Chapter 17: Corporate Liquidations and Reorganizationsby Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany Advanced Accounting, 10th editionby Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn

Corporate Liquidations: ObjectivesUnderstand differences among types of bankruptcy filings.Comprehend trustee responsibilities and accounting during liquidation.Understand financial reporting during reorganization.Understand financial reporting after emerging from reorganization, including fresh-start accounting.

1: Types of BankruptciesCorporate Liquidations and Reorganizations

InsolvencyEquity insolvencyInability to pay debts on timeMay avoid bankruptcy proceedingsNegotiate directly with creditors

Bankruptcy insolvencyHaving total debts in excess of the fair value of assetsMay be liquidated, orReorganized

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Types of BankruptciesChapter 7: LiquidationTrustee appoint to sell assets of business Chapter 9: Adjustments of Debts of a MunicipalityChapter 11: ReorganizationDebtor is expected to be rehabilitatedChapter 12: FarmersChapter 13: Adjustment of Debts of an Individual with Regular Income

CharacteristicsVoluntary bankruptcy proceedingsFiled by debtorInvoluntary bankruptcy proceedingsFiled by creditor or group of creditorsCourt actionDismiss a caseAccept the petitionChange form Chapter 11 reorganization Chapter 7 liquidation

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Duties of TrusteeTrustee in liquidation casesInvestigate debtor's financial affairsProvide information Examine, perhaps object to, creditor claimsFile report on trusteeshipIf authorized to operate debtor's business, other period reports are requiredIn reorganization cases, in addition to aboveFiling reorganization plan or statement why one cannot be filed

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Ranking of Claims: Liquidation

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2: Corporate LiquidationCorporate Liquidations and Reorganizations

Statement of AffairsLegal document prepared for bankruptcy courtAssets at expected net realizable valuesClassified on basis of availability for classes of creditorsLiabilities are classifiedPriority, fully secured, partially secured, unsecuredHistorical values included for reference

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Trustee AccountingAt start of caseNew set of booksThrough caseRecords transactionsStatement of cash receipts and disbursementsStatement of changes in estate equityBalance sheetStatement of realization and liquidationAt close of caseFinal settlement of claimsTrustee is dismissed

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3: Corporate ReorganizationCorporate Liquidations and Reorganizations

Chapter 11: Balance Sheet Prepetition liabilities subject to compromise are reported as a separate line item in liabilitiesArose before filingIncludeUnsecured and under-secured liabilitiesPrepetition secured liabilities and post petition liabilities reported in normal fashionPrepetition claims discovered after filing Included at court allowed amounts

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Chapter 11: Other StatementsReorganization costs shown separatelyInterest to be paid or probable amountDifferences from contractual amounts should be notedExpected stock or stock equivalent issuances should be disclosedCash flow items related to reorganization shown separately

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Combined Financial StatementsCondensed combined financial statements are prepared for all entities in reorganization proceedings as supplementary informationIntercompany receivables and payablesWrite-down if necessary

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4: Emerging from ReorganizationCorporate Liquidations and Reorganizations

Reorganization ValueApproximates fair value of entity without considering liabilitiesDiscounted future cash flows of reorganized businessConsider business and financial riskReorganization value determines how much creditors recoverEmerging business will either useFresh start reportingReport liabilities at present value and forgiveness of debt as extraordinary item

Qualify for Fresh Start ReportingJust before confirmation of the plan,Revaluation value must be less than post petition liabilities and allowed claims, andHolders of existing voting shares receive less than 50% of emerging entity

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Apply Fresh Start ReportingAllocated reorganization value to identifiable assetsUnallocated amount is an intangibleReorganization value in excess of amounts allocated to identifiable assetsLiabilities at current value at confirmation dateDeferred taxes follow FASB No. 109Prepare final reports of old entity

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Reorganization ExampleTiger files for protection under Chapter 11 on 1/5/08. Accordingly, it reclassifies prepetition liabilities.It obtains short term financing, acquires additional equipment and continues operations through 6/31/09 when the plan is approved.

First, we'll look at the statements pre and post reorganization. Then we'll go through the entries and adjustments that occurred.

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Balance Sheet Assets

Filed 1/5/08FYE 12/31/08Before6/30/09Fair value 6/30/09Revalu-ationAFTER 6/30/09Cash50 150 300 300 300 Accounts receivable500 350 335 335 335 Inventory300 370 350 375 25 375 Other current assets50 50 30 30 30 Land200 200 200 300 100 300 Building, net500 450 425 350 (75)350 Equipment, net300 330 290 260 (30)260 Patent200 150 125 0 (125)0 Reorganization value in excess of identifiable assets250 2,100 2,050 2,055 1,950 (105)2,200

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Changes to AssetsFair values and revaluation amounts are shown on 6/30/09 for comparison.Tiger continues operations, records depreciation and even acquires equipment from filing on 1/5/08 to reorganization on 6/30/09.The reorganization revalues the assets to their fair value on that date. Patents are completely written off.Tiger records an intangible "Reorganization value in excess of identifiable assets" of $250. Not all reorganizations result in this intangible.

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Balance Sheet Liability & Equity

Filed 1/5/08FYE 12/31/08Before 6/30/09AFTER 6/30/09Short term borrowing (post)150 75 75 Accounts payable (pre/post)600 100 125 125 Wages payable (post)50 55 55 Taxes payable (pre)150 150 Accrued bond interest (pre)90 Note payable (pre)260 Subordinated debt (post)395 12% bonds payable current (post)100 12% bonds payable (post)500 15% bonds payable (pre)1,200 Liabilities subject to compromise2,300 2,300 Capital stock (old)500 500 500 Capital stock (new)800 Additional paid in capital0 Deficit(700)(1,050)(1,000)0 2,100 2,050 2,055 2,200

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What Happened to Liabilities?Upon filing on 1/5/08, Tiger reclassifies the unsecured and partially secured liabilities at that point as Pre-petition Liabilities subject to compromise. Pre-petition Liabilities subject to compromise are reclassified or settled according to the plan.Accounts payable on 12/31/08 does not include any of the $600 due prior to filing.Taxes payable are still to be paid, and eventually recorded again in full.

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Changes in EquitySome of the creditors receive stock in the reorganized firm. The old shareholders also receive stock, but now own only $100 of $800 of the stock at book value.Although some APIC was recorded in reorganizing, it was subsequently eliminated. If it had been sufficient to wipe out the deficit, no intangible "reorganization value in excess of identifiable assets" would be recorded.The Deficit is removed: Fresh Start!

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Can Tiger Use Fresh Start?On 6/30/09 there were $255 in post-petition liabilities. All $2,300 pre-petition liabilities were allowed by the courts. Firm value is $2,200.1. Liabilities exceed reorganization value2. Old shareholders retain less than 50% Yes, fresh start is appropriate.

Post-petition liabilities$255 Allowed claims2,300 Total liabilities$2,555 Less reorganization value(2,200)Excess liabilities$355

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Reorganization Plan: 6/30/09

Pre-petition Liabilities and EquityNew AgreementsDebt Dis-charge15% partially secured bonds, $1200

$500 new stock, $500 senior 12% bonds, and another $100 bonds due 12/31/09$100Priority tax claims $150To be paid cash once confirmed$0Remaining unsecured claims, $950:$600 accounts payable$275 subordinated debt and $140 new stock$185$90 accrued interestForgiven$90$260 note$120 subordinated debt and $60 new stock$80Total debt discharged$455Old stock$100 new stockEquity

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Record New Debt AgreementsThis entry reclassifies the pre-petition debt according to the reorganization plan.

Liabilities subject to compromise (pre)2,300 Taxes payable150 12% senior debt500 12% senior debt - current 100 Subordinated debt395 Common stock (new)700 Gain on debt discharge455 settlement of prepetition claims

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Give Shareholders New SharesThey will lose control since creditors have $700 of common stock.

Common stock (old)500 Common stock (new)100 Additional paid in capital400 exchange of stock with owners

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Revalue AssetsA loss is recorded in revaluing the assets. Refer back to the Asset side of the balance sheet.

Inventory25 Land100 Loss on asset revaluation105 Buildings, net75 Equipment, net30 Patent125 revalue assets to fair value

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Calculate Balance in Retained Earnings (Deficit)If sufficient APIC had existed, there would be no intangible asset, and excess APIC would remain on the balance sheet.

Deficit, 6/30/09(1,000)Gain on debt discharge455 Loss on asset revaluation(105)Final measure of deficit, 6/30/09($650)Write-off Additional paid in capital400 Reorganization value in excess of identifiable assets (intangible asset)($250)

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Eliminate Deficit in EquityThe $1,000 deficit on 6/30/09 is adjusted for the gain on debt discharge and loss on asset revaluation. The net $650 deficit eliminates all of the APIC and creates a $250 intangible.

Reorganization value in excess of identifiable assets250 Gain on debt discharge455 Additional paid in capital400 Loss on asset revaluation105 Deficit 1,000

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Simplifying AssumptionsAll transactions are recorded on 6/30/09. Generally this takes some time.Creditors may have interest between submission and approval of plan. All pre-petition debt is approved.The $2,200 reorganization value of the firm probably used a discounted cash flow firm valuation model.

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DisclosuresAdjustments to historical valuesAssetsLiabilitiesDebt forgivenessPrior retained earnings or deficit eliminatedSignificant factors in determining the reorganization value

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