Advanced financial accounting by baker chapter 20

20
Corporations in
Financial
Difficulty

McGraw-Hill/Irwin

© 2009 The McGraw-Hill Companies, Inc. All rights reserved.


Overview
•

•

•

A company in financial difficulty has a large
number of alternatives, of which bankruptcy
is only a final course
A company may petition the courts for
bankruptcy for other reasons, such as to
protect itself from an onslaught of legal suits
Several companies have also attempted to
void union contracts by petitioning for
bankruptcy
20-2


Courses of Action
•

•

Bankruptcy is the final step for a financially
distressed business
Nonjudicial Actions
– Formal agreements between the company
and its creditors are legally binding but are not
administered by a court

20-3


Nonjudicial Actions
•

Debt Restructuring Arrangements
– The debtor may solicit an extension of due
dates of its debt, ask for a decrease of the
interest rate on the debt, or ask for a
modification of other terms of the debt
contract
– Composition agreement: Creditors agree to
accept less than the face amount of their
claims
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Nonjudicial Actions
•

Creditors’ committee management
– The creditors may agree to assist the debtor
in managing the most efficient payment of
creditors’ claims
– Most creditors’ committees are advisory and
counsel closely with the debtor because the
creditors 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
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Nonjudicial Actions
•

Transfer of assets
– Debtors may transfer assets, such as
receivables or other financial instruments, in
an effort to obtain quick cash
– 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

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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

20-7


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
20-8


Chapter 11 Reorganizations

•

Chapter 11 of the Bankruptcy Code
– Allows for legal protection from creditors’
actions during a time needed to reorganize
the debtor company and return its operations
to a profitable level
– The bankruptcy court administers
reorganizations and often appoints trustees to
direct the reorganization
– The company petitions the bankruptcy court
– If granted protection, the company receives
an order of relief to suspend making any
payments on its prepetition debt

20-9


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

20-10

Chapter 11 Reorganizations
•

Statement of Position No. 90-7 provides
guidance for financial reporting for
companies in reorganization
– The financial statements should distinguish
transactions and events directly associated
with the reorganization from those associated
with ongoing operations

20-11


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
20-12


Chapter 11 Reorganizations
•

Fresh start accounting
– First, the company is required to compute the
reorganization value of the emerging entity’s
assets
•

Reorganization value represents the 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
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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
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Chapter 11 Reorganizations
•

Companies not qualifying for fresh start
accounting
– Companies should determine whether their
assets are impaired in value
– They should report liabilities at the present
values of the amounts to be paid, with any
gain or loss on the revaluation of the liabilities
recorded in accordance with APB 30 as to
extraordinary or ordinary events

20-15


Chapter 11 Reorganizations

•

Companies not qualifying for fresh start
accounting
– They 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
– Long-lived assets are divided between (1)
those to be held and used and (2) those to be
disposed of by sale
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Chapter 11 Reorganizations
•

Plan of reorganization – Components:
1.
2.
3.
4.

Disposing of unprofitable operations
Restructuring of debt with specific creditors
Revaluation of assets and liabilities
Reductions or eliminations of claims of original
stockholders and issuances of new shares to
creditors or others

20-17


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

20-18


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, who have priority over
other unsecured creditors
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Chapter 7 Liquidations
•

Classes of creditors
– Unsecured creditors
•
•

•

The lowest priority is given to these claims
They are paid only after secured creditors and
unsecured creditors with priority are satisfied to
the extent of any legal limits
Often they receive less than the full amount of
their claim

20-20

Chapter 7 Liquidations
•

Statement of affairs
– The basic accounting report made at the
beginning of the process to present 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
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Chapter 7 Liquidations
•

Statement of affairs
– It is an important planning report for the
anticipated liquidation of a company
– It presents the book values of the debtor
company’s balance sheet accounts, the
estimated fair market values of the assets, the
order of the claims, and the estimated
deficiency to the general unsecured creditors

20-22

Additional Considerations
•

Trustee accounting and reporting
– Bankruptcy courts appoint trustees to manage
a company under Chapter 11 reorganization in
cases of management fraud, dishonesty,
incompetence, or gross mismanagement
– The trustee then attempts to rehabilitate the
business

20-23


Additional Considerations
•

Trustee accounting and reporting
– In Chapter 7 liquidations, the trustee normally
has the responsibility to expeditiously
liquidate the bankrupt company and pay
creditors in conformity with the legal status of
their secured or unsecured interests
– In some cases under Chapter 7, 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

20-24


Additional Considerations
•

Trustee accounting and reporting
– Trustees examine the proofs of all creditors’
claims against the debtor’s bankruptcy estate,
that is, the debtor’s net assets
– 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

20-25