Chapter 17: Corporate Liquidations and Reorganizations

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy to accompany Advanced Accounting, 10th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn

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Corporate Liquidations: Objectives

1. Understand differences among types of bankruptcy filings. 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 appoint to sell assets of business
Chapter 9: Adjustments of Debts of a Municipality

Chapter 11: Reorganization Debtor is expected to be rehabilitated

Chapter 12: Farmers Chapter 13: Adjustment of Debts of an Individual with Regular Income
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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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Duties of Trustee
Trustee 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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Corporate Liquidations and Reorganizations

2: Corporate 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 New set of books Through 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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Corporate Liquidations and Reorganizations

3: Corporate 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 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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Qualify for Fresh Start Reporting

Just before confirmation of the plan, Revaluation value must be less than post petition liabilities and allowed claims, and 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 Reorganization value in excess of amounts allocated to identifiable assets Liabilities at current value at confirmation date Deferred taxes follow FASB No. 109 Prepare final reports of old entity

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Reorganization Example
Tiger files for protection under Chapter 11 on 1/5/08. Accordingly, it reclassifies prepetition liabilities. It obtains short term financing, acquires additional equipment and continues operations through 6/31/09 when the plan is approved.
First, we'll look at the statements pre and post reorganization. Then we'll go through the entries and adjustments that occurred.
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Balance Sheet Assets

Filed FYE Before 1/5/08 12/31/08 6/30/09

Fair value Revalu6/30/09 ation

AFTER 6/30/09

Cash 50 150 300 300 Accounts receivable 500 350 335 335 Inventory 300 370 350 375 Other current assets 50 50 30 30 Land 200 200 200 300 Building, net 500 450 425 350 Equipment, net 300 330 290 260 Patent 200 150 125 0 Reorganization value in excess of identifiable assets 2,100 2,050 2,055 1,950
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100 (75) (30) (125) (105)

300 335 375 30 300 350 260 0 250 2,200

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Changes to Assets
Fair values and revaluation amounts are shown on 6/30/09 for comparison.

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

Short term borrowing (post) Accounts payable (pre/post) Wages payable (post) Taxes payable (pre) Accrued bond interest (pre) Note payable (pre) Subordinated debt (post) 12% bonds payable current (post) 12% bonds payable (post) 15% bonds payable (pre) Liabilities subject to compromise Capital stock (old) Capital stock (new) Additional paid in capital Deficit
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Filed 1/5/08
600 150 90 260

FYE 12/31/08 150 100 50

Before 6/30/09 75 125 55

AFTER 6/30/09 75 125 55 150

395 100 500 1,200 2,300 500 2,300 500 800 0 0 2,200
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500

(700) 2,100

(1,050) 2,050

(1,000) 2,055

What Happened to Liabilities?

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

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

On 6/30/09 there were $255 in post-petition liabilities. All $2,300 pre-petition liabilities were allowed by the courts. Firm value is $2,200. 1. Liabilities exceed reorganization value 2. Old shareholders retain less than 50% Yes, fresh start is appropriate.
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Reorganization Plan: 6/30/09

Pre-petition Liabilities and Equity 15% partially secured bonds, $1200 Priority tax claims $150 $600 accounts payable $90 accrued interest $260 note Old stock
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New Agreements

Debt Discharge

$500 new stock, $500 senior 12% bonds, and another $100 bonds due 12/31/09 To be paid cash once confirmed
$275 subordinated debt and $140 new stock Forgiven $120 subordinated debt and $60 new stock Total debt discharged $100 new stock

$100

$0
$185 $90 $80 $455 Equity
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Remaining unsecured claims, $950:

Record New Debt Agreements

Liabilities subject to compromise (pre) Taxes payable 12% senior debt 12% senior debt - current Subordinated debt Common stock (new) Gain on debt discharge settlement of prepetition claims 2,300
150 500 100 395 700 455

This entry reclassifies the pre-petition debt according to the reorganization plan.
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Give Shareholders New Shares

Common stock (old) Common stock (new) Additional paid in capital exchange of stock with owners 500
100 400

They will lose control since creditors have $700 of common stock.

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Revalue Assets
Inventory Land 25 100

Loss on asset revaluation

Buildings, net Equipment, net Patent revalue assets to fair value

105
75 30 125

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, 6/30/09 Gain on debt discharge Loss on asset revaluation Final measure of deficit, 6/30/09 Write-off Additional paid in capital Reorganization value in excess of identifiable assets (intangible asset) (1,000) 455 (105) ($650) 400
($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 Gain on debt discharge 250 455

Additional paid in capital Loss on asset revaluation

400
105

Deficit 1,000 The $1,000 deficit on 6/30/09 is adjusted for the gain on debt discharge and loss on asset revaluation. The net $650 deficit eliminates all of the APIC and creates a $250 intangible.
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Simplifying Assumptions
All transactions are recorded on 6/30/09. Generally this takes some time. Creditors may have interest between submission and approval of plan. All pre-petition debt is approved. The $2,200 reorganization value of the firm probably used a discounted cash flow firm valuation model.

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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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