chap13 hoyle 6th ed

53
CHAPTER 13 ACCOUNTING FOR LEGAL REORGANIZATIONS AND LIQUIDATIONS ANSWERS TO QUESTIONS "Insolvent" refers to a state of financial position whereby a company (or individual) is unable to pay debts as they come due. 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. 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. 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 debts of over $10,775) 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 $10,775. 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 the time to decide on a future course of action. It also brings the court into the process to provide a structure for what might otherwise be a chaotic event, the distribution of assets to the parties involved. 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

description

Chapter 13 Bankruptcy

Transcript of chap13 hoyle 6th ed

Chapter 13

CHAPTER 13

ACCOUNTING FOR LEGAL REORGANIZATIONS AND LIQUIDATIONS

ANSWERS TO QUESTIONS

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

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.

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.

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 debts of over $10,775) 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 $10,775.

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 the time to decide on a future course of action. It also brings the court into the process to provide a structure for what might otherwise be a chaotic event, the distribution of assets to the parties involved.

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.

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 are as follows:

Claims for administrative expenses,

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 90 days preceding the filing of a bankruptcy petition (limited to $4,300 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 $1,950 limit),

Government claims for unpaid taxes.

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.

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.

Unsecured creditors often face the possibility of absorbing substantial losses in a Chapter 7 liquidation since their claims rank below fully secured and partially secured liabilities. Because of this risk, unsecured creditors may feel that they have a better chance of limiting their losses by agreeing to a reorganization plan.

The statement of financial affairs 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 cash proceeds being anticipated, 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.

In general, a trustee is assigned to prevent loss of the insolvent company's assets and oversee the liquidation 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 may 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.

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.

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) current asset and liability balances.

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 a debtor in possession.

In a Chapter 11 bankruptcy, the debtor in possession (the 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.

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.

To become effective, a reorganization plan must be accepted by all interested parties. For approval, each class of creditors (more than twothirds in dollar amount and onehalf in number) must vote for the proposal. Each group of stockholders (twothirds of the shares being voted) must also accept the plan. The court will then confirm the reorganization plan but only if 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.

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.

During reorganization, some debts are in jeopardy of being settled at a reduced amount whereas others will probably be satisfied entirely. Unsecured and partially secured liabilities are likely to be settled at an amount below face value. 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 subject to compromise or not 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.

A company going through a Chapter 11 bankruptcy will report specified reorganization items on its income statement separately from operating figures. These reorganization items are reported prior to income tax expense rather than in a manner similar to an extraordinary item. These separately reported figures include gains and losses on the sale of assets necessitated by the reorganization. Professional fees incurred in connection with the reorganization are reported in a similar manner. Any interest revenue that would not have been earned except for the bankruptcy proceeding is also reported as a reorganization item.

Professional fees incurred during a reorganization must be expensed as incurred.

Fresh start accounting refers to the adjustment of a company's assets and liabilities 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 market 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 and liabilities are reported at current value. If the reorganization value of the companys assets is greater than the total value of the individual assets, an intangible asset somewhat like goodwill must be established. Retained earnings must be zero.

Fresh start accounting is used by companies emerging from a bankruptcy reorganization if the value of the assets held at that time are less than the allowed claims associated with 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.

In fresh start accounting, the tangible and intangible assets of the company are reported at their current values. Liabilities are reported at the present value of the future cash flows.

When a company emerges from bankruptcy, the reorganization value of its assets 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. The total value may well be greater than the current value of the individual assets. If so, the residual amount is recorded as an intangible asset with a title such as "reorganization value in excess of amounts allocable to identifiable assets." This asset is amortized to expense over a period of up to 40 years although a shorter period is highly encouraged.

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

22.(10 Minutes) (Distribution of cash in a liquidation)

Free Assets:

Current Assets

$ 35,000

Buildings and Equipment

110,000

Total

$145,000

Liabilities with Priority:

Administrative Expenses

$ 20,000

Salary Payable (only $3,000 per employee)

6,000

Income Taxes

8,000

Total

$ 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)

$ 30,000

Accounts Payable

85,000

Bonds Payable

70,000

Total

$185,000Percentage of Unsecured Liabilities To Be Paid: $111,000/$185,000 = 60 %

Payment On Notes Payable:

Value of Security (land)

$ 90,000

60% of Remaining $30,000

18,000

Total Collected

$108,00023.(5 Minutes) (Distribution of assets in a liquidation) .

Liabilities with Priority

Paid first administrative expense

$3,000

Paid second wages up to a maximum of

$4,300 each

8,600

Remaining money government claims to unpaid taxes 400

Total of free assets

$12,000The remainder of the salaries and the government claims and all of the unsecured accounts payable will not result in any amount distributed from the liquidation of the Xavier company since no money is left.

24.(8 Minutes) (Distribution of assets to partially secured creditors)

Free Assets:

Other Assets

$ 80,000

Excess from Assets Pledged with fully Secured Creditors

($116,000 $70,000)

46,000

Total

$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)

$ 80,000

Unsecured Creditors

200,000

Total

$280,000

Percentage of Unsecured Liabilities To Be Paid: $84,000/$280,000 = 30 %

Payment On Partially Secured Debt:

Value of Pledged Asset

$ 50,000

30% of Remaining $80,000

24,000

Total to be Collected

$ 74,000(8 Minutes) (Distribution of assets to partially secured creditors.)

Free Assets:

Cash

$50,000

Excess from Assets Pledged with fully Secured

Creditors ($90,000 - $80,000)

10,000

Total

$60,000

Liabilities with Priority

20,000Free Assets after Payment of Liabilities with Priority

$40,000Unsecured liabilities:

Excess of Partially Secured Liabilities Over

Pledged Assets ($150,000 - $130,000)

$20,000

Accounts Payable

180,000

Total

$200,000Percentage of Unsecured Liabilities to be Paid: $40,000/$200,000 = 20%

Payment on Bond:

Value of Pledged Asset

$130,000

20% of Remaining $20,000

4,000

Total to be Received

$134,00026.(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

$198,000In 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.

(8 Minutes) (Payments to be made on unsecured and partially secured liabilities)

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

$350,000

Liabilities with Priority

(160,000)

Available for Unsecured Creditors

$190,000

Accounts Payable

$390,000

Excess of Partially Secured Debt in Excess of Pledged

Assets ($490,000 - $380,000)

(110,000)

Unsecured Liabilities

$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%).

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.

28.(20 Minutes) (Distribution of assets in a liquidation)

Free Assets: (fair market value)

Cash

$ 10,000

Inventory

60,000

Equipment

50,000

Total

$120,000

Liabilities with Priority:

Administrative Expenses

$ 20,000

Income Taxes

30,000

Total

$ 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)

$ 20,000

Note Payable B (in excess of value of security)

80,000

Note Payable C

60,000

Accounts Payable

120,000

Total

$280,000

Percentage of Unsecured Liabilities To Be Paid: $70,000/$280,000 = 25%

Payment on Note Payable A:

Value of Security (land)

$ 70,000

25% of Remaining $20,000

5,000

Total Collected

$ 75,000

Payment on Note Payable B:

Value of Security (building)

$ 40,000

25% of Remaining $80,000

20,000

Total Collected

$ 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 $20,000 is paid.

Payment on Accounts Payable (unsecured):

25% of $120,000

$ 30,000

Payment on Income Taxes Payable:

As a liability with priority, the entire $30,000 is paid.

(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

$180,000

Note payable A unsecured portion

10,000

Note payable B

250,000

Total

$440,000Free Assets (except for equipment):

Cash

$24,000

Accounts receivable

28,000

Inventory

56,000

Land (value does not cover related debt)

0

Buildings ($320,000 less coverage of $300,000

in bonds)

20,000

Total

$128,000

Less: Liabilities with Priority:

Estimated administrative expenses

(12,000)

Taxes payable to government

(20,000)

Total free assets except for equipment

$96,000In 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).

30.(15 Minutes) (Payment of various liabilities in a liquidation)

Free Assets:

Cash

$30,000

Receivables (30 percent collectible)

15,000

Inventory

39,000

Land (value in excess of secured note:

$120,000 - $110,000)

10,000

Total

$94,000

Less: Liabilities with priority

Salary payable (below maximum)

(10,000)

Free assets available

$84,000Unsecured Liabilities:

Accounts payable

$90,000

Bonds payable (less secured interest in

building: $300,000 - $180,000)

120,000

Unsecured liabilities

$210,000Percentage of unsecured liabilities to be paid: $84,000/$210,000 = 40%

Amounts to be collected:

Salary payable (liability with priority to be paid

in full)

$10,000

Accounts payable (unsecured will collect 40%

of debts of $90,000)

$36,000

Note payable (fully secured by land will collect

entire balance)

$110,000

Bonds payable (partially secured will collect

$180,000 from building and 40 percent of the

remaining $120,000)

$228,000

(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.

(9 Minutes) (Adjusting a company coming out of reorganization to fresh start accounting)

The assets of this company have a fair market value of $700,000 but the reorganization value of $760,000. Thus, an intangible asset 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)

10,000

Inventory ($210,000 - $200,000)

10,000

Buildings ($400,000 - $300,000)

100,000

Reorganization value in excess of amount

allocated to identifiable assets

60,000

Retained Earnings (eliminate deficit)

70,000

Additional Paid-in Capital

($130,000 - $20,000)

110,000

(15 Minutes) (Prepare Income statement for company going through a bankruptcy reorganization)

ADDISON CORPORATION

Income Statement

Revenues

$ 467,000

Costs and expenses:

Cost of goods sold

$ 211,000

Rent expense

16,000

Salary expense

70,000

Depreciation expense

22,000

Advertising expense

24,000

Interest expense

4,000(347,000)

Earnings before reorganization items and tax effects

120,000

Reorganization items:

Loss on closing of branch

(109,000)

Professional fees

(71,000)

Interest revenue

32,000 (148,000)

Loss before income tax benefit

(28,000)

Income tax benefit (20 percent)

5,600

Net loss

(22,400)

34.(15 Minutes) (Description of balance sheet for a company emerging from bankruptcy reorganization)

a.SOP 907 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 market 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 entitys 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 in an intangible asset account with a title such as "reorganization value in excess of amounts allocable to identifiable assets."

c.The reorganization value account is an intangible asset that should be amortized to expense over a period of up to 40 years. SOP 907 suggests using a life substantially less than 40 years.

35.(15 Minutes) (Prepare a balance sheet for a company in bankruptcy reorganization)

JAEZ COMPANY

Balance Sheet

December 31, 2001

Current assets:

Cash

$ 23,000

Inventory

45,000$ 68,000

Land, buildings, and equipment:

Land

140,000

Buildings

220,000

Equipment

154,000514,000

Total assets

$582,000

Liabilities not subject to compromise

Current liabilities:

Accounts payable

$ 60,000

Long-term liabilities:

Note payable (due 2003)

$110,000

Note payable (due 2004)

100,000 210,000$ 270,000

Liabilities subject to compromise

Accounts payable

123,000

Accrued expenses

30,000

Income taxes payable

22,000

Note payable (due 2006)

170,000345,000

Total liabilities

615,000

Stockholders' (equity)

Common stock

200,000

Retained earnings (deficit)

(233,000)

Total liabilities and shareholders' (deficit)

$ 582,00036.(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 paidin 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 (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 paidin capital equals $6.66 per share.

Because the company has a reorganization value of $780,000 but the assets have a market value of only $735,000, an account entitled Reorganization Value In Excess of Amount Allocable to Identifiable Assets must be established for $45,000

JOURNAL ENTRIES

Land and buildings

80,000

Reorganization value in excess of amount allocable to

identifiable assets

45,000

Accounts receivable

20,000

Inventory

22,000

Equipment

13,000

Additional paid-in capital

70,000

To adjust accounts to market value as part of fresh

start accounting.

Common stock

144,000

Additional paidin capital

144,000

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.

36.(continued)

Accounts payable

80,000

Note payable

5,000

Common stock ($8 per share par value)

8,000

Additional paidin capital ($6.66 per sharesee

above, or 1/30 of company total)

6,666

Gain on debt discharge

60,334

To record settlement of accounts payable.

Accrued expenses

35,000

Note payable

4,000

Gain on debt discharge

31,000

To record settlement of accrued expenses.

Note payable

200,000

Note payable

50,000

Common stock ($8 per share par value)

80,000

Additional paidin capital ($6.66 per sharesee

above, or 1/3 of company total)

66,667

Gain on debt discharge

3,333

To record settlement of note payable due in 2004.

Note payable

185,000

Note payable

71,000

Common stock ($8 per share par value)

56,000

Additional paidin capital ($6.66 per sharesee

above, or 7/30 of company total)

46,667

Gain on debt discharge

11,333

To record settlement of note payable due in 2002.

Note payable

200,000

Note payable

110,000

Gain on debt discharge

90,000

To record settlement of note payable due in 2003.

Additional paid-in capital ($334,000 $200,000)

134,000

Gain on debt discharge

196,000

Retained earnings (deficit)

330,000

To adjust additional paidin capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.

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 907:

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.Since 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 a Reorganization Value in Excess of Amount Allocable to Identifiable Assets.

SMITH CORPORATION

Balance Sheet

December 31, 2001

ASSETS

Current Assets:

Accounts receivable

$ 18,000

Inventory

111,000$129,000

Land, Buildings, and Equipment:

Land and buildings

278,000

Machinery

121,000399,000

Intangible Assets:

Patents

125,000

Reorganization value in excess of amount

allocable to identifiable assets

147,000272,000

Total Assets

$800,000LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities:

Accounts payable

$ 97,000

Longterm Liabilities:

Note payable (due in 2 years)

$ 35,000

Note payable (due in 5 years)

50,000

Note payable (due in 8 years)

100,000185,000

Total Liabilities

$282,000

Stockholders' Equity:

Common stock (par value)

$500,000

Additional paidin capital (balancing figure)

18,000

Retained earnings

0518,000

Total Liabilities and Stockholders' Equity

$800,00038.(15 Minutes) (Distribution of assets in a liquidation.)

Free assets: (liquidation value)

Other assets

$ 81,000

Assets pledged with fully secured creditors in

excess of debt

45,000

Total free assets

$126,000

Free assets after paying liabilities with priority

($126,000 $36,000)

$ 90,000

Unsecured debts:

Accounts payable

$283,000

Partially secured liabilities in excess of pledged assets

($180,000 $103,000)

77,000

Total unsecured debts

$360,000Percentage 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.

39.(35 Minutes) (Prepare a statement of financial affairs)

LIMESTONE COMPANY

Statement of Financial Affairs

June 3, 2001

Available for

Book

Unsecured

Values

AssetsCreditors

Pledged with Fully Secured Creditors:

$400,000Land and buildings $310,000

Less: Notes payable-longterm (190,000)$120,000

Pledged with Partially Secured Creditors:

180,000 Equipment$130,000

Notes payable current (250,000)0

Free Assets:

3,000 Cash

3,000

65,000Accounts receivable

26,000

88,000Inventory

80,000

Total amount available to pay liabilities

with priority and unsecured creditors

$229,000

Less: Liabilities with priority

(listed below)

(42,000)

Available for unsecured creditors

$187,000

Estimated deficiency

21,000

$736,000

$208,00039. (continued)

Unsecured

Book

Nonpriority

ValuesLiabilities and Stockholders' Equity

Liabilities

Liabilities with Priority:

Administrative expenses $ 18,000

$ 10,000 Salaries payable 10,000

Taxes payable 14,000

Total $ 42,000

Fully Secured Creditors:

190,000 Notes payable longterm $190,000

Less: Land and Buildings (310,000)

0

Partially Secured Creditors:

250,000 Notes payable current $250,000

Less: Equipment(130,000)

$120,000

Unsecured Creators:

88,000 Accounts payable (other than salaries)

88,000

198,000 Stockholders' equity

0

$736,000

$208,00040.(25 Minutes) (Distribution of assets in a liquidation)

Free Assets:

Cash

$ 6,000

Accounts Receivable

18,000

Inventory

31,000

Investments

8,000

Land Value In Excess of Related Debt ($72,000 $65,000)

7,000

Total

$ 70,000

Liabilities With Priority:

Administrative Expenses (estimated)

22,000

Salary Payable

$6,000

Taxes Payable

10,000

Total

$ 38,000

Free Assets After Payment of Liabilities With Priority

($70,000 $38,000)

$ 32,000

Unsecured Liabilities:

Notes Payable (in excess of value of buildings) .

$ 10,000

Bonds Payable (in excess of value of equipment)

80,000

Accounts Payable

70,000

Total

$160,000

Percentage of Unsecured Liabilities To Be Paid: $32,000/$160,000 = 20%

Payment on $65,000 notes payable secured by land will be made in total since the value of the land is greater than the debt.

Payment on Notes Payable (secured by buildings):

Value of Security (building)

$ 68,000

20% of Remaining $10,000

2,000

Total Collected

$ 70,000

Payment on Bonds Payable:

Value of Security (equipment)

$ 35,000

20% of Remaining $80,000

16,000

Total Collected

$ 51,000

Payment on Accounts Payable (unsecured):

20% of $70,000

$ 14,000Payment of Salary Payable:

As a liability with priority, the entire $6,000 is paid.

Payment of Taxes Payable:

As a liability with priority, the entire $10,000 is paid.

Payment of Administrative Expenses:

As a liability with priority, the entire $22,000 is paid.

41.(20 Minutes) (Reporting of a reorganization and a liquidation)

a.Since the land's net realized value is less than the amount of the note payable, the debt will be reported on a statement of financial affairs as a liability owed to "partially secured creditors." The $80,000 obligation Is disclosed In this manner and then reduced by the $48,000 anticipated cash proceeds. The remaining $32,000 balance will be shown by Anteium as an unsecured nonpriority liability.

The land is still reported as an asset, one pledged with partially secured creditors. The $31,000 cost is revealed within the statement of financial affairs although this information is not considered relevant in a liquidation. The $48,000 net realizable value is reported but is offset by the $80,000 liability; thus, no cash will be available to unsecured creditors unless a greater amount is generated by the sale.

b.Fresh start accounting must be used because the reorganization value is less than the debts and the original owners are left with less than 50 percent of the voting stock.

After the reorganization, the assets will be reported at $82,000 with one $5,000 debt. Since the common stock has a total par value of $40,000, additional paidin capital must be $37,000.

Land

17,000

Investments

5,000

Reorganization value in excess of amounts assigned

to identifiable assets

9,000

Additional paidin capital

31,000

To adjust asset values to fair market value (a total of $73,000) with a reorganization value account established to bring the total up to $82,000.

Note payable

80,000

Additional paidin capital (60% of company total)

22,200

Gain on discharge of debt

57,800

To record issuance of stock to bank in settlement of

debt.

Accounts payable

20,000

Note payable

5,000

Gain on discharge of debt

15,000

To record settlement of accounts payable for 3year note.

Gain on discharge of debt

72,800

Additional paidin capital

16,200

Retained earnings (deficit)

89,000

To reduce additional paidin capital balance to correct figure, to close out gain account, and to eliminate deficit as a step in establishing fresh start accounting.

c.The bank will collect a total of $59,000. Obviously, the $50,000 proceeds generated by the land sale must go to the bank with the remaining $30,000 obligation then being ranked as an unsecured-nonpriority liability. Anteium (the insolvent company) will have $15,000 of the $26,000 cash left after paying the $11,000 administrative expenses. Unsecured debts total $50,000 ($30,000 from the note and $20,000 of accounts payable). Thus, 30% of these debts will be paid ($15,000/$50,000). The bank collects an additional $9,000 ($30,000 x 30%); the accounts payable collect $6,000 ($20,000 x 30%).

42.(25 Minutes) (Prepare a statement of realization and liquidation)

a.LITZ CORPORATION

Statement of Realization and Liquidation

Stock-

Liabilities FullyPartiallyUnsecured holders'

Noncashwith. Secured SecuredNonpriority Equity

Cash AssetsPriorityCreditors CreditorsLiabilities(Deficits)

Balances, 8/8/01 $ 16,000 $763,0000$259,000 $132,000$150,000$238,000

Investments sold 39,000 (32,000)

7,000

Inventory sold 48,000 (69,000)

(21,000)

Payment is made on note from

proceeds of auction (48,000)

(48,000)

Remaining debt is reclassified

(84,000)84,000

Administrative expenses incurred

$15,000

(15,000)

Land and buildings all sold 315,000 (370,000)

(55,000)

Payment is made on note from

proceeds of sale (259,000)

(259,000)

Reclassify liabilities with priority

34,000

(34,000)

Equipment sold 84,000 (210,000)

(126,000)

Receivables collected 34,000(82,000)

(48,000)

Administrative expenses paid(15,000)

(15,000)

Final balances remaining for

unsecured creditors$214,000 0$34,000 0 0$200,000$(20,000)b. Total amount available to pay

liabilities with priority and

unsecured creditors (see part a) $214,000

Less: liabilities with priority (34,000)

Available for unsecured creditors $180,000

Percentage of claim to be received

by each unsecured creditor

($180,000/$200,000) 90%

43.(40 Minutes) (Prepare journal entries for company emerging from bankruptcy using fresh start accounting)

Company must use fresh start accounting because the reorganization value of $650,000 is less than the company's allowed debts and the original owners hold less than 50 percent of the voting stock after the reorganization.

BOOK VALUES AFTER EMERGING FROM REORGANIZATION

Total assets = $637,000 (reorganization value of $650,000 plus proceeds from sale of stock of $77,000 less $90,000 value of land and investments used to settle two debts)

Total liabilities = $350,000 ($130,000 + $40,000 + $180,000)

Total common stock = $160,000 (10,000 additional shares are issued with a $10 per share par value so that total outstanding shares = 16,000)

Deficit = 0 (eliminated by the reorganization)

Additional paidin capital = $127,000 (figure needed to balance above accounts after reorganization)

Because the company has a reorganization value of $650,000 but the assets have a market value of only $623,000, an account entitled Reorganization Value in Excess of Amount Allocable to Identifiable Assets must be established for $27,000.

JOURNAL ENTRIES

Investments

14,000

Land

23,000

Buildings

52,000

Reorganization value in excess of amount allocable to

identifiable assets

27,000

Accounts receivable

20,000

Inventory

16,000

Equipment

31,000

Additional paidin capital

49,000

To adjust accounts to market value as part of fresh

start accounting.

Cash

77,000

Common stock ($10 par value)

70,000

Additional paidin capital

7,000

To record shares sold to new investor.

Cash

40,000

Investments

40,000

Investments sold.

43. (continued)

Notes payable current

220,000

Cash

40,000

Notes payable (due in 2005)

130,000

Gain on discharge of debt

50,000

To record settlement of current notes.

Accounts payable

129,000

Notes payable (due in 2002)

40,000

Gain on discharge of debt

89,000

To record settlement of accounts payable.

Notes payable (due in 2004)

325,000

Land

50,000

Notes payable (due in 2004)

180,000

Common stock ($10 par value)

30,000

Additional paidin capital

(3/16 of total computed above)

23,813

Gain on discharge of debt

41,187

To record settlement of longterm debt.

Gain on debt discharge

180,187

Additional paidin capital ($127,000 $79,813)

47,187

Retained earnings (deficit)

133,000

To adjust additional paidin capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.

44.(40 Minutes) (Prepare statement of financial affairs, determine amounts to be paid in liquidation.)

a.

OREGON CORPORATION

Statement of Financial Affairs

Available for

Book

Unsecured

Values

AssetsCreditors

Pledged with Fully Secured Creditors:

$33,000Land (Plots A and D) $43,000

Less: Notes payable (30,000)$13,000

Pledged with Partially Secured Creditors:

28,000Land (Plots B and C) $25,000

Less: Notes payable (30,000)--0--

Free Assets:

6,000Cash

6,000

25,000Accounts receivable

12,000

Total available to pay liabilities with

priority and unsecured creditors

$31,000

Less: Liabilities with priority

(listed below)

28,000

Available for unsecured creditors

$3,000

Estimated deficiency

47,000

$92,000

$50,000

Unsecured

Book

Nonpriority

ValuesLiabilities and Stockholders' Equity

Liabilities

Liabilities with Priority:

0Administrative expenses (estimated)$16,000

$12,000Salaries payable 12,000

Total (above) $28,000

Fully Secured Creditors:

30,000Notes payable $30,000

Land (Plots A and D) (43,000)--0--

Partially Secured Creditors:

30,000Notes payable $30,000

Land (Plots B and C)(25,000)$ 5,000

Unsecured Creditors:

25,000Notes payable

25,000

20,000Accounts payable (less salaries

shown above)

20,000

(25,000)*Stockholders' equity

$92,000

$50,000

*Derived as a balancing figure.

44. (continued)

b.According to the statement of financial affairs prepared above, $3,000 cash should be available for unsecured nonpriority creditors. Unfortunately, $50,000 in unsecured nonpriority liabilities exist. Thus, only 6% of these claims will be covered ($3,000/$50,000).

Cash of $11,240 will be paid on the note payable that is secured by plot B. The land is to be sold for $11,000 leaving a $4,000 unsecured debt. Since 6% of this amount is expected to be paid, the holder will only receive an additional $240.

c.As Indicated in part b, only 6% of the unsecured nonpriority claims can be satisfied. Thus, just $1,500 will be paid on the unsecured $25,000 note payable.

d.Selling plot D for $30,000 rather than $27,000 generates an additional $3,000 in available cash. The statement of financial affairs produced above would then report $6,000 as the amount available for unsecured nonpriority claims or 12% of the total ($6,000/$50,000). After plot B is sold for $11,000, the remaining $4,000 of this note is classified as an unsecured nonpriority liability. Since 12% of this amount is to be paid, an additional $480 is transferred to the holder of the note for a total of $11,480.

45.(40 Minutes) (Prepare a statement of financial affairs)

LYNCH, INC.

Statement of Financial Affairs

March 14, 2001

Available for

Book

Unsecured

Values

AssetsCreditors

Pledged with Fully Secured Creditors:

$40,000Land and building $75,000

Less: Notes payable(70,000)$5,000

Pledged with Partially Secured Creditors:

14,000Equipment $19,000

Less: Notes payable (150,000)--0--

Free Assets:

1,000Cash

1,000

25,000Accounts receivable

15,000

100,000Inventory

33,000

15,000Investments

21,000

Total available to pay liabilities with

priority and unsecured creditors

$75,000

Less: Liabilities with priority

(listed below)

(22,000)

Available for unsecured creditors

$53,000

Estimated deficiency

115,000

$195,000

$168,000

45. (continued)

Unsecured

Book

Nonpriority

ValuesLiabilities and Stockholders' Equity

Liabilities

Liabilities with Priority:

0Administrative expenses (estimated)$16,000

$5,000Salaries payable 5,000

1,000Payroll taxes payable 1,000

Total (above). $22,000

Fully Secured Creditors:

70,000Notes payable $70,000

Land and building(75,000)0

Partially Secured Creditors:

150,000Notes payable $150,000

Equipment(19,000)$ 131,000

Unsecured Creditors:

33,000Accounts payable

33,000

4,000Advertising payable

4,000

(68,000)

Stockholders' equity

$195,000

$168,000

'1'

46. (30 Minutes) (Prepare a statement of realization and liquidation.)

LYNCH, INC.

Statement of Realization and Liquidation

March 14, 2001 to July 23, 2001

Stock-

Liabilities FullyPartiallyUnsecured holders'

Noncashwith. Secured SecuredNonpriority Equity

Cash AssetsPriorityCreditors CreditorsLiabilities(Deficits

Book balances, 8/8/01

Answer to Problem 45$ 1,000$194,000$6,000$70,000$150,000$ 37,000$(68,000)

Accounts receivable collected

--remaining balance assumed

to be uncollectible18,000(25,000)

(7,000)

Inventory sold 40,000 (100,000)

(60,000)

Accounts payable discovered

10,000(10,000)

Land and buildings all sold 71,000 (40,000)

31,000

Fully secured note paid(70,000)

(70,000)

Equipment sold 11,000 (14,000)

(3,000)

Payment made on partially

secured debt(11,000)

(11,000)

Investments sold21,000(15,000)

6,000

Administrative expenses accrued

20,000

(20,000)

Remaining partially secured

claims reclassified as

unsecured liabilities

_______

(139,000)139,000

Final balances remaining for

unsecured creditors$81,000 0$26,000 0 0$186,000$(131,000)b.The statement of realization and liquidation prepared in (a) indicates that $81,000 in cash remains. However, $26,000 of this amount must be distributed to the liabilities with priority leaving only $55,000 for the unsecured nonpriority creditors. Since these unsecured liabilities amount to $186,000, only 30% (rounded) ($55,000/$186,000) of each debt will be paid. Thus, a creditor holding a $1,000 claim will receive approximately $300.

47.(30 Minutes) (Prepare Journal entries for company emerging from bankruptcy using fresh start accounting)

The Holmes Corporation must use fresh start accounting because the reorganization value of $225,000 is less than the company's allowed debts and the original owners hold less than 50 percent of the voting stock after the reorganization.

BOOK VALUES AFTER EMERGING FROM REORGANIZATION

Total assets = $248,200 ($225,000 reorganization value plus proceeds of sale of stock of $36,000 less $12,800 payment made to settle unsecured liabilities [20 percent of $64,000])

Total liabilities = $118,000 ($18,000 + $70,000 + $30,000)

Total common stock = $105,000 (11,000 additional shares are issued with a $5 per share par value total outstanding shared = 21,000)

Deficit = 0 (eliminated by the reorganization)

Additional paidin capital = $25,200 (figure needed to balance above accounts after reorganization)

JOURNAL ENTRIES

Reorganization value in excess of amount allocable

to identifiable assets

15,000

Additional paidin capital

15,000

To adjust to total reorganization value as part of fresh

start accounting ($225,000 - $210,000).

Salary payable

18,000

Note payable1 year

18,000

To record note issued for accrued salaries.

Notes payable

140,000

Note payable6 years

30,000

Common stock ($5 par value)

25,000

Additional paidin capital

(5/21 of total computed above)

6,000

Gain on discharge of debt

79,000

To record settlement of partially secured debt.

Cash

36,000

Common stock ($5 par value)

30,000

Additional paidin capital

6,000

To record shares sold to new investor.

Notes payable

50,000

Accounts payable

10,000

Accrued expenses

4,000

Cash

12,800

Gain on discharge of debt

51,200

To record payment of unsecured debts20% payment

made.

Gain on debt discharge

130,200

Additional paidin capital ($27,000 $25,200)

1,800

Retained earnings (deficit)

132,000

To adjust additional paidin capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.

McGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2001

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Advanced Accounting, Updated 6/e 13- PAGE \* MERGEFORMAT 37Updated Sixth EditionMcGraw-Hill/Irwin The McGraw-Hill Companies, Inc., 2001

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