Chapter 14
Bankruptcy:
Liquidation and
Reorganization
McGraw-Hill/Irwin
©The McGraw-Hill Companies, Inc. 2006
Scope of Chapter
 Reasons
for Business Failures
 The Bankruptcy Code
 Bankruptcy Liquidation
 Bankruptcy Reorganization
2
Reasons For Bankruptcy
 Poor
Management.
 Excessive Debt.
 Inadequate Accounting.
 Inability to pay liabilities as they
become due.
3
Reasons For Bankruptcy
Unsecured Creditors often resort to
lawsuits to satisfy their unpaid claims.
 Secured Creditors may force foreclosure
proceedings for real property or may
repossess personal property that
collateralizes a security agreement.

4
Reasons For Bankruptcy
Internal Revenue Services may seize the
assets, for failure to pay FICA and
income taxes withheld from employees.
 A business enterprise may be unable to
pay its liabilities even though the current
fair values of its assets exceed its
liabilities.

5
Reasons For Bankruptcy
An enterprise may experience a severe
cash shortage in times of price inflation
because of the lag between the purchase
or production of goods at inflated costs
and the recovery of the inflated costs
through increased selling prices.
 State of insolvency.

6
Insolvent Means

With reference to an entity other than a
partnership and a municipality, financial
condition such that the sum of such entity’s
debts is greater than all of its property, at a fair
valuation exclusive of –.
1.
2.
7
Property transferred, concealed, or removed with intent
to hinder, delay, or defraud such entity’s creditors; and.
Property that may be exempted from property of the
estate under … this title.
Insolvent Means

With reference to a partnership, financial
condition such that the some of such
partnership’s debts is greater than the
aggregate of, at fair valuation –.
–
–
8
All of such partnership’s property, exclusive of property
of the kind specified in subparagraph 1 above; and.
The sum of the excess of the value of each general
partner’s non-partnership property, exclusive of property
of the kind specified in subparagraph 2 above, over
such partner’s non-partnership debts;
Insolvent Means


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The terms insolvent and bankruptcy often
are used as interchangeable adjectives. Such
usage technically is incorrect.
Insolvent refers to the financial condition of a
person or business enterprise.
Bankrupt refers to the legal state of a person or
business enterprise.
The Bankruptcy Code
For the first 89 years under the
constitution, 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 insolvency prevailed.

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The Bankruptcy Code
In 1898 a Bankruptcy Act was enacted
that as amended, remained in effect for
80 years.
 This made state laws on insolvency to be
relatively dormant.
 In 1978 the Bankruptcy Reform Act
established the present Bankruptcy
Code.

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The Bankruptcy Code
In 1980 the Bankruptcy Tax Act
established a uniform group of income
tax rules for bankruptcy and insolvency.
 In 1994 the Bankruptcy Code was
amended by the Bankruptcy Reform Act
of 1994.

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The Bankruptcy Code


13
The U.S. Supreme Court may prescribe by
general rules the various legal practices and
procedures under the Bankruptcy Code.
Thus, the Federal Rules of Bankruptcy
Procedures established by the Supreme Court
constitute important interpretations of
provisions of the Bankruptcy Code.
Bankruptcy Liquidation

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The process of bankruptcy liquidation
under Chapter 7 of the Bankruptcy Code
involves the realization (sale) of the
assets of an individual or a business
enterprise and the distribution of the cash
proceeds to the creditors of the individual
or enterprise.
Bankruptcy Liquidation

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Creditors having security interests
collateralized by specific assets of the
debtor generally are entitled to obtain
satisfaction of all or part of their claims
from the assets pledged as collateral.
Bankruptcy Liquidation

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The Bankruptcy Code provides for priority
treatment for certain unsecured creditors;
their claims are satisfied in full, if possible,
from proceeds of realization of the debtor’s
non-collateralized assets.
Unsecured creditors without priority receive
cash, in proportion to the amounts of their
claims.
Bankruptcy Liquidation

Thus, there are four classes of creditors
in a bankruptcy liquidation:
–
–
–
–
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Fully secured creditors.
Partially secured creditors.
Unsecured creditors with priority.
Unsecured creditors without priority.
Debtor’s (Voluntary) Petition


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Under chapter 7 of Bankruptcy Code, any
person may file petition in a federal bankruptcy
court for voluntary liquidation.
Certain entities such as a rail road, an
insurance company, a bank, a credit union, or
a savings and loan association can not file
voluntary petition under chapter 7.
Debtor’s (Voluntary) Petition


The voluntary petition must be accompanied by
supporting documents exhibiting petitioner’s
debts and property.
The debts are classified as –.
–
–
–
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Creditors having priority.
Creditors holding security.
Creditors having unsecured claims without priority.
Debtor’s (Voluntary) Petition

The debtor’s property is reported as follows –.
–
–
–

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Real Property.
Personal Property.
Property claimed as exempt.
Valuations of property are at market or current fair
values.
The debtor’s bankruptcy petition must also be
accompanied by statement of financial affairs
(different from accounting statement).
Creditors’ (Involuntary)
Petition

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If a debtor other than a farmer, a nonprofit organization,
or one of the types precluded from filing voluntary
petitions owes amounts to 12 or more unsecured
creditors who are not employees, relatives,
stockholders, or other “insiders”, three or more of the
creditors having unsecured claims totaling $ 10,000 or
more may file in a federal bankruptcy court a
creditors’ petition for bankruptcy, also known as an
involuntary petition.
Creditors’ (Involuntary)
Petition


If fewer than 12 creditors are involved, one or
more creditors having unsecured claims of $
10,000 or more may file the petition.
The creditors’ petition for bankruptcy must
claim either.
–
–
22
The debtor is not paying debts as they come due or.
Within 120 days prior to the date of the petition, a
custodian was appointed for or had taken
possession of the debtor’s property.
Unsecured Creditors With
Priority
The following unsecured debts are to
be paid in full, in the order specified if
adequate cash is not available for all,
out of a debtor’s estate before any
cash is paid to other unsecured
creditors:
1. Administrative Costs.

23
Unsecured Creditors With
Priority
2. Claims arising after the commencement of a
creditors’ bankruptcy proceeding but before
appointment of a trustee or order for relief.
3. Claims for wages, salaries, and commissions,
including vacation, severance, and sick leave
pay not in excess of $ 4,000 per claimant,
earned within 180 days before the date of
filing the petition for bankruptcy.
24
Unsecured Creditors With
Priority
4.

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Claims for contributions to employee
benefit plans arising within 180 days
before the date of filing the petition.
The limit of such claim is $ 4,000 times
the number of employees covered by
the plans, less the aggregate amount
paid to the covered employees under
priority 3 above.
Unsecured Creditors With
Priority
5. Claims by producers of grain or fishermen
against storage or processing facilities, not
in excess of $ 4,000 per claimant.
6. Claims for cash deposited for goods or
services for the personal, family, or
household use of the depositor, not in
excess of $1,800 per claimant.
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Unsecured Creditors With
Priority
7. Claims for alimony, maintenance, or
support of a spouse, former spouse, or
child of the debtor, under a separation
agreement, divorce decree, or court
order.
8. Claims of governmental entities for
various taxes, subject to varying time
limitations.
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Property Claimed As Exempt
Certain property of petitioner is not
included in the debtor’s estate.
 Residential Property.
 Life Insurance Policies payable upon
death to spouse or relative.

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Roles of Court, Creditors &
Trustee


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The federal bankruptcy court oversees all
aspects of bankruptcy proceedings.
The first acts of the court is either to dismiss
the petition or to grant an order for relief
under the bankruptcy code.
The court appoints an interim trustee after
the order for relief, to serve permanently or
until a trustee is elected by the creditors.
Roles of Court, Creditors &
Trustee
Within 10 to 30 days after the order for
relief, court calls a meeting of the
creditors. At the meeting, the “outsider”
creditors appoint a trustee to manage the
debtor’s estate.
 The trustee assumes custody of the
debtor’s nonexempt property.
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Roles of Court, Creditors &
Trustee


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Trustee continues the operation of debtor’s
business if directed by the court.
Trustee realizes the free assets of the
operating the debtor’s estate, and pay cash
to unsecured creditors.
The trustee is responsible for keeping
accounting records to enable the filing of a
final report with the court.
Roles of Court, Creditors &
Trustee

The bankruptcy code empowers the trustee to
invalidate a preference,
–
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defined as the transfer of cash or property to an “outsider”
creditor for an existing debt, made while the debtor was
insolvent and within 90 days of filing the bankruptcy petition,
provided the transfer caused the creditor to receive more cash
or property than would be receive in the bankruptcy liquidation.
The trustee may recover from the creditor the cash or
property constituting the preference and include it in
the debtor’s estate.
Discharge of Debtor

Once the debtor’s property has been
liquidated, all secured and priority
creditors’ claims have been paid, and all
remaining cash has been paid to
unsecured and non-priority creditors:
–
33
the debtor mar receive a discharge, defined
as a release of debtor from all un-liquidated
debts, except followings:
Discharge of Debtor
–
–
–
–
34
The taxes payable to United States or any state
or subdivision, including taxes attributable to
improper preparation of tax returns.
Debts resulting from the debtor.’
Debts resulting from the debtor’s obtaining money
or property under false pretense or willful
conversion of the property of others.
Debts arising from embezzlement or other
fraudulent acts of debtor.
Discharge of Debtor
–
–
–
–
35
Amounts payable for alimony, maintenance or child
support.
Debts for willful and malicious injuries to the
persons or property of others.
Debts for fines, penalties, or forfeitures payable to
governmental entities, other than for tax penalties.
With certain exceptions, debts for educational loans
made, insured, or guaranteed by governmental
entities or by nonprofit universities or colleges.
Discharge of Debtor

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A debtor will not be discharged if any
crimes, misstatements, or other malicious
acts were committed by the debtor in
connection with the court proceedings.
In addition, a debtor will not not be
discharged if the current bankruptcy petition
was filed within six years of a previous
bankruptcy discharge to the same debtor.
The Statement of Affairs

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The accountant’s role in liquidation is concerned with
proper reporting of the financial condition of the debtor
and adequate accounting and reporting of the debtor’s
estate.
A business enterprise that enters bankruptcy
liquidation is a quitting concern, not a going
concern.
The financial statement designed for a business
enterprise entering liquidation is the statement of
affairs.
The Statement of Affairs


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The purpose of the statement of affairs is to display the
assets and liabilities of the debtor enterprise from a
liquidation viewpoint.
The assets displayed in the statement of affairs are
valued at current fair values; carrying amounts are
presented on a memorandum basis.
Assets and liabilities are classified according to the
rankings and priorities set forth in the Bankruptcy
Code.
Accounting & Reporting for
Trustees


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The accounting records of the debtor should be used
during the period that a trustee carries on the
operations of the debtor’s business.
An accountability technique should be used once the
trustee begins realization of the debtor’s assets.
The interim and final reports of the trustee to the
bankruptcy court are a statement of cash receipts and
payments, a statement of realization and liquidation,
supporting exhibits of assets not yet realized and
liabilities not yet liquidated.
Bankruptcy Reorganization


40
Chapter 11 of bankruptcy code provides for the
court-supervised reorganization of a debtor
business enterprise.
Reorganization involves the reduction of
amounts payable to some creditors, other
creditors’ acceptance of equity securities of the
debtor for their claims, and revision of the par
or stated value of the common stock of the
debtor.
Bankruptcy Reorganization

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A debtor’s petition for reorganization may be
filed by a railroad or by any “person” eligible to
petition for liquidation except a stockbroker or a
commodity broker.
Requirements for creditors’ petition for
reorganization are the same as those for a
liquidation petition.
Bankruptcy Reorganization

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During the process of reorganization,
management or owner of the business
enterprise may continue to operate the
enterprise as debtor in possession.
Alternatively, the bankruptcy court may appoint
a trustee to manage the enterprise.
Bankruptcy Reorganization

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A trustee is appointed because of fraud, dishonesty,
incompetence, or gross mismanagement by current
owners or managers.
A trustee may be appointed to protect the interests of
creditors or stockholders of the enterprise.
In some reorganization cases an examiner to
investigate possible fraud or mismanagement by the
current management.
Bankruptcy Reorganization

Among the powers and duties of the trustee are the
following:
–
–
–
44
Prepare and file in court a list of creditors of each class and
their claims and a list of stockholders of each class.
Investigate the acts, conduct, property, liabilities, and business
operations of the enterprise, consider the desirability of
continuing operations, and formulate a plan for such
continuance for submission to the bankruptcy judge.
Report to the bankruptcy judge any facts ascertained as to
fraud against or mismanagement of the debtor enterprise.
Plan & Accounting for
Reorganization

45
The plan of reorganization submitted by
the management or trustee to the
bankruptcy court is given to the debtor
enterprise’s creditors and stockholders,
to the U.S. Secretary of the Treasury, and
possibly to the SEC.
Plan & Accounting for
Reorganization
The plan must include provisions altering
or modifying the interests and rights of
the creditors and stockholders, as well as
a number of additional provisions.
 SEC may review the plan and may be
heard in the bankruptcy court’s
consideration of the plan.

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Plan & Accounting for
Reorganization

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Before the plan is confirmed by court, it must be
accepted by a majority of creditors, whose claims must
account for two-thirds of the total liabilities, and by
stockholders owning at least two-thirds of the
outstanding capital stock of each class.
If one or more classes of stockholders or creditors has
not accepted a plan, the bankruptcy court may confirm
the plan if the plan is fair and equitable to the nonacceptors.
Plan & Accounting for
Reorganization

The accounting for a reorganization typically
requires:
–
–
–
–
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journal entries for adjustments of carrying amounts
of assets;
reductions of par or stated value of capital stock;
extensions of due dates and revisions of interest
rates of notes payable;
exchanges of equity securities for debt securities;
and the elimination of a retained earnings deficit.
Plan & Accounting for
Reorganization

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The elimination of a retained earnings is
associated with fresh start reporting for a
reorganized enterprise whose liabilities exceed
the reorganization value of its assets.
Because of changes in the ownership of
common stock of such an enterprise, it is no
longer controlled by former stockholder group,
and it is a new reporting enterprise.
Plan & Accounting for
Reorganization


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Accountants must be careful to avoid charging postreorganization operations with losses that arose before
the reorganization.
Disclosure of Reorganization: The elaborate and
often complex issues involved in a bankruptcy
reorganization are disclosed in a note to the financial
statements for the period in which the plan of
reorganization was carried out.
The reorganized Company will account for the
Reorganization Plan utilizing the `Fresh Start’
reporting principles contained in SOP 90-7