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Chapter 18

Corporate Liquidations
and Reorganizations

to accompany
Advanced Accounting, 11th edition
by Beams, Anthony, Bettinghaus, and Smith

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Corporate Liquidations and
Reorganizations: Objectives
1. Understand differences among types
of bankruptcy filing.
2. Comprehend trustee responsibilities
and accounting during liquidation.
3. Understand financial reporting during
reorganization.
4. Understand financial reporting after
emerging from reorganization,
including fresh-start accounting.
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Corporate Liquidations and Reorganizations

1: TYPES OF BANKRUPTCIES

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Insolvency
Equity insolvency
Inability to pay debts on time
May avoid bankruptcy proceedings
Negotiate directly with creditors

Bankruptcy insolvency
Having total debts in excess of the fair value
of assets
May be liquidated, or
Reorganized
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Types of Bankruptcies
Chapter 7: Liquidation
Trustee appointed to sell assets of
business
Chapter 9: Adjustment of Debt of a Municipality
Chapter 11: Reorganization
Debtor is expected to be rehabilitated
Chapter 12: Farmers
Chapter 13: Adjustment of Debts of an Individual
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Characteristics
Voluntary bankruptcy proceedings
Filed by debtor
Involuntary bankruptcy proceedings
Filed by creditor or group of creditors
Court action
Dismiss a case
Accept the petition
Change form
Chapter 11 reorganization Chapter 7 liquidation
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Corporate Liquidations and Reorganizations

2: TRUSTEE
RESPONSIBILITIES AND
ACCOUNTING

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Duties of Debtor Corporation

In both liquidation and reorganization cases,


the debtor corporation must
File a list of creditors, a schedule of assets
and liabilities, and a statement of financial
affairs
Cooperate with trustee
Surrender property to the trustee, including
records
Appear at court hearings

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Duties of Trustee
Trustee serves in liquidation cases
Investigate debtor's financial affairs
Provide information
Examine, perhaps object to, creditor claims
File report on trusteeship
If authorized to operate debtor's business,
other period reports are required
In reorganization cases, in addition to above
Filing reorganization plan or statement why
one cannot be filed
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Ranking of Claims: Liquidation

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Statement of Affairs
Legal document prepared for bankruptcy
court
Assets at expected net realizable values
Classified on basis of availability for classes
of creditors
Liabilities are classified
Priority, fully secured, partially secured,
unsecured
Historical values included for reference
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Trustee Accounting
At start of case, trustee creates a new set of
books.
During the case,
Records transactions
Statement of cash receipts and disbursements
Statement of changes in estate equity
Balance sheet
Statement of realization and liquidation
At close of case,
Final settlement of claims
Trustee is dismissed
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Debtor in Possession

Unless there is a reason to appoint a


trustee, the debtor corporations
management is permitted to continue to
run the company while in bankruptcy.

The Debtor in Possession has the same


responsibilities as a trustee in a
reorganization case.

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Creditors Committee
The Creditors Committee is elected in a
liquidation case, and is appointed in a
reorganization case from the largest
unsecured creditors.
Makes decisions on behalf of all
creditors
Reviews ongoing transactions of the
debtor in possession and can object
Handles negotiations with any creditor
regarding settlement or continued
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Benefits of Chapter 11
Benefits of being the Debtor in Possession
include:
Rejecting executory contracts
Cancelling unexpired leases
Legal protection from creditor action, such
as lawsuits or repossession of property

However, day-to-day operations may become


more difficult as lenders, suppliers, customers,
and employees are aware of the bankruptcy
filing.
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Reorganization Plan
A plan may be filed at the time of the bankruptcy
filing (prepackaged bankruptcy) or by the
debtor corporation within 120 days of filing.
Other interested parties may file proposed plans
after 120 days.
Identify classes of claims
Specify the expected payout of each class
Claims within a given class must be treated
alike
Define the expected requirements for
execution of the plan
Must be fair and equitable
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Corporate Liquidations and Reorganizations

3: FINANCIAL REPORTING
DURING REORGANIZATION

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Chapter 11: Balance Sheet
Prepetition liabilities subject to compromise
are reported as a separate line item in liabilities
Arose before filing
Include unsecured and under-secured liabilities
Likely to be paid at an amount less than face value

Prepetition secured liabilities and post petition


liabilities reported in normal fashion

Prepetition claims discovered after filing


Included at court-allowed amounts
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Chapter 11: Other Statements
Reorganization costs shown separately
Interest to be paid or probable amount
Differences from contractual amounts
should be noted
Expected stock or stock equivalent
issuances should be disclosed
Cash flow items related to reorganization
shown separately
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Combined Financial Statements

Condensed combined financial


statements are prepared for all entities in
reorganization proceedings as
supplementary information
Intercompany receivables and payables
Write-down if necessary

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Corporate Liquidations and Reorganizations

4: EMERGING FROM
REORGANIZATION

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Reorganization Value
Approximates fair value of entity without
considering liabilities
Discounted future cash flows of reorganized
business
Consider business and financial risk
Reorganization value determines how much
creditors recover
Emerging business will either use
1. Fresh start reporting
2. Report liabilities at present value and
forgiveness of debt as extraordinary item
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Fresh-Start Reporting
Fresh-Start Reporting recognizes that the
emerging company is a new entity.

To qualify,
1. Revaluation value immediately before the
reorganization plan is confirmed must be less
than post-petition liabilities and allowed
claims, and
2. Holders of existing voting shares receive less
than 50% of emerging entity
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Apply Fresh Start Reporting
Allocated reorganization value to identifiable
assets
Unallocated amount is an intangible called
Reorganization value in excess of amounts allocated
to identifiable assets
Liabilities at current value at confirmation date
Deferred tax benefits are first applied to reduce any
intangible asset recorded
Prepare final reports of old entity
The effects of adjustments to asset and liability
accounts are shown, so that ending balance sheet
of old entityCopyright
= beginning
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Continued Reporting of Old Company

If a company does not qualify for Fresh-Start


Reporting, then

Report liabilities at the appropriate interest


rate under GAAP
Report debt forgiveness as an extraordinary
item

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Reorganization Example
Tig files for protection under Chapter 11 on
January 5, 2011. Accordingly, it
reclassifies prepetition liabilities
obtains short-term financing
acquires additional equipment
continues operations through June 30, 2012
when the plan is approved, with a
reorganization value of $2,200
First, we'll look at the statements pre and post
reorganization. Then we'll go through the
entries and adjustments that occurred.
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Balance Sheet Assets
Fair
Filed FYE Before Re- value AFTER
1/5/11 12/31/11 6/30/12 valuation 6/30/12 6/30/12
Cash 50 150 300 0 300 300
Accountsreceivable 500 350 335 0 335 335
Inventory 300 370 350 25 375 375
Othercurrentassets 50 50 30 0 30 30
Land 200 200 200 100 300 300
Building,net 500 450 425 (75) 350 350
Equipment,net 300 330 290 (30) 260 260
Patent 200 150 125 (125) 0 0
Reorganization value in excess of identifiable assets 250
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Changes to Assets
Fair values and revaluation amounts are shown on 6/30/12 for
comparison.
Tig continues operations, records depreciation, and
even acquires equipment from filing on 1/5/11 to
reorganization on 6/30/12.
The reorganization revalues the assets to their fair
value on that date. Patents are completely written
off.
Tig records an intangible "Reorganization value in
excess of identifiable assets" of $250. Not all
reorganizations result in this intangible.
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Balance Sheet - Liability & Equity
Filed FYE Before AFTER
1/5/11 12/31/11 6/30/12 6/30/12
Short-termborrowing(post) 150 75 75
Accountspayable(pre/post) 600 100 125 125
Wagespayable(post) 50 55 55
Taxespayable(pre) 150 150
Accruedbondinterest(pre) 90
Notepayable(pre) 260
Subordinateddebt(post) 395
12%bondspayablecurrent(post) 100
12%bondspayable(post) 500
15%bondspayable(pre) 1,200
Liabilities subject to compromise 2,300 2,300
Capitalstock(old) 500
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Changes to Liabilities
Upon filing on 1/5/11, Tig reclassifies the
unsecured and partially secured liabilities at that
point as Pre-petition Liabilities Subject to
Compromise.
Pre-petition Liabilities Subject to Compromise
are then reclassified or settled according to the
plan.
Accounts payable on 12/31/11 does not include
any of the $600 due prior to filing.
Taxes payable are still to be paid, and eventually
recorded again inCopyright
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Changes to Equity
Some of the creditors receive stock in the
reorganized firm. The old shareholders also
receive stock, but now own only $100 of $800 of
the stock at book value.
Although some APIC was recorded in
reorganizing, it was subsequently eliminated. If
it had been sufficient to wipe out the deficit, no
intangible "reorganization value in excess of
identifiable assets" would be recorded.
The Deficit is removed!
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Can Tig Use Fresh Start?
Post-petitionliabilities $255
Allowedclaims 2,300
Totalliabilities $2,555
Lessreorganizationvalue (2,200)
Excessliabilities $355
On 6/30/12 there were $255 in post-petition
liabilities. All $2,300 pre-petition liabilities were
allowed by the courts. Firm value is $2,200.
1. Liabilities exceed reorganization value
2. Old shareholders retain less than 50%
Yes, fresh start is appropriate.
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Reorganization Plan: 6/30/12
Pre-petition Debt Dis-
Liabilities and Equity New Agreements charge
15%partiallysecured $500newstock,$500
bonds,$1200 senior12%bonds,and
another$100bondsdue
12/31/12 $100
Prioritytaxclaims$150 Tobepaidcashonce
confirmed $0
Remaining unsecured claims, $950:
$600accountspayable $275subordinateddebt
and$140newstock $185
$90accruedinterest Forgiven $90
$260note $120subordinateddebt
and$60newstock $80
Total debt discharged
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Oldstock $100newstock Equity
Record New Debt Agreements
Liabilitiessubjecttocompromise(pre) 2,300
Taxespayable 150
12%seniordebt 500
12%seniordebt-current 100
Subordinateddebt 395
Commonstock(new) 700
Gainondebtdischarge 455
settlement of prepetition claims

This entry reclassifies the pre-petition debt


according to the reorganization plan.
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Give Shareholders New Shares

Commonstock(old) 500
Commonstock(new) 100
Additionalpaidincapital 400
exchange of stock with owners

They will lose control since creditors have


$700 of common stock.

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Revalue Assets
Inventory 25
Land 100
Loss on asset revaluation 105
Buildings,net 75
Equipment,net 30
Patent 125
revalue assets to fair value

A loss is recorded in revaluing the assets. Refer


back to the Asset side of the balance sheet.
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Calculate Balance in Retained
Earnings (Deficit)
Deficit,6/30/12 (1,000)
Gainondebtdischarge 455
Lossonassetrevaluation (105)
Finalmeasureofdeficit,6/30/12 ($650)
Write-offAdditionalpaidincapital 400
Reorganization value in excess of
identifiable assets (intangible asset) ($250)

If sufficient APIC had existed, there would be


no intangible asset, and excess APIC would
remain on the balance sheet.
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Eliminate Deficit in Equity

Reorganization value in excess of


identifiable assets 250
Gainondebtdischarge 455
Additionalpaidincapital 400
Lossonassetrevaluation 105
Deficit 1,000
The $1,000 deficit on 6/30/12 is adjusted for
the gain on debt discharge and loss on asset
revaluation. The net $650 deficit eliminates
all of the APIC and creates a $250 intangible.
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Simplifying Assumptions

All transactions are recorded on


6/30/12.
Generally this takes some time.
Creditors may have interest between
submission and approval of plan.
All pre-petition debt is approved.
The $2,200 reorganization value of the
firm probably used a discounted cash
flow firm valuation model.
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Disclosures

Adjustments to historical values


Assets
Liabilities

Debt forgiveness

Prior retained earnings or deficit eliminated

Significant factors in determining the


reorganization value
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