Chapter 20
Corporations
in Financial
Difficulty
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1
Understand the courses
of action available to
financially distressed
firms.
20-2
Overview
 A company in financial difficulty has a
large number of alternatives.

Bankruptcy is only a final course.
 A company may petition the courts for
bankruptcy to protect itself from an
onslaught of legal suits.


Some have also attempted to void union
contracts by petitioning for bankruptcy.
U.S. auto industry?
20-3
Courses of Action
 Nonjudicial Actions

Formal agreements between the company and
its creditors are legally binding but are not
administered by a court.
 Bankruptcy is the final step for a
financially distressed business.
20-4
Nonjudicial Actions
 Debt Restructuring Arrangements

Extension of due dates of its debt

Decrease of the interest rate on the debt

Modification of other terms of the debt contract
 Composition agreement

Creditors agree to accept less than the face
amount of their claims
20-5
Nonjudicial Actions
 Creditors’ committee management


Creditors may agree to “assist” the debtor in
managing the most efficient payment of
creditors’ claims.
Most creditors’ committees are advisory .



Counsel closely with the debtor
Do not want to assume additional liabilities and
problems of actual operation of the debtor
Usually initiated with a plan of settlement
proposed by the debtor
20-6
Nonjudicial Actions
 Transfer of assets

Debtors may transfer assets to obtain quick cash



Example: Factoring receivables
Assets may be sold “with recourse” or “without
recourse”
A transfer of financial assets is considered a sale
only if the transferor has surrendered control
over the transferred assets.

SFAS 140
20-7
Judicial Actions
Bankruptcy is a judicial action administered by
bankruptcy courts and bankruptcy judges using
the guidance provided in Title 11 of the United
States Bankruptcy Code.
Chapters of the Bankruptcy Code
Chapter 1
General Provisions
Chapter 3
Case Administration
Chapter 5
Creditors, the Debtor, and the Estate
Chapter 7
Liquidation
Chapter 9
Adjustment of Debts of a Municipality
Chapter 11
Reorganization
Chapter 12
Adjustment of Debts of a Family Farmer with Regular Annual Income
Chapter 13
Adjustment of Debts of an Individual with Regular Income
20-8
Judicial Actions
 Either the debtor or its creditors may
decide that a judicial action is best.


The debtor may file a voluntary petition
seeking judicial protection in the form of an
order of relief against the initiation or
continuation of legal claims by the creditors.
Creditors may file an involuntary petition
against the debtor.

Certain conditions must exist before creditors
may file a petition.
20-9
Practice Quiz Question #1
Which of the following is usually NOT
one of the debt restructuring
arrangements available to companies
in distress?
a. Extension of due dates.
b. Extension of additional loans from
the same lenders to pay off current
debt.
c. A decrease in interest rates.
d. Modification of debt terms.
e. None of the above.
20-10
Practice Quiz Question #2
Which of the following statements is true?
a. A Chapter 11 bankruptcy leads to the
liquidation of the corporation.
b. A Chapter 7 bankruptcy leads to the
reorganization of the corporation’s
debt.
c. A Chapter 11 bankruptcy leads to the
reorganization of the corporation’s
debt.
d. A Chapter 7 bankruptcy leads to the
adjustments of debt for an individual.
20-11
Learning Objective 2
Understand Chapter 11
reorganizations and be able
to prepare financial
statements for debtors-inpossession as well as a plan
of recovery.
20-12
Chapter 11 Reorganizations
 Temporary protection from creditors
 Allows time needed to

reorganize the debtor company

return its operations to a profitable level
 If granted protection, the company
receives an order of relief to suspend
making any payments on its prepetition
debt
 Bankruptcy court administers
reorganizations.

Can appoint trustees to direct the reorganization
20-13
Chapter 11 Reorganizations
 The company continues to operate while
it prepares a plan of reorganization.
 A disclosure statement is transmitted to
all creditors and other parties eligible to
vote on the plan of reorganization.
 The bankruptcy court then evaluates the
responses to the plan from creditors and
other parties and either confirms the plan
of reorganization or rejects it.
20-14
Chapter 11 Reorganizations
 Statement of Position No. 90-7


Provides guidance for financial reporting for
companies in reorganization
Financial statements should distinguish between


transactions and events directly associated with the
reorganization and
those associated with ongoing operations
20-15
Chapter 11 Reorganizations
 Fresh start accounting

SOP 90-7 states that fresh start reporting should
be used as of the confirmation date of the plan of
reorganization if both the following conditions
occur:
1. The reorganization value of the assets of the
emerging entity immediately before the date of
confirmation is less than the total of all postpetition
liabilities and allowed claims.
2. Holders of existing voting shares immediately before
confirmation receive less than 50 percent of the
voting shares of the emerging entity.
20-16
Chapter 11 Reorganizations
 Fresh start accounting

Compute the reorganization value of the
emerging entity’s assets


Fair value of the entity before considering liabilities
and approximates the amount a willing buyer would
pay for the entity’s assets
The reorganization value is then allocated to the
assets using the allocation of value method
20-17
Chapter 11 Reorganizations
 Fresh start accounting





A reorganization value in excess of amounts
assignable to identifiable assets is reported as an
intangible asset
The emerging company’s liabilities are recorded
at the present values of the amounts to be paid
Any retained earnings or deficits are eliminated
A set of final operating statements is prepared
just prior to emerging from reorganization
In essence, the company is a new reporting
entity after reorganization
20-18
Chapter 11 Reorganizations
 Companies not qualifying for fresh start
accounting should:
 Determine whether assets are impaired
 Report liabilities at the present values of
the amounts to be paid


Any gain or loss on the revaluation of the
liabilities can be extraordinary or ordinary
Unusual and infrequent = extraordinary
20-19
Chapter 11 Reorganizations
 Companies not qualifying for fresh start
accounting should:
 Recognize a liability for a cost associated
with an exit or disposal activity when the
liability is incurred, not at the earlier time
the company makes a commitment to an
exit plan

LT assets are divided between
1. Those to be held and used and
2. Those to be sold
20-20
Chapter 11 Reorganizations
 Plan of reorganization – Components
1. Disposing of unprofitable operations
2. Restructuring of debt with specific creditors
3. Revaluation of assets and liabilities
4. Reductions or eliminations of claims of original
stockholders and issuances of new shares to
creditors or others
20-21
Practice Quiz Question #3
Which of the following statements is true
about fresh start accounting?
a. Fresh start accounting focuses on prebankruptcy book values.
b. Fresh start accounting allows
management to revalue assets to any
value they feel is “fair and normal.”
c. Fresh start accounting is no longer legal
in the U.S.
d. Fresh start accounting focuses the fair
value of assets a willing buyer would
pay to acquire them.
20-22
Chapter 11 Reorganizations
PRACTICE—E20-2
20-23
Plan of Reorganization
Elimination
of Debt
Surviving
Reduction
of
and Equity
Debt
Assets
Post-petition liabilities
(30,000)
Claims/Interest:
Accounts Payable
(80,000)
8,000
Notes Payable, 10%
Related Int. Payable
(150,000)
(16,000)
25,000
16,000
Bonds Payable, 12%
Related Interest
Payable
(200,000)
(24,000)
18,000
(470,000)
67,000
(100,000)
(200,000)
(100,000)
171,000
178,000
(622,000)
(178,000)
(40,000)
Total
Common shareholders:
Common Stock
Additional Paid-In
Retained Earnings
Deficit
Total
Common
%
$2 par
Stock
Total
Value
$
(30,000)
%
(30,000)
100%
(72,000)
(72,000)
90
(125,000)
(125,000)
-0-
83
0
(200,000)
(6,000)
100
25
(200,000)
(6,000)
(230,000)
Recovery
(203,000)
100%
(200,000)
(29,000)
(200,000)
(29,000)
100%
(229,000)
(662,000)
20-24
Journal entries to record reorganization
(1)
Accounts Payable
Notes Payable, 10%
Interest Payable
Cash
Accounts Receivable (net)
Land
Gain on Disposal of Land
Gain on Discharge of Debt
Record discharge of debt.
80,000
150,000
40,000
6,000
72,000
85,000
40,000
67,000
20-25
Journal entries to record reorganization
(1)
(2)
Accounts Payable
Notes Payable, 10%
Interest Payable
Cash
Accounts Receivable (net)
Land
Gain on Disposal of Land
Gain on Discharge of Debt
Record discharge of debt.
80,000
150,000
40,000
Common Stock ($1 par)
Additional Paid-In Capital
Gain on Disposal of Land
Gain on Discharge of Debt
Common Stock ($2 par)
Retained Earnings
Record change in par value of stock
and elimination of deficit.
100,000
171,000
40,000
67,000
6,000
72,000
85,000
40,000
67,000
200,000
178,000
20-26
Learning Objective 3
Understand Chapter 7
liquidations and be able to
prepare a statement of
affairs.
20-27
Chapter 7 Liquidations
 Liquidations are administered by the
bankruptcy courts in the interests of the
corporation’s creditors and shareholders.
 The intent in liquidation is to maximize
the net dollar amount recovered from
disposal of the debtor’s assets.
20-28
Chapter 7 Liquidations
 Classes of creditors

Secured creditors



Have liens, or security interests, on specific
assets, often called “collateral”
A creditor with such a legal interest in a
specific asset has the highest priority claim on
that asset
Creditors with priority

Unsecured creditors having no collateral
claim against specific assets but have priority
over other unsecured creditors
20-29
Chapter 7 Liquidations
 Classes of creditors

Unsecured creditors



The lowest priority is given to these claims
Paid only after secured creditors and
unsecured creditors with priority are
satisfied
Often receive less than the full amount of
their claim
20-30
Chapter 7 Liquidations
 Statement of Affairs


The basic accounting report made at the
beginning of the process.
Presents the expected realizable amounts from

Disposal of the assets,

The order of creditors’ claims, and


The expected amount that unsecured creditors will
receive as a result of the liquidation.
A different report, also entitled the “Statement of
Affairs,” is a list of questions the debtor must
answer as part of the bankruptcy petition.
20-31
Chapter 7 Liquidations
 Statement of Affairs


An important planning report for the anticipated
liquidation of a company.
The Statement of Affairs includes

Book values of the debtor company’s balance sheet
accounts,

Estimated fair market values of the assets,

Order of the claims, and

Estimated deficiency to the general unsecured
creditors.
20-32
Practice Quiz Question #4
Which of the following is NOT one of the
classes of creditors that could be paid in
a Chapter 7 liquidation?
a. Secured creditors.
b. Unsecured creditors.
c. Creditors in jeopardy.
d. Creditors with priority.
20-33
Chapter 7 Liquidations
PRACTICE—E20-4
20-34
E20-4 Solution
a.
Schedule to calculate amount available for general unsecured creditors:
Total estimated fair values
$471,000
Claims of secured creditors:
Notes payable and interest
(Receivables and Inventory)
$115,000
Bonds payable and interest
(Land and Building)
231,000
(346,000)
$125,000
Claims of creditors with priority:
Wages payable
Taxes payable
Available to general unsecured creditors
$
9,500
14,000
(23,500)
$101,500
20-35
E20-4 Solution
b.
Accounts payable
Notes payable and interest
Less: Secured by receivables
and inventory
Total unsecured claims
Estimated
dividend:
$195,000
(115,000)
$ 95,000
80,000
$175,000
$101,500
$175,000 = 58%
20-36
E20-4 Solution
b.
Accounts payable
Notes payable and interest
Less: Secured by receivables
and inventory
Total unsecured claims
Estimated
dividend:
c.
$101,500
$175,000
$195,000
(115,000)
$ 95,000
80,000
$175,000
= 58%
Group
Credit
Percentage
Distributed
Accounts Payable
$ 95,000
58%
$ 55,100
Wages Payable
Taxes Payable
Notes Payable
and Interest
Bonds Payable
and Interest
9,500
14,000
80,000
115,000
100
100
58
100
9,500
14,000
46,400
115,000
231,000
100
231,000
$471,000
20-37
E20-4 Solution
Book Values
ASSETS:
Fair Values
(1) Assets pledged with fully secured creditors
100,000Land
220,000Building (net)
Less Bond Payable
Less Interest on Bonds Payable
(2) Assets pledged with partially secured creditors
60,000Receivables
90,000Inventory
Less Notes Payable
Less Interest on Notes Payable
80,000
160,000
240,000
(220,000)
(11,000)
Amt Avail to
Unsecured
Claims
(20,000)
(60,000)
9,000
50,000
65,000
115,000
(190,000)
(5,000)
(3) Free assets:
16,000Cash
250,000Equipment
Estimated Amount Available
Less Creditors with Priority
(a) Net estimated amount available to unsecured creditors:
Estimated Deficiency
16,000
100,000
Estimated G/L
on Realization
(10,000)
(25,000)
16,000
100,000
125,000
(23,500)
0
(150,000)
101,500
73,500
736,000
(265,000)
Total Unsecured Debt from liabilities
(b) Percent paid out to unsecured creditors:
175,000
0.58cents on the dollar
20-38
E20-4 Solution
Estimated
Amount
Unsecured
LIABIITLIES AND STOCKHOLDERS' EQUITY:
(1) Fully Secured Creditors
220,000 Bond Payable
11,000 Interest Payable
190,000
5,000
9,500
14,000
220,000
11,000
(2) Partially secured creditors
Notes Payable
Interest Payalbe
190,000
5,000
Less receivables and inventory
(115,000)
(3) Creditors with Priority
Wages Payable
Taxes Payable
80,000
9,500
14,000
23,500
(4) Remaining unsecured creditors
95,000
Accounts Payable
191,500
(5) Stockholders' equity
BV of Stockholders' Equity (736,000 - 544,500)
736,000
(Carry up to asset section)
95,000
175,000
20-39
Chapter 7 Liquidations
PRACTICE—P20-7
20-40
Assets
Estimated
Current
Values
Book
Value
(1)
$ 50,000
80,000
162,000
Assets pledged with fully secured
creditors:
Accounts receivable (net)
Less: 12% note payable and
interest
Land
Plant and equipment (net)
Less: Mortgages payable
and interest
(2)
30,000
79,000
5,000
55,000
81,000
7,000
250,000
72,000
$871,000
(3)
Estimated
Gain
(Loss) on
Realization
$ 50,000
(44,000)
$ 6,000
$110,000
150,000
$260,000
(234,600)
Assets pledged with partially
secured creditors:
Marketable securities
Less: 10% note payable
and interest
$ 22,000
Inventory
Less: Accounts payable
$ 75,000
(105,000)
Free assets:
Cash
Accounts receivable (net)
Inventory
Prepaid insurance
Plant and equipment (net)
Franchises
Estimated
Amount
Available
to
Unsecured
Claims
$
30,000
(12,000)
25,400
(8,000)
(29,400)
$
5,000
55,000
76,000
1,500
190,000
30,000
(4,000)
5,000
55,000
76,000
1,500
190,000
30,000
Estimated amount available
Less: Creditors with priority
Net available to unsecured creditors
Estimated deficiency
$388,900
(45,000)
$343,900
82,500
Total unsecured debt
$426,400
(5,000)
(5,500)
(60,000)
(42,000)
$(106,500)
20-41
Liabilities and Equities
Estimated
Amount
Unsecured
Book
Value
$ 44,000
234,600
29,400
105,000
-020,000
12,000
160,000
212,000
17,000
240,000
(203,000)
$871,000
b.
(1) Fully secured creditors:
12% note payable and interest
Mortgages payable and interest
(2) Partially secured creditors:
10% note payable and interest
Less: Marketable securities
Accounts payable
Less: Inventory
$ 44,000
234,600
$278,600
$ 29,400
(22,000)
$105,000
(75,000)
(3) Creditors with priority:
Estimated liquidation expenses
Wages payable
Taxes payable
(4) Unsecured creditors:
Accounts payable
Notes payable
Interest payable
$
7,400
30,000
$ 13,000
20,000
12,000
$ 45,000
160,000
212,000
17,000
(5) Stockholders' equity:
Common stock
Retained earnings (deficit)
% to unsecured
creditors:
$426,400
$343,900 = 80.65%
$426,400
20-42
Learning Objective 4
Understand trustee
accounting and reporting.
20-43
Additional Considerations
 Trustee accounting and reporting


Chapter 11 reorganization: Bankruptcy courts
appoint trustees to manage a company under

Management fraud,

Dishonesty,

Incompetence, or

Gross mismanagement
The trustee then attempts to rehabilitate the
business
20-44
Additional Considerations
 Trustee accounting and reporting


Chapter 7 liquidations: the trustee
expeditiously

Liquidates the company and

Pays creditors in conformity with the legal status
In some cases, the court appoints a trustee to
operate the company for a short time in an
effort to obtain a better price for the company
in entirety rather than selling it piecemeal
20-45
Additional Considerations
 Trustee accounting and reporting


Trustees examine the proof of all creditors’
claims against the debtor company
Sometimes the trustee receives title to all assets
as a receivership,


Becomes responsible for the actual management of
the debtor, and
must direct a plan of reorganization or liquidation
20-46
Additional Considerations
 Trustee accounting and reporting

The general form of the trustee’s opening entry,
accepting the assets of the debtor company, is as
follows:
Assets
Debtor Company – In Receivership
XXX
XXX
20-47
Additional Considerations
 Trustee accounting and reporting

Statement of realization and liquidation

a monthly report prepared for the bankruptcy court

shows the results of the trustee’s fiduciary actions
20-48
Additional Considerations
 Sections of the statement of realization
and liquidation
20-49
Practice Quiz Question #5
Which of the following is NOT true about
bankruptcy trustees?
a. Trustees are often appointed in a
Chapter 11 bankruptcy when
management cannot be trusted.
b. Trustees can be considered voluntary
employees of the company.
c. In a Chapter 7 bankruptcy, the trustee
liquidates the company and pays the
creditors.
d. In a Chapter 11 bankruptcy, the trustee
attempts to rehabilitate the business.
20-50
Conclusion
The End
20-51