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Chapter 20 - Corporations in Finanacial Difficulty

CHAPTER 20

CORPORATIONS IN FINANCIAL DIFFICULTY

ANSWERS TO QUESTIONS

Q20-1 The nonjudicial actions available to a financially distressed company are debt restructuring arrangements and creditor's committee management. The judicial actions available are corporate liquidation (Chapter 7) and corporate reorganization (Chapter 11).

Q20-2 The major difference between a Chapter 7 action and a Chapter 11 action is that the debtor continues as a business after a Chapter 11 reorganization whereas the business does not survive a Chapter 7 liquidation.

Q20-3 Under two circumstances an involuntary petition for relief may be filed. The first circumstance is that the debtor is generally not paying debts as they become due. The second circumstance is that within the last 120 days a custodian has been appointed by other creditors, by the debtor, or by some other agency to take possession of the debtor's assets. If more than 12 creditors exist, then three or more creditors must combine to file the petition. These three or more creditors must have aggregate unsecured claims of at least $5,000.

Q20-4 The following items are usually included in the Plan of Reorganization filed as part of a Chapter 11 reorganization:

All major actions to be taken during the reorganization:(1) Discontinuances of unprofitable operations(2) Restructuring of debt with specific creditors(3) Revaluation of assets and liabilities(4) Changes in the par value of outstanding stock, or realignment of

stockholders' equity with newly issued shares of voting common stock.

Q20-5 The account Reorganization Value in Excess of the Amount Assigned to Identifiable Assets is established during a Chapter 11 fresh start accounting to record the excess of the reorganization value that is not assigned to specific assets. The account is an intangible asset and is accounted for in accordance with FASB 142.

Q20-6 A company in Chapter 11 reorganization qualifies for fresh start accounting if both of the following occur: 1. The reorganization value of the entity's assets of the emerging entity immediately before the date of confirmation is less than the total of all post-petition liabilities and allowed claims; and 2. Holders of existing voting shares immediately before confirmation receive less than 50% of the voting shares of the emerging entity.

Companies using fresh start accounting revalue their assets to fair values, using the procedures in FASB 141. An account called Reorganization Value in Excess of the Amount Assigned to Identifiable Assets is used to record any excess in reorganization value not assigned to specific assets.

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Q20-7 The financial statements that must be filed by a company during a Chapter 11 reorganization include a complete set of audited financial statements. SOP 90-7 established specific guidelines for these statements, noting that amounts associated with reorganization should be reported separately.

Q20-8 The rights of creditors with priority in a Chapter 7 liquidation are to receive any assets available to unsecured creditors after the secured creditors have been satisfied.

Q20-9 The statement of affairs is the basic accounting report made at the beginning of the liquidation process to present the expected realizable amounts from disposal of the assets, the order of creditors' claims, and the expected amount unsecured creditors will receive as a result of the liquidation. In addition, the statement of affairs presents the book values of the debtor company's balance sheet accounts and the estimated deficiency to the general unsecured creditors. As a final point, the statement of affairs is not a going concern report.

Q20-10* A trustee who takes title to the debtor's assets in a liquidation must make a periodic financial report to the bankruptcy court reporting on the progress of the liquidation and on the fiduciary relationship held. When the trustee accepts the assets, a new set of books is opened for the debtor and a new account is created to recognize the debtor's interest in the net assets accepted by the trustee. A statement of realization and liquidation is prepared on a monthly basis for the bankruptcy court showing the results of the trustee's fiduciary actions’ beginning at the point the trustee accepts the debtor's assets.

Q20-11* Sales of assets are reported in the statement of realization and liquidation as assets realized in the assets section of the statement.

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SOLUTIONS TO CASES

C20-1 Creditors' Alternatives

The options to the creditors are (1) form a creditors' committee, (2) a Chapter 11 reorganization, and (3) a Chapter 7 liquidation. The eventual decision must rest upon the creditors' assessment of the viability of the rehabilitation of the debtor versus the liquidation values of the debtor's assets.

Most creditors do not want to see the liquidation of a debtor because, as creditors, they are in the business of loaning monies, not trying to manage a business or attempting to obtain as much of a liquidation dividend as possible in a liquidation. Most creditors will work with the debtor's management as long as possible. Secured creditors have greater protection of their receivables than do unsecured creditors. However, even most secured creditors prefer to see a debtor company be rehabilitated after a time of financial difficulty rather than see the debtor liquidated. The timing of the cash flows is somewhat dependent on the amount of reduction in debt the creditors are willing to absorb. If the creditors are willing to work with the debtor, the creditors may eventually realize a greater percentage of their debt, but it usually takes a longer time to receive the payments from the debtor.

The creditors' committee is a nonjudicial action that provides for flexibility to both the creditors and the debtor. The creditors' committee typically works with the debtor company to enact a plan of settlement of the debtor's indebtedness. In some cases, the creditors may assume management control of the company, but most creditors are reluctant to do this because of the added risk of legal action if the company does enter bankruptcy. Creditors may eventually receive a substantial part, or possibly all, of their receivables as the debtor is able to "work down" its debt over time.

Chapter 11 reorganization offers the creditors a chance to continue having a customer once the customer solves its immediate financial problems. A reorganization is an acceptable option if the creditors feel the company would have the basic operating and financial foundations after the reorganization to become a going concern. Creditors often accept reduced amounts as settlements of their receivables, or will modify the terms of existing debt as part of the reorganization agreement.

Chapter 7 liquidations are the final step. The creditors must go through the judicial process that may take a long time to complete. Liquidation should be used only if no other alternative is viable. Creditors often receive a smaller portion of their receivables because of the forced liquidation of the assets and the extensive legal and administrative costs involved in a liquidation.

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C20-2 Research Related to Bankruptcy

The website for the U.S. Bankruptcy Courts is: www.uscourts.gov/bankruptcycourts.html

a. The Frequently Asked Questions (FAQs) for the U.S. Bankruptcy Courts state that a U.S. bankruptcy judge is a district court judicial officer who is appointed by the majority of judges of the U.S. appeals court to have jurisdiction over bankruptcy matters. As bankruptcy cases come before a district court, a bankruptcy judge is assigned to the case. Some courts assign judges based on random assignment while other courts have a chief judge who seeks to select a judge to assign based on a judge’s experience or special expertise relevant to the case. Each court will have a written plan or system for assigning cases.

b. The U.S. Bankruptcy Court’s Website has a link to Official Bankruptcy Forms to be used in filings before the courts. The forms and instructions for a Voluntary Petition are available in Part I of the Bankruptcy Forms Manual page. The official form is FORM B1 for a voluntary petition. A voluntary petition is initiated by the debtor and therefore the information required is principally related to the debtor, such as name, address, and location of the principal assets of the debtor. The debtor must declare such items as the number of creditors, the estimated assets, the estimated debts, the type of petition (i.e., Chapter 7, Chapter 11, etc.), if sufficient funds will be available to satisfy the unsecured creditors. The debtor may also be required to file additional exhibits (Exhibit A for publicly traded companies, Exhibit B is used in personal filings and Exhibit C to describe any property that might pose a threat of identifiable harm to public health or safety).

c The United States Bankruptcy Courts Website presents a link to Bankruptcy Statistics that are presented in .pdf format. Statistics are presented for various time periods such as quarters, fiscal years and calendar years. Note that Case 20-3 asks for the most recent calendar year ending on December 31. (1) Total business filings are presented at the top of the form for business and

nonbusiness filings for the twelve month period ended for the most recent year. Statistics for prior years are also available. Business filings are typically about 34,000 but do fluctuate slightly based on economic conditions. Approximately sixty percent of these filings are under Chapter 7, about twenty-eight percent under Chapter 11, and the remainder under various other chapters of the Bankruptcy Code.

(2) Students should find the Federal judicial district in which their educational institution is located. The larger states typically have several districts and students may have to make an assumption for which district they are located. It is instructive to see that the numbers of filings vary widely by district. The number of filings may differ due to different economic factors for specific parts of the United States, the nature of the industrial base in a specific district, the size of a district, and other factors reflecting business factors across court districts. Students might reflect on why the number of filings in their Federal court district are different from those in other districts in other circuits.

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C20-3* Selection of Bankruptcy Trustee and Trustee’s Responsibilities

Title 11 of the United States Code may be obtained from several sources through using a web browser and the search term, “Title 11 of the U.S. Code.” The case asks about trustees for a Chapter 7 bankruptcy filing.

a. Subchapter 1 of Chapter 7 of Title 11 of the U.S. Code specifies the administration of a Chapter 7 bankruptcy filing. Section 701 states that the United States Trustee shall appoint an interim trustee who is a member of the panel of private trustees established under federal law. Private trustees are persons who have prior financial expertise and experience and have been approved by a formal review process. After the appointment of an interim trustee, Section 702 describes how creditors may elect a trustee under the circumstances in which creditors holding at least twenty percent of the unsecured claims request that an elected trustee administer the Chapter 7 bankruptcy. A candidate must receive the votes of creditors holding a majority of the claims of the unsecured creditors.

b. Section 704 of Subchapter 1 of Chapter 7 of Title 11 of the U.S. Code defines the duties of the trustee. The trustee is responsible for administering the business, is accountable for all property received, and must evaluate the claims of the creditors to make sure the claims are valid prior to settlement. The trustee also prepares periodic reports and summaries of the operations of the business which it provides to the United States Trustee or Bankruptcy Court. Upon completion of the operations, the trustee must file a final report on the administration of the estate with the court and with the United States Trustee.

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C20-4 The Bankruptcy of WorldCom

Overall, the 2002 bankruptcy of WorldCom resulted in a cumulative net reduction to their shareholders’ equity of $70.8 billion as of December 31, 2001, and a reduction in previously reported net income of $17.1 billion and $53.1 billion for the years ended December 31, 2001, and 2000 respectively. Goodwill of $44.9 billion was reduced to zero at December 31, 2001. The WorldCom bankruptcy and resultant adjustments made during the reorganization process are certainly one of the most significant bankruptcies in U.S. business history.

The following information is taken from WorldCom Inc.’s 10-K for the fiscal year 2002 that was filed with the SEC on March 12, 2004.

a. (Source: Item 3, Legal Proceedings) WorldCom filed a voluntary petition for bankruptcy on July 21, 2002, under Chapter 11, Reorganization.

b. (Source: Item 3, Legal Proceedings and the MD&A) The primary reason seems to be that management and the Board of Directors had been informed of very significant accounting irregularities and needed time to investigate the possible irregularities, and to protect the company from lawsuits from creditors and others. For example, on June 26, 2002, the SEC filed a civil suit against the company for its past financial reports. On April 29, 2002, Bernard Ebbers resigned as President and Chief Executive Officer. The company undoubtedly felt it needed the protection of bankruptcy to give it time to study the breadth of its financial and accounting problems and to reorganize to recover from those problems without additional legal pressure from its creditors.

c. (Source: Item 3, Legal Proceedings) On June 25, 2002, the company publicly announced that an internal audit found a number of transfers from line cost expenses (referred to as access cost expenses) to capital accounts, thus decreasing expenses and increasing assets. For the year 2001 and the first quarter of 2002, this amount of transfer was $3.9 billion. In addition to this item, the company was improperly accounting for impairment tests on its long-lived assets, its acquisitions, its revenue contracts and several other irregularities. However, it was the accounting for the access costs as assets when they were clearly expenses that were the primary accounting irregularity that initiated the internal review.

d. (Source: Item 7, Management’s Discussion and Analysis) Item 7 of the company’s 2002 10-K presents a section titled “Restatements and Reclassifications of Previously Issued Consolidated Financial Statements”. A table is presented that summarizes the restatement items on revenue and pre-tax income or loss for the years ended December 31, 2001 and 2000. The major categories of income statement restatement adjustments are presented below (in $millions), with a brief explanation of each category following the table: (Parentheses used for decreases in reported amounts)

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C20-4 (continued)Year Ended

December 31, 2001Year Ended

December 31, 2000

Item: RevenuePre-tax

income (loss) RevenuePre-tax

income (loss)Previously reported 35,121 2,375 39,020 7,581Restatement adjustments:1. Impairment --- (12,592) --- (47,180)2. Improper reduction of access costs

--- (2,933) 6 (1,827)

3. Purchase accounting 14 (2,273) (193) (3,567)4. Long lived asset adjustments

--- 2,750 --- (1,713)

5. International adjustments (749) (899) 18 (487)6. Revenue related adjustments

(1,204) (575) (36) (995)

7. Adjustments to accrued liabilities

--- (823) --- (732)

8. Embratel and Avantel acquisitions

5,268 (35) 1,127 (325)

9. Unclassified income/ (expense)

--- 383 --- (426)

10. Other (7) (506) 4 (750)Total adjustment items 3,322 (17,503) 926 (58,002)Discontinued Operations Adjustment

(775) 1,323 (602) 449

Revenue, as restated 37,668 39,344Minority interest adjustment (669) 52Pre-tax loss, as restated (14,474) (49,920)

Because most of the accounting personnel, including the Chief Financial Officer and the controller, were terminated shortly after the large scope of the accounting irregularities were discovered, the company determined that it could not objectively restate periods prior to the 2000 fiscal year. However, a minor adjustment decrease of $.7 billion was made to the ending shareholders’ equity as of December 31, 1999. A brief explanation of each of the 10 adjustment categories above is summarized from the disclosures in Item 6 of WorldCom’s 2002 10-K.1. Impairment: The company discovered that impairment tests had not been

performed for goodwill and long-lived assets even though FASB 121 triggers had occurred. The application of these impairment tests resulted in very significant writedowns for both 2000 and 2001.

2. Improper reduction of access costs: The primary adjustments for this item were due to the improper capitalization of access costs that should have been expensed as incurred in accordance with GAAP.

3. Purchase accounting: The company made numerous acquisitions, including the MCI acquisition, between 1993 and 2001 and a review of these acquisitions concluded that a number of errors were found in the application of purchase accounting valuations and procedures that overstated the amounts capitalized for the acquisitions.

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C20-4 (continued)

4. Long lived asset accounting: This item includes adjustments to depreciation and amortization, changes in the estimated useful lives of long-lived assets, including those acquired in the MCI combination, and other costs that had been inappropriately capitalized as long-lived assets that should have been expensed.

5. International: Adjustments were made for correcting the U.S. GAAP-based statements from the foreign accounting principles. In addition, a review of the functional currency rules resulted in changing the functional currencies for many of the international subsidiaries from the local currency to the U.S. dollar.

6. Revenue related adjustments: A number of adjustments were made because of lack of documentation to support the company’s deferral of income under SAB 101. In addition, the company had incorrectly accounted for some contracts as sales when in fact the company had acted as an agent and should have recorded just the net of the amounts as income rather than record gross sales and gross costs.

7. Adjustments to accrued liabilities: Adjustments were made to eliminate improper accruals of liabilities for items such as legal reserves, employee benefits and tax liabilities.

8. Embratel and Avantel acquisitions: A review of the Embratel acquisition showed an incorrect interpretation with regard to not having control over Embratel and that Embratel should have been consolidated rather than reported net as an investment. A review of the Avantel relationship to WorldCom resulted in changing the accounting from an equity investment to a full consolidation.

9. Unclassified income/ (expense): A review of several accrued liability accounts showed that there was inadequate documentation to support the accruals. Also, there were other accrued assets and some liabilities recorded on the historical balance sheet for which there was either no, or inadequate, documentation to support that the company owned the assets or owed the liabilities.

10. Other: The company made a number of reclassifications, revaluations of derivatives, intercompany balances, and certain capitalized costs such as interest, labor and overhead for capital projects.

These adjustments were also carried through the restated balance sheet and statement of cash flows for 2001 and 2000.

e. (Source: Item 7 of WorldCom’s 2002 10-K) From the date the bankruptcy petition was filed, July 21, 2002, through the entire reorganization period, the company used the provisions of SOP 90-7 for accounting and financial reporting purposes. The “Debtors-In-Possession” heading informs readers of the financial statements that the company is in bankruptcy reorganization but management still controls the company under the administration of a bankruptcy trustee. The balance sheet reports pre-petition liabilities separately from others and liabilities not subject to compromise are reported separately in both the current and noncurrent sections of the balance sheet. The income statement separately reports the reorganization gain or loss realized during the reorganization period.

f. (Source: Item 7 of WorldCom’s 2002 10-K) Towards the beginning of Item 7, the 10-K reports that the company will adopt fresh-start accounting under the provisions of SOP 90-7 as of the fresh-start reporting date. The company will revalue its assets and liabilities, allocate the reorganization value to the assets and liabilities, eliminate the accumulated deficit in shareholders’ equity, and the company’s new debt and equity will be recorded.

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SOLUTIONS TO EXERCISES

E20-1 Multiple-Choice Questions on Chapter 11 Reorganizations [AICPA Adapted]

1. c

2. d

3. c

4. d

5. c

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E20-2 Recovery Analysis for a Chapter 11 Reorganization

a. Recovery analysis for plan of reorganization:

Taylor Companies, Inc.Plan of Reorganization

Recovery AnalysisDecember 31, 20X1

Recovery

Elimination Reduction $2 parof Debt Surviving of Taylor's Common Stock Total Recovery

and Equity Debt Assets % Value $ %

Post-petition liabilities (30,000 ) (30,000) (30,000) 100%

Claims/Interest: Accounts Payable (80,000) 8,000 (72,000) (72,000) 90

Notes Payable, 10% (150,000) 25,000 (125,000) (125,000) 83 Related Interest Payable (16,000) 16,000 -0- 0

Bonds Payable, 12% (200,000) (200,000) (200,000) 100 Related Interest Payable (24,000 ) 18,000 (6,000) (6,000) 25

Total (470,000) 67,000

Common shareholders: Common Stock (100,000) (100,000) 100% (200,000) (200,000) Additional Paid-In (200,000) 171,000 (29,000) (29,000) Retained Earnings Deficit 178,000 (178,000) Total (622,000) (40,000 ) (230,000) (203,000) 100% (229,000) (662,000)

Note: Parentheses indicate credit amount.

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E20-2 (continued)

b. Journal entries to record reorganization:

(1) Accounts Payable 80,000Notes Payable, 10% 150,000Interest Payable 40,000 Cash 6,000 Accounts Receivable (net) 72,000 Land 85,000 Gain on Disposal of Land 40,000 Gain on Discharge of Debt 67,000 Record discharge of debt.

(2) Common Stock ($1 par) 100,000Additional Paid-In Capital 171,000Gain on Disposal of Land 40,000Gain on Discharge of Debt 67,000 Common Stock ($2 par) 200,000 Retained Earnings 178,000 Record change in par value of stock and elimination of deficit.

E20-3 Multiple-Choice Questions on Chapter 7 Liquidations

1. c

2. a

3. d

4. a

5. c

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E20-4 Chapter 7 Liquidation

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 $ 9,500 Taxes payable 14,000 (23,500 )Available to general unsecured creditors $101,500

b. Accounts payable $ 95,000 Notes payable and interest $195,000 Less: Secured by receivables and inventory (115,000) 80,000 Total unsecured claims $175,000

Estimated dividend: $101,500 = 58%$175,000

c. Group Credit Percentage Distributed

Accounts Payable $ 95,000 58% $ 55,100Wages Payable 9,500 100 9,500Taxes Payable 14,000 100 14,000Notes Payable 80,000 58 46,400 and Interest 115,000 100 115,000Bonds Payable and Interest 231,000 100 231,000

$471,000

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E20-5* Statement of Realization and Liquidation

Pace CorporationStatement of Realization and Liquidation

Assets

Assets to be Realized Assets Realized

Old Receivables, net $ 38,000 Old Receivables $ 21,000Marketable Securities 12,000 New Receivables 47,000Old Inventory 60,000 Marketable Securities 10,500Depreciable Assets, net 96,000 Sales of Inventory 75,000

Assets Acquired Assets Not Realized

New Receivables 75,000 Old Receivables, net 17,000New Receivables, net 28,000Depreciable Assets 80,000

Supplementary Items

Supplementary Charges Supplementary Credits

Trustee's Fee $ 4,300 Net Loss $ 6,800

Liabilities

Liabilities Liquidated Liabilities to be Liquidated

Old Current Payables $ 22,000 Old Current Payables $ 48,000

Liabilities Not Liquidated Liabilities Incurred

Old Current Payables 26,000 $333,300 $333,300

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SOLUTIONS TO PROBLEMS

P20-6 Chapter 11 Reorganization

a. Recovery analysis for plan of reorganization:

Polydorous CorporationPlan of Reorganization

Recovery Analysis

Recovery

Pre-Confir-mation

Eliminationof Debt

and Equity

SurvivingDebt

Cash12%

SecuredNotes

Common%

StockValue

Total$

Recovery%

Post-petition liabilities (10,000 ) (10,000) (10,000) 100%

Claims/Interest: Accounts Payable (160,000) 20,000 (40,000) (100,000) (140,000) 88

Interest Payable (20,000) 10,000 (10,000) (10,000) 50

Notes Payable, 10% (340,000) 60,000 (10,000) (240,000) 30 (30,000) (280,000) 82

Total (520,000) 90,000

Preferred Shareholders (100,000) 50,000 50 (50,000) (50,000)

Common Shareholders (150,000) 130,000 20 (20,000) (20,000)

Retained Earnings Deficit 80,000 (80,000 )

Total (700,000) 190,000 (10,000) (60,000) (340,000) 100% (100,000) 510,000

Pre-confirmation total equities of $700,000 includes $690,000 pre-petition and $10,000 post-petition increase.Note: Parentheses indicate credit amount.

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P20-6 (continued)

b. Analysis for evaluating qualifications for fresh start accounting:

First condition: Post-petition liabilities $ 10,000 Liabilities deferred pursuant to Chapter 11 proceedings 520,000 Total post-petition liabilities and allowed claims $530,000 Reorganization value (510,000) Excess of liabilities over reorganization value $ 20,000

Second condition: Holders of existing voting shares immediately before confirmation receive 20% of voting shares of emerging entity.

Therefore, both conditions for a fresh start occur, and fresh start accounting is used to account for the company.

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P20-6 (continued)

c. Entries for execution of plan of reorganization:

(1) Liabilities Subject to Compromise 520,000 Cash 60,000 Notes Payable, 12%, secured 340,000 Common Stock (new) 30,000 Gain on Debt Discharge 90,000 Record debt discharge.

(2) Preferred Stock 100,000Common Stock (old) 150,000 Common Stock (new) 70,000 Additional Paid-In Capital 180,000 Record exchange of stock for stock.

(3) Reorganization Value in Excess of Amounts Allocable to Identifiable Assets 30,000Gain on Debt Discharge 90,000Additional Paid-In Capital 180,000 Accounts Receivable (net) 30,000 Inventory 7,000 Property, Plant, and Equipment 183,000 Retained Earnings - Deficit 80,000 Record fresh start accounting and eliminate deficit.

Schedule to support allocation of reorganization value:

Book Fair Value Value Difference

Cash $ 30,000 $ 30,000 $ -0- Accounts Receivable (net) 140,000 110,000 (30,000)Inventory 25,000 18,000 (7,000)Property, Plant, and Equipment (net) 445,000 262,000 (183,000)Reorganization Value in Excess of Amounts Allocable to Identifiable Assets -0- 30,000 30,000 Total $640,000 $450,000 $(190,000)

Note: The post-reorganization total fair value is the reorganization value of $510,000 less the $60,000 paid to fulfill the plan of reorganization.

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P20-6 (continued)

d. Fresh start balance sheet workpaper for company emerging from reorganization: (Worksheet not required)

Pre- confirmation

Adjustments to Record Confirmation of Plan

Company's Reorganized

Balance Sheet

Debt Exchange Fresh Discharge of Stock Start

Assets:Cash 90,000 (60,000) 30,000 Accounts Receivable (net) 140,000 (30,000) 110,000 Inventory 25,000 (7,000 ) 18,000

255,000 (60,000) -0- (37,000) 158,000 Property, Plant, and Equipment (net) 445,000 (183,000) 262,000 Reorganization Value In Excess of Amounts Allocable to Identifiable Assets 30,000 30,000 Total Assets 700,000 (60,000 ) -0- (190,000) 450,000

Liabilities:Liabilities Not Subject to Compromise: Current Liabilities (10,000) (10,000)Liabilities Subject to Compromise (520,000) 520,000 Notes Payable, 12%, secured (340,000) (340,000)Total Liabilities (530,000

) 180,000 -0- -0- (350,000)

Shareholders' Equity:Preferred Stock (100,000) 100,000 Common Stock (old) (150,000) 150,000 Common Stock (new) (30,000) (70,000) (100,000)Additional Paid-In Capital (180,000) 180,000 Retained Earnings 80,000 (90,000) 90,000

(80,000 ) -0- Total Shareholders' Equity (170,000

)(120,000) -0- 190,000 (100,000)

Total Liabilities and Shareholders’ Equity (700,000

) 60,000 -0- 190,000 (450,000)

Note: Parentheses indicate credit amount.

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P20-6 (continued)

d. Balance sheet for company emerging from Chapter 11 reorganization with fresh start accounting:

Polydorous CompanyBalance SheetEmerging Date

Assets:Cash $ 30,000Accounts Receivable (net) 110,000Inventory 18,000 Total Current Assets $158,000

Property, Plant, and Equipment (net) 262,000Reorganization Value In Excess of Amounts Allocable to Identifiable Assets 30,000 Total Assets $450,000

Liabilities:Accounts Payable $ 10,000Notes Payable, 12%, secured 340,000 Total Liabilities $350,000

Shareholders' Equity:Common Stock 100,000 Total Shareholders' Equity $100,000Total Liabilities and Shareholders' Equity $450,000

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P20-7 Chapter 7 Liquidation, Statement of Affairs

a. Name Brand CompanyStatement of Affairs

July 31, 20X1

AssetsEstimatedAmount

Available Estimated Estimated to Gain

Book Current Unsecured (Loss) on Value Values Claims Realization

(1) Assets pledged with fully secured creditors:

$ 50,000 Accounts receivable (net) $ 50,000 Less: 12% note payable and interest (44,000 ) $ 6,000

80,000 Land $110,000 $ 30,000 162,000 Plant and equipment (net) 150,000 (12,000)

$260,000 Less: Mortgages payable and interest (234,600) 25,400

(2) Assets pledged with partially secured creditors:

30,000 Marketable securities $ 22,000 (8,000) Less: 10% note payable and interest (29,400 )

79,000 Inventory $ 75,000 (4,000) Less: Accounts payable (105,000)

(3) Free assets:5,000 Cash $ 5,000 5,000

55,000 Accounts receivable (net) 55,000 55,000 81,000 Inventory 76,000 76,000 (5,000)

7,000 Prepaid insurance 1,500 1,500 (5,500)250,000 Plant and equipment (net) 190,000 190,000 (60,000)

72,000 Franchises 30,000 30,000 (42,000)

Estimated amount available $388,900 Less: Creditors with priority (45,000 )Net available to unsecured creditors $343,900

Estimated deficiency 82,500 $871,000 $(106,500)

Total unsecured debt $426,400

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P20-7 (continued)

EquitiesEstimated

Book Amount Value Unsecured

(1) Fully secured creditors:$ 44,000 12% note payable and interest $ 44,000

234,600 Mortgages payable and interest 234,600 $278,600

(2) Partially secured creditors:29,400 10% note payable and interest $ 29,400

Less: Marketable securities (22,000 ) $ 7,400

105,000 Accounts payable $105,000 Less: Inventory (75,000 ) 30,000

(3) Creditors with priority:-0- Estimated liquidation expenses $ 13,000

20,000 Wages payable 20,000 12,000 Taxes payable 12,000

$ 45,000

(4) Unsecured creditors:160,000 Accounts payable 160,000212,000 Notes payable 212,000

17,000 Interest payable 17,000

(5) Stockholders' equity:240,000 Common stock

(203,000) Retained earnings (deficit) $871,000 $426,400

b. Percentage to unsecured creditors: $343,900 = 80.65%$426,400

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P20-8 Chapter 7 Liquidation, Statement of Affairs [AICPA Adapted]

a. Tower, Inc.Statement of AffairsDecember 31, 20X1

Assets

Estimated Amount Estimated

Estimated Available to Gain Book Current Unsecured (Loss) on Value Values Claims Realization

(1) Assets pledged with fully secured creditors:

$ 40,000 Accounts receivable $ 40,000 13,000 Land 25,000 $ 12,000 90,000 Building (net) 110,000 20,000

140,000 Machinery (net) 75,000 (65,000)$250,000

Less: Fully secured claims from liability side: Note payable-bank $ 30,000 Mortgage payable and related interest 132,400 (162,400) $ 87,600

(2) Assets pledged with partially secured creditors:

20,200 Marketable securities $ 19,000 Accrued interest 200

$ 19,200 (1,000) Less: Notes payable (to bank) (20,000 )

(3) Free assets:1,500 Cash $ 1,500 1,500

35,000 Accounts receivable (after reclassifying $5,000 of credit balances to accounts payable) 35,000 35,000

60,000 Finished goods 50,000 50,000 (10,000)40,000 Raw materials (net of $10,000

of conversion costs) 60,000 60,000 20,000 5,000 Prepaid expenses -0- (5,000)

Estimated amount available for unsecured creditors, including creditors with priority $234,100 Less: Liabilities with priority (41,500 )Estimated amount available for unsecured creditors $192,600 Estimated deficiency to unsecured

creditors (plug) 18,200 $444,700 $(29,000)


20-21


P20-8 (continued)

Book Amount Value Liabilities and Stockholders' Equity Unsecured

(1) Fully secured creditors:$ 30,000 Notes payable- bank $ 30,000

132,400 Mortgage payable and interest 132,400 Total (deducted on asset side) $162,400

(2) Partially secured creditors:20,000 Notes payable-bank $ 20,000

Less: Pledged marketable securities and interest (from asset side) (19,200 ) $ 800

(3) Liabilities with priority: Estimated liquidation expenses $ 11,000

15,000 Wages payable 15,000 15,500 Payroll taxes payable 15,500

Total (deducted on asset side) $ 41,500

(4) Unsecured creditors:70,000 Accounts payable (after excluding $15,000

of payroll taxes payable and including $5,000 of credit balances reclassified from accounts receivable) 70,000

85,000 Notes payable 85,0005,000 Audit fee of prior year 5,000

50,000 Contingent liability on damage suit 50,000

21,800 (5) Stockholders' equity, after giving effect to unrecorded items that are properly bookable as of December 31, 20X1* ($100,000 - $20,000 - $500 + $200 - $500 - $2,400 - $5,000 - $50,000)

$444,700


* Common stock, $100,000; retained earnings deficit, ($20,000); cash expended for travel, ($500); accrued interest receivable, $200; unrecorded employer's payroll taxes, ($500); unrecorded interest on mortgage, ($2,400); bill for last year's audit, ($5,000); and probable damage suit judgment, ($50,000).

b. Estimated settlement per dollar of unsecured liabilities:

Estimated amount available for unsecured creditors $192,600 = $0.914Total unsecured debt $210,800

20-22


P20-9 Financial Statements for a Firm in Chapter 11 Proceedings

a. Income statement for a company in reorganization proceedings:

Hobbes Company(Debtor-in-Possession)

Income StatementFor the Year December 31, 20X2

Revenue: Sales $246,000

Cost and Expenses: Cost of Goods Sold 170,000 Selling, Operating, and Administrative 50,000 Interest (contractual interest $51,000) 4,000

$224,000 Earnings before Reorganization Items and Income Taxes $ 22,000

Reorganization Items: Professional Fees $(15,000) Interest Earned on Accumulated Cash Resulting from Chapter 11 Proceeding 3,000 Total Reorganization Items (12,000 )

Income before Income Tax and Discontinued Operations $ 10,000

Income Tax (5,000 )

Income before Discontinued Operations $ 5,000

Discontinued Operations: Operating Loss, Net-of-Tax $(16,000) Gain on Sale of Assets, Net-of-Tax 9,000 Net Discontinued Operations (7,000 )

Net Loss $ (2,000 )

20-23


P20-9 (continued)

b. Statement of cash flows for a company in reorganization proceedings:


Statement of Cash FlowsFor the Year December 31, 20X2

Cash Flows from Operating Activities: Cash Received from Customers $ 264,000 Cash Paid to Suppliers and Employees (206,000) Interest Paid (4,000 )Net Cash Provided by Continuing Operating Activities before Reorganization Items $ 54,000

Operating Cash Flows from Reorganization Activities: Professional Fees $ (15,000) Interest Received on Cash Accumulated Because of Chapter 11 Proceeding 3,000 Net Cash Used by Reorganization Items $ (12,000 )

Operating Cash Flows from Discontinued Operations:Net Cash Used by Discontinued Operations $ (3,000 )

Net Cash Provided by Operating Activities $ 39,000

Cash Flows Provided by Investing Activities: Proceeds from Sale of Assets Due to Chapter 11 Proceeding $ 18,000 Net Cash Provided by Investing Activities $ 18,000

Cash Flows Provided by Financing Activities: Net Borrowings under Short-Term Financing Plan $ 10,000 Principal Payments on Pre-petition Debt Authorized by Court (Bonds Payable) (10,000 )Net Cash Provided by Financing Activities $ -0-

Net Increase in Cash $ 57,000 Cash at January 1, 20X2 15,000 Cash at December 31, 20X2 $ 72,000

20-24


P20-9 (continued)

c. Balance sheet for a company in reorganization proceedings:


Balance SheetDecember 31, 20X2

AssetsCash $ 72,000Accounts Receivable (net) 47,000Inventory 88,000 Total Current Assets $207,000Property, Plant, and Equipment (net) 460,000 Total Assets $667,000

LiabilitiesLiabilities Not Subject to Compromise: Current Liabilities (post petition): Short-Term Borrowings $ 10,000 Accounts Payable - Trade 7,000 Total Liabilities Not Subject to Compromise $ 17,000

Liabilities Subject to Compromise (pre-petition): Accounts Payable $ 138,000 Notes Payable, 10% 170,000 Bonds Payable, 12% 240,000* Accrued Interest Payable 47,000 Total Liabilities Subject to Compromise 595,000 Total Liabilities $612,000

Shareholders' EquityPreferred Stock $ 50,000 Common Stock ($1 par) 50,000 Additional Paid-In Capital 75,000 Retained Earnings (Deficit) (120,000 )Total Shareholders' Equity $ 55,000 Total Liabilities and Shareholders' Equity $667,000

* $10,000 payment approved by the Court, reducing pre-petition bonds payable from $250,000 to $240,000.

20-25

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