Chapter 17 Corporate Liquidations and Reorganizations by Jeanne

Chapter 17: Corporate Liquidations and Reorganizations by Jeanne M. David, Ph. D. , Univ. of Detroit Mercy to accompany Advanced Accounting, 10 th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn © Pearson Education, Inc. publishing as Prentice Hall 17 -1

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. © Pearson Education, Inc. publishing as Prentice Hall 17 -2

Corporate Liquidations and Reorganizations 1: Types of Bankruptcies © Pearson Education, Inc. publishing as Prentice Hall 17 -3

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -4

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -5

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 © Pearson Education, Inc. publishing as Prentice Hall Chapter 7 liquidation 17 -6

Duties of 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 © Pearson Education, Inc. publishing as Prentice Hall 17 -7

Ranking of Claims: Liquidation © Pearson Education, Inc. publishing as Prentice Hall 17 -8

Corporate Liquidations and Reorganizations 2: Corporate Liquidation © Pearson Education, Inc. publishing as Prentice Hall 17 -9

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -10

© Pearson Education, Inc. publishing as Prentice Hall 17 -11

© Pearson Education, Inc. publishing as Prentice Hall 17 -12

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -13

Corporate Liquidations and Reorganizations 3: Corporate Reorganization © Pearson Education, Inc. publishing as Prentice Hall 17 -14

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -15

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -16

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -17

Corporate Liquidations and Reorganizations 4: Emerging from Reorganization © Pearson Education, Inc. publishing as Prentice Hall 17 -18

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -19

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -20

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 © Pearson Education, Inc. publishing as Prentice Hall 17 -21

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. © Pearson Education, Inc. publishing as Prentice Hall 17 -22

Balance Sheet Assets Filed FYE Before 1/5/08 12/31/08 6/30/09 Fair value Revalu 6/30/09 ation Cash 50 150 300 Accounts receivable 500 350 335 Inventory 300 370 350 375 Other current assets 50 50 30 30 Land 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, 055 1, 950 © Pearson Education, Inc. publishing as Prentice Hall 25 100 (75) (30) (125) (105) AFTER 6/30/09 300 335 375 30 300 350 260 0 250 2, 200 17 -23

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. © Pearson Education, Inc. publishing as Prentice Hall 17 -24

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 Filed 1/5/08 FYE 12/31/08 150 100 50 600 150 90 260 1, 200 2, 300 500 © Pearson Education, Inc. publishing as Prentice Hall (700) 2, 100 (1, 050) 2, 050 Before AFTER 6/30/09 75 75 125 55 55 150 395 100 500 2, 300 500 800 0 (1, 000) 0 2, 055 2, 200 17 -25

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. © Pearson Education, Inc. publishing as Prentice Hall 17 -26

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! © Pearson Education, Inc. publishing as Prentice Hall 17 -27

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. © Pearson Education, Inc. publishing as Prentice Hall 17 -28

Reorganization Plan: 6/30/09 Pre-petition Liabilities New Agreements Debt Disand Equity charge 15% partially secured $500 new stock, $500 bonds, $1200 senior 12% bonds, and another $100 bonds due 12/31/09 $100 Priority tax claims $150 To be paid cash once confirmed $0 Remaining unsecured claims, $950: $600 accounts payable $90 accrued interest $260 note Old stock © Pearson Education, Inc. publishing as Prentice Hall $275 subordinated debt and $140 new stock Forgiven $120 subordinated debt and $60 new stock Total debt discharged $100 new stock $185 $90 $80 $455 Equity 17 -29

Record New Debt Agreements Liabilities subject to compromise (pre) Taxes payable 12% senior debt - current 2, 300 Subordinated debt Common stock (new) Gain on debt discharge settlement of prepetition claims 150 500 100 395 700 455 This entry reclassifies the pre-petition debt according to the reorganization plan. © Pearson Education, Inc. publishing as Prentice Hall 17 -30

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. © Pearson Education, Inc. publishing as Prentice Hall 17 -31

Revalue Assets Inventory Land 25 100 Loss on asset revaluation 105 Buildings, net Equipment, net Patent revalue assets to fair value 75 30 125 A loss is recorded in revaluing the assets. Refer back to the Asset side of the balance sheet. © Pearson Education, Inc. publishing as Prentice Hall 17 -32

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. © Pearson Education, Inc. publishing as Prentice Hall 17 -33

Eliminate Deficit in Equity Reorganization value in excess of identifiable assets Gain on debt discharge Additional paid in capital Loss on asset revaluation 250 455 400 105 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. © Pearson Education, Inc. publishing as Prentice Hall 17 -34

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. © Pearson Education, Inc. publishing as Prentice Hall 17 -35

Disclosures • Adjustments to historical values – Assets – Liabilities • Debt forgiveness • Prior retained earnings or deficit eliminated • Significant factors in determining the reorganization value © Pearson Education, Inc. publishing as Prentice Hall 17 -36

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall © Pearson Education, Inc. publishing as Prentice Hall 17 -37