Solution manual advanced accounting 9e by hoyle ch13

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CHAPTER 13
ACCOUNTING FOR LEGAL REORGANIZATIONS
AND LIQUIDATIONS
Chapter Outline
I.

Because of a myriad of possible financial or business difficulties, a company may become
insolvent, unable to pay its debts as they come due.
A. To ensure the equitable treatment of all parties involved with an insolvent company
(stockholders as well as creditors), laws have been written to provide structure for the
bankruptcy process in the United States.
B. At present, legal guidance is provided primarily by the Bankruptcy Reform Act of 1978
as amended.
1. This law attempts to arrive at a fair distribution of a debtor's assets.
2. It also seeks to discharge the obligations of an honest debtor.

II. Bankruptcy proceedings can be formally instigated by either the debtor or a group of
creditors.
A. A voluntary petition is filed with the court by the insolvent company while an involuntary
petition must be filed by a minimum number of creditors with a minimum level of debt.
B. After a bankruptcy petition is received, normally the court will grant an order for relief to
halt all actions against the debtor.
III. Within the bankruptcy process, determining the appropriate classification of all creditors is
an important step in achieving a fair settlement.
A. Fully secured creditors hold a collateral interest in assets of the insolvent company
having a value in excess of the related liability.
B. Partially secured creditors also have a collateral interest but the expected net realizable
value will not satisfy the entire obligation.
C. Some unsecured obligations (including administrative expenses, certain debts to

employees, and government claims for unpaid taxes) have priority over other unsecured
debts.
D. The remaining unsecured creditors receive assets from the debtor only after the above
claims have been satisfied.
IV. A Statement of Financial Affairs is frequently produced by an insolvent company to disclose
its current financial position.
A. Assets are reported at net realizable value along with the disclosure of any pledged
amounts. Liabilities are classified according to the security or priority of the creditor.
B. A Statement of Financial Affairs is especially useful if prepared at the beginning of the
bankruptcy process to assist all parties in evaluating the outcome of various actions.
C. Most of the asset balances reported in this statement are merely estimations,
projections of future events.
V. Bankruptcy proceedings often conclude with the assets of the debtor being liquidated to
satisfy creditor claims (a Chapter 7 bankruptcy).
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A. A trustee is appointed to oversee termination of business affairs, liquidation of noncash
properties, and distribution of cash resources.
B. The trustee prepares a periodic reporting of activities, frequently in the form of a
Statement of Realization and Liquidation.
1. This statement indicates the book value and classification of remaining assets and
liabilities.
2. It also discloses the effects of all transactions that have occurred to date.

Vl. As an alternative to liquidation, a company may seek to stay in business and attempt to
return to solvency (a Chapter 11 bankruptcy).
A. A reorganization plan has to be devised that can win the approval of each class of
creditors and each class of stockholders as well as the court.
B. Reorganization plans normally entail a specific course of action designed to save the
company and can include proposed changes in operations, methods of generating
additional working capital, and a settlement of the debts that were in existence on the
day that the order for relief was entered.
Vll. Financial reporting during reorganization.
A. The AICPA Statement of Position 90-7 (SOP 90-7) provides guidance for preparing
financial statements while a company goes through reorganization.
1. Gains, losses, revenues, and expenses that result from reorganization must be
reported separately on the income statement.
2. Professional fees incurred in connection with the bankruptcy must be expensed
immediately.
3. Liabilities subject to compromise are reported based on the expected amount of the
allowed claims.
VIII.
Fresh start accounting may be required when a company emerges from reorganization.
A. Assets are restated to current value but only if the fair value of assets is less than the
allowed claims and the original owners are left holding less than 50 percent of company.
B. The recognition of goodwill may also be required if the reorganization value of the
emerging company is greater than the value of the identifiable assets (both tangible and
intangible).
C. Retained earnings is set at zero to indicate that a new entity has been formed.

Learning Objectives
Having completed Chapter 13 of this textbook, "Accounting for Legal Reorganizations and
Liquidations," students should be able to fulfill each of the following learning objectives:
1. Understand the necessity of having laws to protect the parties involved with an insolvent

company.
2. Identify the Bankruptcy Reform Act of 1978 as the primary legal basis for bankruptcy
proceedings in this country.
3. Explain the difference between a voluntary and an involuntary bankruptcy petition.

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4. Describe the purpose of an order for relief.
5. List and describe the categories used to classify creditors during bankruptcy proceedings.
6. Give examples of the types of unsecured liabilities that have priority in a bankruptcy.
7. Produce a Statement of Financial Affairs for an insolvent company.
8. Identify the responsibilities of a trustee in a liquidation (a Chapter 7 bankruptcy).
9. Prepare a Statement of Realization and Liquidation for a business going through liquidation.
10. Indicate possible proposals that might be included in a reorganization plan and the method
by which a plan becomes accepted and confirmed.
11. Produce an income statement during reorganization with reorganization items identified and
separately reported.
12. Produce a balance sheet during reorganization with liabilities classified as "subject to
compromise" and "not subject to compromise."
13. Identify companies that are required to apply fresh start accounting when they emerge from
reorganization.
14. Apply fresh start accounting to a company emerging from bankruptcy according to SOP 907.

Answers to Discussion Questions
What Do We Do Now?
Students are given a chance in this case to look at a non-accounting business decision: the
forcing of a valued client into bankruptcy proceedings. Thurber has already committed several
unfortunate mistakes in this case. For example, he has seen a dramatic slowdown in cash
payments by Abraham and Sons without seeking any further information about the prospects of
the client. Furthermore, he has let the treasurer pressure him into providing additional credit
without any valid justification. He is now being pushed by another company into filing a
bankruptcy petition without adequate assurance that Abraham and Sons has a real problem.
Because Thurber has not acted earlier, he should now request audited financial statements
from Abraham and Sons so that he can make a reasonable decision as to the course of action
to take. Many important figures can be gleaned from these statements including the amount of
the company's working capital, the current ratio, the debt to equity ratio, the trend in sales, the
trend in long-term debt, operating cash flows, the gross profit percentage, any expenses that
have risen at a fast rate, the amount of property that has been mortgaged, and the like. He
should then ask for a meeting with the treasurer (or another officer) of Abraham and Sons. In
this meeting, Thurber should discuss the possibility of having the current debt secured in some
manner as protection. The development of a formal repayment schedule would also be wise.
If Thurber is not satisfied by the financial statements and the discussion with the client, he
should meet with the clothing manufacturer who has called as well as with a lawyer and/or
accountant. They should discuss possible actions and the outcomes that could result from
each. Inevitably, if loss of the receivable seems probable, filing an involuntary petition for
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bankruptcy may be the wisest course of action to take. However, that procedure should only be
undertaken after adequate study has been made. In the long run, companies do not prosper by
having their clients go into bankruptcy.
Students often address this type of case as either a black or white issue: give more credit or
force them into bankruptcy. The case simply does not provide enough data to arrive at either
choice. Thus, the students should be directed to consider the types of information that could
prove to be beneficial in making this decision. Often, in decision-making, the gathering of
information is the key step in arriving at the proper conclusion.
How Much Is That Building Really Worth?
College textbooks often present fair value as if it were a known number that was dependable.
Students may view an asset’s fair value as if getting that much money was virtually assured.
Thus, students often believe that producing a statement of financial affairs requires little more
than establishing and reporting what a buyer will pay for an asset.
This case was written to emphasize that a net realizable value might actually be no more than a
wild guess. Obviously, the value of most stocks and bonds can be determined with accuracy.
However, many other assets such as the building in this case might eventually prove to have a
liquidation value that can vary from zero (many deserted buildings are simply never sold
because no one wants to buy that type of building in that particular location even if it is in great
condition) up to a significant amount.
The accountant faces the problem of preparing a statement of financial affairs that requires that
a single number be reported as the value of each asset. Users of this statement can then make
important financial decisions based on the number that is presented. Subsequently, the actual
amount received may be significantly higher or lower than the figure shown. The users of the
information may feel as if they have been mislead when, in fact, the accountant made the best
possible estimation.
Given the problems faced in determining fair value, the accountant will probably seek a very
conservative number for reporting purposes. In most cases, less potential damage will be
created by reporting a relatively low figure. However, use of a particularly low value may tempt
the creditors to allow the company to reorganize because little would seem to be gained by

forcing liquidation. For this reason, a conservative approach can favor the company attempting
to avoid liquidation.
Probably the most important lesson from this case is that decision makers should look with
skepticism on many of the numbers reported as representing fair value. In some cases, fair
value is a figure that can only be estimated and may depend on a number of factors that cannot
be anticipated in advance by the accountant or by anyone else.
Is this the Real Purpose of the Bankruptcy Laws?
During the 1980s, as described in this case, the country saw a rash of bankruptcies that were
filed to resolve major financial problems. Previously, the bankruptcy laws had been used almost
exclusively to settle insolvency problems. However, if a voluntary petition is filed and accepted
by the courts, companies such as Manville and A. H. Robins are provided with a method of
settling issues before actual insolvency occurs. Sometimes the final results are good for the
companies but not always. A. H. Robins, for example, had to agree to be bought as one of the
conditions of its reorganization. In effect, the company lost its independence in order to satisfy
the lawsuits resulting from the Dalkon Shield.

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As with many of the discussion questions in this book, this case is simply intended to alert
students to a real-life issue and encourage them to consider the ramifications. To function in
society, accounting students must know more than just the mechanical aspects of a
bankruptcy. What are the objectives of the bankruptcy laws and do these particular cases fall
outside of those objectives? Would either Manville or its claimants, for example, have been

better served by having the company slowly pulled into insolvency over years or perhaps
decades? Should a different set of bankruptcy laws be established for companies having these
types of financial crises? Although these questions are not directly related to accounting, they
are the types of questions that accountants (both as business people and as citizens) need to
address.

Answers to Questions
1. "Insolvent" refers to a state of financial position whereby a company (or individual) is unable
to pay debts as they come due.
2.

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.

3.

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.

4. 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 unsecured debts of over $13,475) 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 $13,475.
5. 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 time to decide on a future

course of action. It also brings the court into the process and provides a structure for what
might otherwise be a chaotic event, the distribution of assets to the parties involved.
6. 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.
7. 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 include the following:
— Claims for administrative expenses,

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— 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 180 days preceding the filing of a
bankruptcy petition (limited to $10,950 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 $2,425 limit),
— Government claims for unpaid taxes.
8. 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. Also, these debts were
incurred after the order for relief.
9. 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.
10. Unsecured creditors often face the possibility of absorbing substantial losses in a Chapter 7
liquidation because their claims rank below fully secured and partially secured liabilities.
Frequently, little or nothing is expected. As a result of this risk, unsecured creditors may feel
that they have a better chance of limiting their losses by agreeing to a reorganization plan to
keep the company alive as a potential future customer.
11. The statement of financial affairs helps the parties involved with a bankruptcy to anticipate
their potential losses. It 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 potential cash inflows and outflows, 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.
12. In general, a trustee is assigned to prevent loss of the insolvent company's assets and
oversee the liquidation and distribution 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 might 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.
13. 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 and the court.

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14. 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) any remaining asset and liability balances.
15. 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 the debtor in possession.
16. In a Chapter 11 bankruptcy, the debtor in possession (the present 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. However, because of recent changes in the bankruptcy laws, the
debtor’s exclusivity to propose a plan cannot be extended beyond 18 months.
17. 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.
18. To become effective, a reorganization plan must be accepted by all interested parties. For
approval, each class of creditors (more than two-thirds in dollar amount and one-half in
number) must vote for the proposal. Each group of stockholders (two-thirds of the shares
being voted) must also accept the plan. The court will then confirm the reorganization plan
but only if the court feels that 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.
19. 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.
20. During reorganization, some debts are in jeopardy of being settled at a significantly reduced
amount whereas others will probably be paid at face value. Unsecured and partially secured
liabilities are likely to be settled at a lowered figure. 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 being subject to compromise (reduction) or not being 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. Such estimations are
often difficult, if not impossible, to make.
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21. A company going through a Chapter 11 bankruptcy will report specified reorganization items
on its income statement separately from operating figures. However, these reorganization
items are reported prior to income tax expense rather than in a manner similar to an
extraordinary item. These separately disclosed figures include gains and losses on the sale
of assets necessitated by the reorganization. Professional fees incurred in connection with
the reorganization are also reported in a similar manner as well as any interest revenue that
would not have been earned except for the bankruptcy proceeding.
22. Professional fees incurred during a reorganization must be expensed as incurred.
Capitalization is not allowed.
23. “Fresh start accounting” refers to the adjustment of a company's assets 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 fair 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 are reported at current value while liabilities are reported
based on the present value of the settlement amounts. If the reorganization value of the
company as a whole is greater than the total fair value of the individual assets, goodwill is
reported for the excess.
Initially, in fresh start accounting, retained earnings must be reported at a zero balance.
24. Fresh start accounting is used by companies that are emerging from a bankruptcy
reorganization if the value of the assets held at that time are less than the allowed claims
associated with company’s 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.
25. In fresh start accounting, the tangible and intangible assets of the company are reported at
their fair values. Liabilities are reported at the present value of the future cash flows.
26. When a company emerges from bankruptcy, the reorganization value of its assets as a
whole 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 based on individual fair values. The total reorganization value may well be greater
than the current value of the individual assets. If so, the residual amount is recorded as the
intangible account Goodwill. Each year (or more often in some cases) it is reviewed for
impairment.

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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

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22. (10 Minutes) (Distribution of cash in a liquidation)
Free Assets:
Current Assets ..........................................................
Buildings and Equipment ........................................
Total ....................................................................

$ 35,000
110,000
$145,000

Liabilities with Priority:
Administrative Expenses .........................................
Salaries Payable (only $3,000 per employee) ..........
Income Taxes ...........................................................
Total ....................................................................

$ 20,000
6,000
8,000
$ 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) ......
Accounts Payable .....................................................
Bonds Payable ..........................................................
Total ....................................................................

$ 30,000
85,000
70,000
$185,000

Percentage of Unsecured Liabilities To Be Paid: $111,000/$185,000 = 60 %
Payment On Notes Payable:
Value of Security (land) ............................................
60% of Remaining $30,000 .......................................
Total Collected by holders .......................................

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$ 90,000
18,000
$108,000

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23. (5 Minutes) (Distribution of assets in a liquidation)
Liabilities with Priority
Paid first—administrative expense ...............................
$2,450
Paid second—wages up to a maximum of
$10,950 for Mr. Key ....................................................
16,950
All remaining money—government claims to unpaid taxes
5800
Total of free assets ....................................................
$25,200
No payments will be made in connection with the remainder of the salaries,
the government claims and all of the unsecured accounts payable since no
money is left.
24. (8 Minutes) (Distribution of assets to partially secured creditors)
Free Assets:
Other Assets .............................................................
Excess from Assets Pledged with Fully Secured
Creditors ($116,000 – $70,000) ...........................
Total ....................................................................

46,000
$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) ................................
Unsecured Creditors ................................................
Total ....................................................................

$ 80,000
200,000
$280,000

$ 80,000

Percentage of Unsecured Liabilities To Be Paid: $84,000/$280,000 = 30%
Payment On Partially Secured Debt:
Value of Pledged Asset ............................................
30% of Remaining $80,000 .......................................
Total to be Collected by holders ........................

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$ 50,000
24,000
$ 74,000

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25. (8 Minutes) (Distribution of assets to partially secured creditors)
Free Assets:
Cash .........................................................................
Excess from Assets Pledged with Fully Secured
Creditors ($90,000 – $80,000) ..............................
Total ......................................................................

$50,000
10,000
$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) ................
Accounts Payable......................................................
Total ....................................................................

$ 20,000
180,000
$200,000

Percentage of Unsecured Liabilities to be Paid: $40,000/$200,000 = 20%
Payment on Bond:
Value of Pledged Asset .............................................
20% of Remaining $20,000 ........................................
Total to be Received by holders .........................

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$130,000
4,000
$134,000

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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.

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27. (8 Minutes) (Payments to be made on unsecured and partially secured
liabilities)
a. 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 ..........................................................
Liabilities with Priority ..................................................
Available for Unsecured Creditors ..........................

$350,000
(160,000)
$190,000

Accounts Payable ..........................................................
Partially Secured Debt in Excess of Pledged
Assets ($490,000 – $380,000) .......................................
Unsecured Liabilities......................................................

$390,000
110,000
$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%).
b. 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
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28. (20 Minutes) (Distribution of assets in a liquidation)
Free Assets: (fair market value)
Cash .........................................................................
Inventory ....................................................................
Equipment .................................................................
Total ....................................................................

50,000
$120,000

Liabilities with Priority:
Administrative Expenses .........................................
Income Taxes ...........................................................
Total .....................................................................

$ 20,000
30,000
$ 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) .....
Note Payable B (in excess of value of security) .....
Note Payable C .........................................................
Accounts Payable .....................................................
Total ....................................................................

$ 20,000
80,000
60,000
120,000
$280,000

$ 10,000
60,000

Percentage of Unsecured Liabilities To Be Paid: $70,000/$280,000 = 25%
Payment on Note Payable A:
Value of Security (land) .................................................
25% of Remaining $20,000 ............................................
Total Collected .........................................................

$ 70,000
5,000
$ 75,000

Payment on Note Payable B:

Value of Security (building) ..........................................
25% of Remaining $80,000 ............................................
Total Collected .........................................................

$ 40,000
20,000
$ 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 amount due is paid.

$ 20,000

Payment on Accounts Payable (unsecured):
25% of $120,000 .............................................................

$ 30,000

Payment on Income Taxes Payable:
As a liability with priority, the entire amount due is paid.

$ 30,000

Payment on Administrative Expenses Payable:
As a liability with priority, the entire amount due is paid.

$ 20,000

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

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29. (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 ......................................................
Note payable A—unsecured portion ........................
Note payable B .........................................................
Total ....................................................................
Free Assets (except for equipment):
Cash .........................................................................
Accounts receivable ..................................................
Inventory ....................................................................
Land (value does not cover related debt) ................
Buildings ($320,000 less $300,000
in bonds) ..............................................................
Total ....................................................................

Less: Liabilities with Priority:
Estimated administrative expenses .........................
Taxes payable to government ..................................
Total free assets except for equipment ..............

$180,000
10,000
250,000
$440,000

$24,000
28,000
56,000
-020,000
$128,000

(12,000)
(20,000)
$96,000

In order for unsecured creditors to receive 50 percent of their claims, $220,000
in free assets must be available (50 percent of $440,000). At present only
$96,000 is available. Thus, $124,000 must be received from the liquidation of
the equipment ($220,000 – $96,000).

McGraw-Hill/Irwin
13-16

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30. (15 Minutes) (Payment of various liabilities in a liquidation)
Free Assets:
Cash
....................................................................
Receivables (30 percent collectible) ........................
Inventory ....................................................................
Land (value in excess of secured note:
$120,000 – $110,000) ............................................
Total ....................................................................
Less: Liabilities with priority
Salary payable (below maximum) .......................
Free assets available ...........................................
Unsecured Liabilities:
Accounts payable ......................................................
Bonds payable (less secured interest in
building: $300,000 – $180,000) ............................
Unsecured liabilities ............................................

$30,000
15,000
39,000
10,000
$94,000

(10,000)
$84,000

$90,000
120,000
$210,000

Percentage of unsecured liabilities to be paid: $84,000/$210,000 = 40%
Amounts to be paid for:
Salary payable (liability with priority to be paid
in full) ....................................................................
Accounts payable (unsecured—will collect 40%
of debts of $90,000)..............................................
Note payable (fully secured by land—will collect
entire balance).....................................................
Bonds payable (partially secured—will collect
$180,000 from building and 40 percent of the
remaining $120,000) .............................................

$10,000
$36,000
$110,000

$228,000

31. (2 Minutes) (Reporting of debts during liquidation)
Because of the uncertainty of the amount that will be paid on an unsecured
debt, no attempt is made in financial reporting to anticipate the payment.
Liabilities are reported at the expected amount of the allowed claim. In this
case, the creditors apparently have a legitimate claim of $200,000.

McGraw-Hill/Irwin

Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

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32. (9 Minutes) (Adjusting a company coming out of reorganization to fresh start
accounting)
The individual assets of this company have a total fair value of $700,000 but a
reorganization value of $760,000. Thus, an intangible asset (Goodwill) equal
to the $60,000 must be recognized.
In addition, the retained earnings deficit must be eliminated and all other asset
and liability accounts adjusted to the value on the day that the company exits
from bankruptcy.
Because common stock was transferred directly from the previous owners to
the creditors, no entry is needed for the stock account. However, because the
reorganization value is $760,000 but liabilities are $300,000, stockholders’
equity must be $460,000. Since retained earnings will be zero and common
stock will remain $330,000, additional paid-in capital should be adjusted to
$130,000.
Receivables ($90,000 - $80,000) ....................................
Inventory ($210,000 - $200,000)......................................
Buildings ($400,000 - $300,000) .....................................
Goodwill .........................................................................
Retained Earnings (eliminate deficit) .................
Additional Paid-in Capital
($130,000 – $20,000) ........................................

McGraw-Hill/Irwin
13-18

10,000
10,000
100,000
60,000
70,000
110,000

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33. (15 Minutes) (Prepare income statement for company going through a
bankruptcy reorganization)
ADDISON CORPORATION
Income Statement
Revenues ......................................................................
Costs and expenses:
Cost of goods sold ...................................................
Rent expense ............................................................
Salary expense .........................................................
Depreciation expense ..............................................
Advertising expense ................................................
Interest expense .......................................................
Earnings before reorganization items and tax effects .
Reorganization items:

Loss on closing of branch ......................................
Professional fees .....................................................
Interest revenue ........................................................
Loss before income tax benefit ...................................
Income tax benefit (20 percent) ...................................
Net loss ....................................................................

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

$ 467,000
$ 211,000
16,000
70,000
22,000
24,000
4,000

(109,000)
(71,000)
32,000

(347,000)
120,000

(148,000)
(28,000)
5,600
$(22,400)

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13-19


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34. (15 Minutes) (Description of balance sheet for a company emerging from
bankruptcy reorganization)
a. SOP 90-7 holds that a company should be considered a new entity (so that
current values would be applicable for reporting purposes) if two criteria are
met. Otherwise, the company is simply considered to be a continuation of the
old concern, a company that should continue to report its historical cost
figures.
The first criterion is that the fair value of the assets of the emerging company
must be less than the allowed claims as of the date of the order for relief (plus
liabilities incurred during reorganization).
The second criterion is that the original owners must be left with less than 50
percent of the voting stock of the emerging company.
Whenever both of these criteria are met, the company's assets should be
reported at current values.
b. Under fresh start accounting, the assets of the company are adjusted to
current value on the date that it successfully emerges from bankruptcy
reorganization. A reorganization value for the entity’s assets as a whole is first
determined by discounting the cash flows that are anticipated. This balance is
assigned to identifiable assets (both tangible and intangible) in the same
manner as in a purchase combination. Any amount of the reorganization value
that exceeds the assigned total is recorded as goodwill.
c. The reorganization value in excess of the value of the identified assets and
liabilities is reported as the intangible asset goodwill. Goodwill is reviewed
each year for impairment.

McGraw-Hill/Irwin
13-20

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35. (15 Minutes) (Prepare a balance sheet for a company in bankruptcy
reorganization)
JAEZ CORPORATION
Balance Sheet
December 31, 2008
Current assets:
Cash .........................................................................
Inventory ...................................................................
Land, buildings, and equipment:
Land .........................................................................
Buildings ...................................................................
Equipment .................................................................
Total assets .........................................................
Liabilities not subject to compromise
Current liabilities:
Accounts payable ...............................................
Long-term liabilities:
Note payable (due 2010) ................
$110,000
Note payable (due 2011) ................

100,000
Liabilities subject to compromise
Accounts payable .....................................................
Accrued expenses ....................................................
Income taxes payable ..............................................
Note payable (due 2013) ..........................................
Total liabilities ......................................................
Stockholders' equity
Common stock .........................................................
Retained earnings (deficit) ......................................
Total liabilities and shareholders' (deficit) ........

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

$ 23,000
45,000

140,000
220,000
154,000

$ 68,000

514,000
$582,000

$ 60,000

210,000

123,000
30,000
22,000
170,000

$ 270,000

345,000
615,000

200,000
(233,000)
$ 582,000

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36. (40 Minutes) (Prepare journal entries for company emerging from bankruptcy
using fresh start accounting)
Preliminary computations:
BOOK VALUES PRIOR TO EMERGING FROM REORGANIZATION
— Total assets at book value = $710,000 ($100,000 + $112,000 + $420,000 +
$78,000)
— Total liabilities at book value = $800,000 ($80,000 + $35,000 + $100,000 +
$200,000 + $185,000 + $200,000)
— Total common stock = $240,000 (given)

— Deficit = $330,000 (given)
— Since the above accounts balance, no additional paid-in capital must exist at
this time.
BOOK VALUES AFTER EMERGING FROM REORGANIZATION
— Total assets = $780,000 (reorganization value)
— Total liabilities = $340,000 ($5,000 + $4,000 + $100,000 + $50,000 + $71,000 +
$110,000)
— Total common stock = $240,000 (all 18,000 returned shares are reissued)
— Deficit = -0- (eliminated by the reorganization)
— Additional paid-in capital = $200,000 (figure needed to balance above accounts
after reorganization)
— Because the company will have 30,000 shares outstanding after the
reorganization, the additional paid-in capital equals $6.66 per share
($200,00/30,000)
— Because the company has a reorganization value of $780,000 but the assets
have a market value of only $735,000, goodwill of $45,000 must be recognized
JOURNAL ENTRIES
— Land and buildings ..................................................
Goodwill ....................................................................
Accounts receivable ...........................................
Inventory ..............................................................
Equipment ...........................................................
Additional paid-in capital (to balance) ...............
To adjust accounts to market value as part of fresh
start accounting.
— Common stock .........................................................
Additional paid-in capital ...................................
To record shares turned in to the company by the
owners as part of the reorganization plan, 18,000
shares at an $8 per share par value.

McGraw-Hill/Irwin
13-22

80,000
45,000
20,000
22,000
13,000
70,000

144,000
144,000

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36. (continued)
— Accounts payable .....................................................
Note payable ........................................................
Common stock ($8 per share par value) ...........
Additional paid-in capital ($6.66 per share—see
above, or 1/30 of company total) ..................
Gain on debt discharge ......................................
To record settlement of accounts payable.

80,000

— Accrued expenses ...................................................
Note payable ........................................................
Gain on debt discharge ......................................
To record settlement of accrued expenses.

35,000

— Note payable ............................................................
Note payable ........................................................
Common stock ($8 per share par value) ...........
Additional paid-in capital ($6.66 per share—see
above, or 1/3 of company total) ....................
Gain on debt discharge ......................................
To record settlement of note payable due in 2011.

200,000

— Note payable .............................................................
Note payable ........................................................
Common stock ($8 per share par value) ...........
Additional paid-in capital ($6.66 per share—see
above, or 7/30 of company total) ..................
Gain on debt discharge ......................................
To record settlement of note payable due in 2009.

185,000

— Note payable ............................................................
Note payable ........................................................

Gain on debt discharge ......................................
To record settlement of note payable due in 2010.

200,000

— Additional paid-in capital ($334,000 – $200,000) ....
Gain on debt discharge ..........................................
Retained earnings (deficit) .................................
To adjust additional paid-in capital to
appropriate balance, close out gain, and
eliminate deficit balance as part of fresh start
accounting.

134,000
196,000

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

5,000
8,000
6,666
60,334

4,000
31,000

50,000
80,000
66,667

3,333

71,000
56,000
46,667
11,333

110,000
90,000

330,000

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37. (25 Minutes) (Prepare a balance sheet for a company emerging from
bankruptcy reorganization)
a. Smith Corporation must apply fresh start accounting because it meets both
requirements established by SOP 90-7:
The reorganization value of $800,000 of the company is less than the
allowed claims of $730,000 ($180,000 + $200,000 + $350,000) plus the
liabilities incurred following the order for relief of $97,000.
The original owners are left with less than 50 percent (40 percent actually)
of the voting stock.
b. Because the company has a reorganization value of $800,000 but only
$653,000 can be assigned to specific assets based on market value, the
remaining $147,000 is reported as Goodwill.

SMITH CORPORATION
Balance Sheet
December 31, 2008
ASSETS
Current Assets:
Accounts receivable .................................................
Inventory ...................................................................
Land, Buildings, and Equipment:
Land and buildings ..................................................
Machinery .................................................................
Intangible Assets:
Patents .......................................................................
Goodwill ....................................................................
Total Assets .........................................................

$ 18,000
111,000

$129,000

278,000
121,000

399,000

125,000
147,000

LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:

Accounts payable .....................................................
Long-term Liabilities:
Note payable (due in 2 years) ..................................
$ 35,000
Note payable (due in 5 years) ..................................
50,000
Note payable (due in 8 years) ..................................
100,000
Total Liabilities ....................................................
Stockholders' Equity:
Common stock (par value) ......................................
$500,000
Additional paid-in capital (balancing figure) ..........
18,000
Retained earnings ....................................................
-0Total Liabilities and Stockholders' Equity ........

McGraw-Hill/Irwin
13-24

272,000
$800,000

$ 97,000

185,000
$282,000

518,000
$800,000

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38. (15 Minutes) (Distribution of assets in a liquidation)
Free assets: (liquidation value)
Other assets .............................................................
Assets pledged with fully secured creditors in
excess of debt .....................................................
Total free assets ..................................................

45,000
$126,000

Free assets after paying liabilities with priority
($126,000 – $36,000) .......................................................

$ 90,000

$ 81,000

Unsecured debts:
Accounts payable ......................................................
$283,000
Partially secured liabilities in excess of pledged assets
($180,000 – $103,000) ..........................................
77,000

Total unsecured debts ........................................
$360,000
Percentage of unsecured debts to be paid: $90,000/$360,000 = 25%
— Liabilities with priority collect the entire amount of $36,000
— Fully secured liabilities collect the entire amount of $200,000
— Partially secured liabilities collect $103,000 from the pledged assets and 25% of
the remaining $77,000 ($19,250) for a total of $122,250.
— Unsecured liabilities collect 25% of the $283,000 balance or $70,750.

McGraw-Hill/Irwin
Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

© The McGraw-Hill Companies, Inc., 2009
13-25