s tangible and intangible
assets.
#3 – Reporting any unallocated value as
goodwill (subsequently to be
evaluated periodically for impairment).
Chapter 11 Bankruptcy
Reorganizations: SOP 90-7
• 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.
Chapter 11 Bankruptcy
Reorganizations: SOP 90-7
• 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.
B.
C.
D.
E.
Accumulated depreciation.
Additional Paid-in Capital.
Retained Earnings.
Accumulated Deficit.
None of the above.
Review Question #1
With Answer
Which accounts are adjusted to a zero
balance in a bankruptcy reorganization
that qualifies for fresh start accounting?
A.
B.
C.
D.
E.
Accumulated depreciation.
Additional Paid-in Capital.
Retained Earnings.
Accumulated Deficit.
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.
Review Question #2
With Answer
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.
Review Question #3
With Answer
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
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