Chapter 13
Accounting for legal reorGANIZATIONS
AND LIQUIDATIONS
ANSWERS TO QUESTIONS
- "Insolvent" refers to a state of financial position whereby a company (or individual) is unable to pay debts as they come due.
- In the United States today, the primary piece of federal legislation that governs most bankruptcy proceedings is the Bankruptcy Reform Act of 1978 and its subsequent amendments.
- Bankruptcy cases have two overriding objectives:
—To achieve a fair distribution of assets to the various parties that are involved with an insolvent company (or individual) and
—To discharge the obligations of an honest debtor.
- A voluntary bankruptcy petition is one filed by an insolvent company to gain protection from its creditors. Creditors may also seek to prevent or limit losses by filing their own (involuntary) petition. Where a company has at least 12 unsecured creditors, a minimum of three (having total debts of over $10,775) must sign an involuntary petition. If fewer than 12 unsecured creditors exist, only one is needed to file the petition but the minimum debt level remains at $10,775.
- The granting of an order for relief halts all actions against an insolvent company. The order for relief provides the company as well as the creditors with the time to decide on a future course of action. It also brings the court into the process to provide a structure for what might otherwise be a chaotic event, the distribution of assets to the parties involved.
- A fully secured creditor has an obligation from an insolvent company but holds a collateral interest in assets that have a value in excess of the debt. Thus, these parties can assume that they will suffer no loss regardless of the outcome of the bankruptcy proceedings. A partially secured creditor also has a collateral interest but the liability is larger than the anticipated proceeds from the realization of the attached assets. A portion of the liability is covered but a risk of loss still exists in connection with the remaining debt. Unsecured creditors have no collateral interest and can only hope to collect after the various secured interests have been satisfied. Obviously, this last group of creditors has the highest chance of incurring a loss.
- A liability classified "with priority" is still unsecured. However, because of provisions of the Bankruptcy Reform Act of 1978, these debts must be paid before any other unsecured obligations. Thus, the chance of loss is reduced, sometimes significantly. Unsecured liabilities having priority are as follows:
—Claims for administrative expenses,
—Obligations arising between the date that a bankruptcy petition is filed and the appointment of a trustee or the issuance of an order for relief.
—Employee claims for wages earned during the 90 days preceding the filing of a bankruptcy petition (limited to $4,300 per person),
—Employee claims for contributions to a benefit plan earned during the 180 days preceding the filing of a bankruptcy petition (within certain restrictions),
—Deposits made with the company to acquire goods or services (up to a $1,950 limit),
—Government claims for unpaid taxes.
- Administrative expenses are classified as liabilities with priority to offer some protection to those individuals who serve the company during the period of insolvency. Without a legitimate chance for monetary reward, few people would be willing to provide the various administrative services needed during the bankruptcy process.
- In a Chapter 7 bankruptcy, the assets of the insolvent company are liquidated to satisfy the claims of the creditors. Business activities cease and noncash assets are sold. Conversely, in a Chapter 11 bankruptcy, the company attempts to survive its financial problems and return to solvency. A reorganization plan is developed that will allow the company to continue operations and reach a settlement of its debts. This reorganization plan must be accepted by each class of creditors, each class of stockholders, and the court.
- Unsecured creditors often face the possibility of absorbing substantial losses in a Chapter 7 liquidation since their claims rank below fully secured and partially secured liabilities. Because of this risk, unsecured creditors may feel that they have a better chance of limiting their losses by agreeing to a reorganization plan.
- The statement of financial affairs reports all assets of the insolvent company at net realizable value whereas liabilities are classified as fully secured, partially secured, with priority, and unsecured. Based on the cash proceeds being anticipated, an estimation can be made of the losses that will be incurred by each group of claimants. A statement of financial affairs is considered especially useful at the beginning of the bankruptcy process since it can assist the parties in evaluating the outcome of various possible actions.
- In general, a trustee is assigned to prevent loss of the insolvent company's assets and oversee the liquidation process. A number of rather procedural tasks are normally accomplished by the trustee shortly after appointment such as notifying the post office, changing locks, obtaining possession of corporate records, and opening a new bank account. Thereafter, the trustee may have to operate the company for a period of time to complete any business still in process. The trustee also has the power to void any transfer made by the debtor within 90 days prior to the filing of the bankruptcy petition if the company was insolvent at the time. Subsequently, the trustee works to liquidate noncash assets and make appropriate disbursements to the various claimants. During this entire process, the trustee needs to make periodic reportings to the court and other interested parties.
- A trustee can demand the return of any payment (or other asset transfer) made within 90 days prior to the filing of a bankruptcy petition if the company was already insolvent. This legal procedure is known as the voiding of a preference transfer and is intended to prevent one party from gaining an unfair advantage over the remaining claimants. In effect, the payment is viewed as a distribution of the insolvent company's assets, a process that is to be controlled solely by the trustee.
- A statement of realization and liquidation is designed to report (1) the account balances of the insolvent company at the date the order for relief is entered, (2) the liquidation of noncash assets, (3) the cash distributions made to the various claimants, (4) any other transactions incurred during this period, and (5) current asset and liability balances.
- During the liquidation of an insolvent company, control is turned over to an outside trustee. However, in a Chapter 11 bankruptcy (a reorganization), operations will usually be continued so that an attempt can be made to arrive at a plan to save the company. While the bankruptcy proceeds, control is normally retained by the ownership, a group legally referred to as a debtor in possession.
- In a Chapter 11 bankruptcy, the debtor in possession (the ownership of the company) is given the initial opportunity of filing a reorganization plan with the court. If a formal proposal is not put forth by the debtor in possession within 120 days of the order for relief or is not accepted within 180 days, any interested party has the right to submit a plan. Bankruptcy proceedings often drag on for lengthy periods because the time limitations can be extended by the court.
- Numerous types of proposals are to be found in reorganization plans. For example, many will set forth specific ideas for changes to be made in the company's operations (to increase profitability) such as selling assets or terminating complete lines of business. In addition, most reorganization plans identify sources that will be tapped in the future to generate additional funding. Proposed changes in management may also be spelled out in an attempt to persuade claimants that the company will have the ability to overcome its past economic problems. Last, and probably most important, a reorganization plan must include some anticipated settlement of the claims against the company that were in existence at the time the order for relief was entered. Before any reorganization plan is approved, the creditors (as well as the court) must be convinced that the financial rewards will outweigh the amounts that could be received from a liquidation.
- To become effective, a reorganization plan must be accepted by all interested parties. For approval, each class of creditors (more than twothirds in dollar amount and onehalf in number) must vote for the proposal. Each group of stockholders (twothirds of the shares being voted) must also accept the plan. The court will then confirm the reorganization plan but only if all parties are being treated fairly. The court also has the authority to confirm a proposal even if not accepted by the creditors or stockholders. This procedure (known as a "cram down") is only used if the plan is judged to be fair and equitable.
- A "cram down" is a legal provision whereby the court can confirm a reorganization proposal for an insolvent company even though the plan has not been accepted by a particular class of creditors or stockholders. This step is not taken unless the court believes the plan being put forth is fair and equitable.
- During reorganization, some debts are in jeopardy of being settled at a reduced amount whereas others will probably be satisfied entirely. Unsecured and partially secured liabilities are likely to be settled at an amount below face value. Conversely, fully secured liabilities and any debts incurred during the reorganization period are normally not at risk of being reduced. Thus, if a balance sheet is produced while a company is in reorganization, all liabilities are reported as either subject to compromise or not subject to compromise. The debts subject to compromise are reported at the expected amount of allowed claims rather than at an estimation of the settlement figure.
- A company going through a Chapter 11 bankruptcy will report specified reorganization items on its income statement separately from operating figures. These reorganization items are reported prior to income tax expense rather than in a manner similar to an extraordinary item. These separately reported figures include gains and losses on the sale of assets necessitated by the reorganization. Professional fees incurred in connection with the reorganization are reported in a similar manner. Any interest revenue that would not have been earned except for the bankruptcy proceeding is also reported as a reorganization item.
- Professional fees incurred during a reorganization must be expensed as incurred.
- Fresh start accounting refers to the adjustment of a company's assets and liabilities to current value at the time the organization emerges from bankruptcy. A company must use fresh start accounting if two criteria are met at the time the reorganization is finalized: (1) the market value of the assets is less than the total allowed claims as of the date of the order for relief plus the liabilities incurred during reorganization and (2) the original owners are left with less than 50 percent of the voting stock.
In fresh start accounting, all assets and liabilities are reported at current value. If the reorganization value of the company’s assets is greater than the total value of the individual assets, an intangible asset somewhat like goodwill must be established. Retained earnings must be zero.
- Fresh start accounting is used by companies emerging from a bankruptcy reorganization if the value of the assets held at that time are less than the allowed claims associated with liabilities (those present at the date of the order for relief and those incurred since that date) and the original owners are left with less than 50 percent of the voting stock of the reorganized company.
- In fresh start accounting, the tangible and intangible assets of the company are reported at their current values. Liabilities are reported at the present value of the future cash flows.
- When a company emerges from bankruptcy, the reorganization value of its assets must be determined. The figure is normally computed by discounting anticipated future cash flows from the business. This figure is then assigned to the various assets of the company. The total value may well be greater than the current value of the individual assets. If so, the residual amount is recorded as an intangible asset with a title such as "reorganization value in excess of amounts allocable to identifiable assets." This asset is amortized to expense over a period of up to 40 years although a shorter period is highly encouraged.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001
Advanced Accounting, Updated 6/e 13-1
ANSWERS TO PROBLEMS
1.B
2.D
3.B
4.C
5.A
6.D
7.C
8.B
9.C
10.B
11.A
12.A
13.A
14.B
15.C
16.A
17.C
18.A
19.D
20.C
21.C
22.(10 Minutes) (Distribution of cash in a liquidation)
Free Assets:
Current Assets ...... $ 35,000
Buildings and Equipment ...... 110,000
Total ...... $145,000
Liabilities with Priority:
Administrative Expenses ...... $ 20,000
Salary Payable (only $3,000 per employee)...... 6,000
Income Taxes ...... 8,000
Total ...... $ 34,000
Free Assets After Payment of Liabilities with Priority
($145,000 $34,000) ...... $111,000
Unsecured Liabilities
Notes Payable (in excess of value of security) ...$ 30,000
Accounts Payable ...... 85,000
Bonds Payable ...... 70,000
Total ...... $185,000
Percentage of Unsecured Liabilities To Be Paid: $111,000/$185,000 = 60 %
Payment On Notes Payable:
Value of Security (land) ...... $ 90,000
60% of Remaining $30,000 ...... 18,000
Total Collected ...... $108,000
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001
Advanced Accounting, Updated 6/e 13-1
23.(5 Minutes) (Distribution of assets in a liquidation) .
Liabilities with Priority
Paid first – administrative expense...... $3,000
Paid second – wages up to a maximum of
$4,300 each...... 8,600
Remaining money – government claims to unpaid taxes 400
Total of free assets...... $12,000
The remainder of the salaries and the government claims and all of the unsecured accounts payable will not result in any amount distributed from the liquidation of the Xavier company since no money is left.
24.(8 Minutes) (Distribution of assets to partially secured creditors)
Free Assets:
Other Assets ...... $ 80,000
Excess from Assets Pledged with fully Secured Creditors
($116,000 $70,000) ...... 46,000
Total ...... $126,000
Liabilities with Priority ...... $ 42,000
Free Assets after Payment of Liabilities with Priority
($126,000 $42,000) ...... $ 84,000
Unsecured Liabilities:
Excess of Partially Secured Liabilities Over Pledged
Assets ($130,000 $50,000) ...... $ 80,000
Unsecured Creditors ...... 200,000
Total ...... $280,000
Percentage of Unsecured Liabilities To Be Paid: $84,000/$280,000 = 30 %
Payment On Partially Secured Debt:
Value of Pledged Asset ...... $ 50,000
30% of Remaining $80,000 ...... 24,000
Total to be Collected ...... $ 74,000
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001
Advanced Accounting, Updated 6/e 13-1
- (8 Minutes) (Distribution of assets to partially secured creditors.)
Free Assets:
Cash...... $50,000
Excess from Assets Pledged with fully Secured
Creditors ($90,000 - $80,000)...... 10,000
Total...... $60,000
Liabilities with Priority...... 20,000
Free Assets after Payment of Liabilities with Priority.$40,000
Unsecured liabilities:
Excess of Partially Secured Liabilities Over
Pledged Assets ($150,000 - $130,000)...... $20,000
Accounts Payable...... 180,000
Total...... $200,000
Percentage of Unsecured Liabilities to be Paid: $40,000/$200,000 = 20%
Payment on Bond:
Value of Pledged Asset...... $130,000
20% of Remaining $20,000...... 4,000
Total to be Received...... $134,000
26.(12 Minutes) (Liquidation of assets to satisfy debt)
The holder of Debt Two will receive $100,000 from the sale of the pledged asset. Since the holder wants to receive $142,000 out of the total debt of $170,000, the company must be able to generate enough cash to pay off 60 percent of the unsecured liabilities ($42,000/$70,000) after paying 100 percent of the liabilities with priority ($110,000).
Unsecured Liabilities:
Unsecured Creditors ...... $230,000
Excess Liability of Debt One in Excess of Pledged Asset
($210,000 $180,000) ...... 30,000
Excess Liability of Debt Two in Excess of Pledged Asset
($170,000 $100,000) ...... 70,000
Total Unsecured Liabilities...... $330,000
Necessary Percentage ...... 60 %
Cash Needed For These Liabilities ...... $198,000
In order for the holder of Debt Two to receive exactly $142,000, the other free assets must be sold for $308,000. With that much money, the liabilities with priority ($110,000) can be paid with the remaining $198,000 going to the unsecured debts of $330,000. This 60 percent figure would insure that the holder of Debt Two would get $100,000 from the pledged asset and $42,000 ($70,000 x 60%) from the free assets.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001
Advanced Accounting, Updated 6/e 13-1
- (8 Minutes) (Payments to be made on unsecured and partially secured liabilities)
- The unpledged assets of $300,000 must be added to any excess to be received from assets pledged on fully secured debts ($200,000 $150,000 = $50,000) to get amount of free assets available of $350,000.
Amount Available ...... $350,000
Liabilities with Priority ...... (160,000)
Available for Unsecured Creditors ...... $190,000
Accounts Payable ...... $390,000
Excess of Partially Secured Debt in Excess of Pledged
Assets ($490,000 - $380,000)...... (110,000)
Unsecured Liabilities...... $500,000
Distribution to Unsecured Creditors: $190,000/$500,000 = 38%
An unsecured creditor to whom $3,000 is owed can expect to receive $1,140 ($3,000 x 38%).
- The bank will receive a total of $87,600. The secured interest will generate $80,000. The remaining $20,000 liability is unsecured so that only an additional payment of $7,600 (38%) can be expected.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001
Advanced Accounting, Updated 6/e 13-1
28.(20 Minutes) (Distribution of assets in a liquidation)
Free Assets: (fair market value)
Cash ...... $ 10,000
Inventory...... 60,000
Equipment...... 50,000
Total ...... $120,000
Liabilities with Priority:
Administrative Expenses ...... $ 20,000
Income Taxes ...... 30,000
Total ...... $ 50,000
Free Assets After Payment of Liabilities With Priority
($120,000 $50,000) ...... $ 70,000
Unsecured Liabilities
Note Payable A (in excess of value of security) ..$ 20,000
Note Payable B (in excess of value of security) ..80,000
Note Payable C ...... 60,000
Accounts Payable ...... 120,000
Total ...... $280,000
Percentage of Unsecured Liabilities To Be Paid: $70,000/$280,000 = 25%
Payment on Note Payable A:
Value of Security (land) ...... $ 70,000
25% of Remaining $20,000 ...... 5,000
Total Collected ...... $ 75,000
Payment on Note Payable B:
Value of Security (building) ...... $ 40,000
25% of Remaining $80,000 ...... 20,000
Total Collected ...... $ 60,000
Payment on Note Payable C (unsecured):
25% of $60,000 ...... $ 15,000
Payment on Administrative Expenses:
As a liability with priority, the entire $20,000 is paid.
Payment on Accounts Payable (unsecured):
25% of $120,000 ...... $ 30,000
Payment on Income Taxes Payable:
As a liability with priority, the entire $30,000 is paid.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001
Advanced Accounting, Updated 6/e 13-1
- (15 Minutes) (Liquidation of assets to satisfy debt)
Note payable B is unsecured. The holders want at least $125,000 of the total balance of $250,000; thus, there must be at least enough money available to pay 50 percent of the unsecured debts. All values are known except for the equipment.
Unsecured Liabilities:
Accounts Payable...... $180,000
Note payable A – unsecured portion...... 10,000
Note payable B ...... 250,000
Total...... $440,000
Free Assets (except for equipment):
Cash...... $24,000
Accounts receivable...... 28,000
Inventory...... 56,000
Land (value does not cover related debt)...... —0—
Buildings ($320,000 less coverage of $300,000
in bonds)...... 20,000
Total...... $128,000
Less: Liabilities with Priority:
Estimated administrative expenses...... (12,000)
Taxes payable to government...... (20,000)