Chapter Thirteen

Accounting for Accounting for Legal Legal

Reorganizations Reorganizations and Liquidationsand Liquidations

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Bankruptcy

A basic assumption of accounting is that a business is a going concern (will remain in business).

Occasionally, a business becomes insolvent (unable to pay debts as they come due).

An insolvent business can either cease to exist, or can seek a legal remedy called bankruptcy.

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What happens to a business when it fails?

Who gets the

assets?

Are the creditors

protected?

How it the business

failure reported?

If the assets are sold, who gets

the money?

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Bankruptcy Reform Act of 1978 (as amended)

Strives to achieve two goals in connection

with insolvency cases:

1) the fair distribution of assets to creditors, and

2) the discharge of an honest debtor from debt.

Strives to achieve two goals in connection

with insolvency cases:

1) the fair distribution of assets to creditors, and

2) the discharge of an honest debtor from debt.

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Bankruptcy Reform Act of 1978

Two basic forms of filings

Two basic forms of filings

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Court Response to the Petition

Neither a voluntary nor involuntary petition automatically creates a bankruptcy.

Court may reject voluntary petitions if the action is considered detrimental to the creditors

Court may reject involuntary petitions unless evidence indicates the debtor’s inability to meet obligations as they come due (slowness of payment is NOT sufficient cause!!)

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Court Response to the Petition

If the court accepts the petition, it grants an order order for relieffor relief..

The order for relief halts all actions against the debtor. This automatic stay prohibits creditors from collecting debts without the court’s permission

A trustee is appointed to oversee the bankruptcy process.

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Fully Secured

Partially Secured

Unsecured With Priority

Unsecured

Top Priority

Classification of Creditors

Stockholders get what’s left over.

Each level must be paid in full prior to

making distributions to the

next level.

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Administrative costs related to liquidationAdministrative costs related to liquidation

Debts arising between the filing date and the issuance of an order of relief.

Debts arising between the filing date and the issuance of an order of relief.

Employee claims for wages earned and/or benefit plan contributions earned

during the 180 days prior to filing (limit $10,950 per employee, each claim).

Employee claims for wages earned and/or benefit plan contributions earned

during the 180 days prior to filing (limit $10,950 per employee, each claim).

Customer deposits. Limited to $2,425 per customer.

Customer deposits. Limited to $2,425 per customer.

Government claims for unpaid taxes.Government claims for unpaid taxes.

Unsecured Liabilities Having Priority

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Reorganization or Liquidation?

How will the debtor be discharged from their obligations?

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Under Chapter 7, the debtor’s assets will be liquidated and the proceeds distributed to to creditors (based on their priority status) OR

Under Chapter 11, the debtor will be permitted to reorganize and continue operations.

(These “chapters” refer to the relevant sections of the Bankruptcy Reform Act)

A legal way to “salvage” a company rather than liquidate it.

A legal way to “salvage” a company rather than liquidate it.

Reorganization -Chapter 11 Bankruptcy

The company is temporarily protected from its creditors.

Creditors are encouraged to negotiate new terms with the company.

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ReorganizationChapter 11 Bankruptcy

Workers keep their jobs.

Suppliers keep their customers.

Customers maintain their source of supply.

Control of the company is normally maintained by the owners (“debtor in

possession”)

Control of the company is normally maintained by the owners (“debtor in

possession”)

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ReorganizationChapter 11 Bankruptcy

Financial Reporting During Reorganization

Gains, losses, revenues and expenses resulting from the reorganization process are reported separately.

Liabilities are restated. Current versus noncurrent

classification not applicable.

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Fresh Start Accounting

Fresh Start Accounting Assets are restated to current

market value. Liabilities are stated at the

discounted present value of future cash payments.

R/E is set to zero. Normally, APIC is adjusted to

balance.

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