corporations in financial difficulty

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

Chapter 20

Corporations in Financial Difficulty

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Learning Objective 1

Understand the courses of action available to

financially distressed firms.

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Overview

A company in financial difficulty has a large number of alternatives. Bankruptcy is only a final course.

A company may petition the courts for bankruptcy to protect itself from an onslaught of legal suits. Some have also attempted to void union

contracts by petitioning for bankruptcy. U.S. auto industry?

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Courses of Action

Nonjudicial Actions Formal agreements between the company and

its creditors are legally binding but are not administered by a court.

Bankruptcy is the final step for a financially distressed business.

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Nonjudicial Actions

Debt Restructuring Arrangements Extension of due dates of its debt Decrease of the interest rate on the debt Modification of other terms of the debt contract

Composition agreement Creditors agree to accept less than the face

amount of their claims

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Nonjudicial Actions

Creditors’ committee management Creditors may agree to “assist” the debtor in

managing the most efficient payment of creditors’ claims.

Most creditors’ committees are advisory . Counsel closely with the debtor

Do not want to assume additional liabilities and problems of actual operation of the debtor

Usually initiated with a plan of settlement proposed by the debtor

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Nonjudicial Actions

Transfer of assets Debtors may transfer assets to obtain quick cash

Example: Factoring receivables

Assets may be sold “with recourse” or “without recourse”

A transfer of financial assets is considered a sale only if the transferor has surrendered control over the transferred assets. SFAS 140

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Judicial Actions

Bankruptcy is a judicial action administered by bankruptcy courts and bankruptcy judges using the guidance provided in Title 11 of the United States Bankruptcy Code.

Chapters of the Bankruptcy CodeChapter 1 General Provisions

Chapter 3 Case Administration

Chapter 5 Creditors, the Debtor, and the Estate

Chapter 7 Liquidation

Chapter 9 Adjustment of Debts of a Municipality

Chapter 11 Reorganization

Chapter 12 Adjustment of Debts of a Family Farmer with Regular Annual Income

Chapter 13 Adjustment of Debts of an Individual with Regular Income

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Judicial Actions

Either the debtor or its creditors may decide that a judicial action is best. The debtor may file a voluntary petition

seeking judicial protection in the form of an order of relief against the initiation or continuation of legal claims by the creditors.

Creditors may file an involuntary petition against the debtor. Certain conditions must exist before creditors

may file a petition.

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Practice Quiz Question #1

Which of the following is usually NOT one of the debt restructuring arrangements available to companies in distress?

a. Extension of due dates.b. Extension of additional loans from

the same lenders to pay off current debt.

c. A decrease in interest rates.d. Modification of debt terms.e. None of the above.

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Which of the following statements is true?a. A Chapter 11 bankruptcy leads to the

liquidation of the corporation.b. A Chapter 7 bankruptcy leads to the

reorganization of the corporation’s debt.

c. A Chapter 11 bankruptcy leads to the reorganization of the corporation’s debt.

d. A Chapter 7 bankruptcy leads to the adjustments of debt for an individual.

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Understand Chapter 11 reorganizations and be able

to prepare financial statements for debtors-in-

possession as well as a plan of recovery.

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Chapter 11 Reorganizations

Temporary protection from creditors Allows time needed to

reorganize the debtor company return its operations to a profitable level

If granted protection, the company receives an order of relief to suspend making any payments on its prepetition debt

Bankruptcy court administers reorganizations. Can appoint trustees to direct the reorganization

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The company continues to operate while it prepares a plan of reorganization.

A disclosure statement is transmitted to all creditors and other parties eligible to vote on the plan of reorganization.

The bankruptcy court then evaluates the responses to the plan from creditors and other parties and either confirms the plan of reorganization or rejects it.

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Statement of Position No. 90-7 Provides guidance for financial reporting for

companies in reorganization Financial statements should distinguish between

transactions and events directly associated with the reorganization and

those associated with ongoing operations

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Fresh start accounting SOP 90-7 states that fresh start reporting should

be used as of the confirmation date of the plan of reorganization if both the following conditions occur:

1. The reorganization value of the assets of the emerging entity immediately before the date of confirmation is less than the total of all postpetition liabilities and allowed claims.

2. Holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity.

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Fresh start accounting

Compute the reorganization value of the emerging entity’s assets Fair value of the entity before considering liabilities

and approximates the amount a willing buyer would pay for the entity’s assets

The reorganization value is then allocated to the assets using the allocation of value method

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Fresh start accounting A reorganization value in excess of amounts

assignable to identifiable assets is reported as an intangible asset

The emerging company’s liabilities are recorded at the present values of the amounts to be paid

Any retained earnings or deficits are eliminated A set of final operating statements is prepared

just prior to emerging from reorganization In essence, the company is a new reporting

entity after reorganization

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Companies not qualifying for fresh start accounting should: Determine whether assets are impaired Report liabilities at the present values of

the amounts to be paid Any gain or loss on the revaluation of the

liabilities can be extraordinary or ordinary Unusual and infrequent = extraordinary

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Companies not qualifying for fresh start accounting should: Recognize a liability for a cost associated

with an exit or disposal activity when the liability is incurred, not at the earlier time the company makes a commitment to an exit plan

LT assets are divided between1. Those to be held and used and2. Those to be sold

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Plan of reorganization – Components1. Disposing of unprofitable operations

2. Restructuring of debt with specific creditors

3. Revaluation of assets and liabilities

4. Reductions or eliminations of claims of original stockholders and issuances of new shares to creditors or others

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Which of the following statements is true about fresh start accounting?

a. Fresh start accounting focuses on pre-bankruptcy book values.

b. Fresh start accounting allows management to revalue assets to any value they feel is “fair and normal.”

c. Fresh start accounting is no longer legal in the U.S.

d. Fresh start accounting focuses the fair value of assets a willing buyer would pay to acquire them.

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PRACTICE—E20-2

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Plan of Reorganization

Elimination Reduction $2 par

of Debt Surviving of Common Stock Total Recovery

and Equity Debt Assets % Value $ %

Post-petition liabilities (30,000) (30,000) (30,000) 100%

Claims/Interest:

Accounts Payable (80,000) 8,000 (72,000) (72,000) 90

Notes Payable, 10% (150,000) 25,000 (125,000) (125,000) 83

Related Int. Payable (16,000) 16,000 -0- 0

Bonds Payable, 12% (200,000) (200,000) (200,000) 100

Related Interest Payable

(24,000) 18,000 (6,000) (6,000) 25

Total (470,000) 67,000

Common shareholders:

Common Stock (100,000) (100,000) 100% (200,000) (200,000)

Additional Paid-In (200,000) 171,000 (29,000) (29,000)

Retained Earnings

Deficit 178,000 (178,000)

Total (622,000) (40,000) (230,000) (203,000) 100% (229,000) (662,000)

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(1) Accounts Payable 80,000Notes Payable, 10% 150,000Interest Payable 40,000 Cash 6,000 Accounts Receivable (net) 72,000 Land 85,000 Gain on Disposal of Land 40,000 Gain on Discharge of Debt 67,000 Record discharge of debt.

Journal entries to record reorganization

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(1) Accounts Payable 80,000Notes Payable, 10% 150,000Interest Payable 40,000 Cash 6,000 Accounts Receivable (net) 72,000 Land 85,000 Gain on Disposal of Land 40,000 Gain on Discharge of Debt 67,000 Record discharge of debt.

(2) Common Stock ($1 par) 100,000Additional Paid-In Capital 171,000Gain on Disposal of Land 40,000Gain on Discharge of Debt 67,000 Common Stock ($2 par) 200,000 Retained Earnings 178,000 Record change in par value of stock and elimination of deficit.

Journal entries to record reorganization

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Understand Chapter 7 liquidations and be able to

prepare a statement of affairs.

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Chapter 7 Liquidations

Liquidations are administered by the bankruptcy courts in the interests of the corporation’s creditors and shareholders.

The intent in liquidation is to maximize the net dollar amount recovered from disposal of the debtor’s assets.

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Classes of creditors Secured creditors

Have liens, or security interests, on specific assets, often called “collateral”

A creditor with such a legal interest in a specific asset has the highest priority claim on that asset

Creditors with priority Unsecured creditors having no collateral

claim against specific assets but have priority over other unsecured creditors

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Classes of creditors Unsecured creditors

The lowest priority is given to these claims Paid only after secured creditors and

unsecured creditors with priority are satisfied

Often receive less than the full amount of their claim

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Statement of Affairs The basic accounting report made at the

beginning of the process. Presents the expected realizable amounts from

Disposal of the assets,

The order of creditors’ claims, and

The expected amount that unsecured creditors will receive as a result of the liquidation.

A different report, also entitled the “Statement of Affairs,” is a list of questions the debtor must answer as part of the bankruptcy petition.

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Statement of Affairs An important planning report for the anticipated

liquidation of a company. The Statement of Affairs includes

Book values of the debtor company’s balance sheet accounts,

Estimated fair market values of the assets,

Order of the claims, and

Estimated deficiency to the general unsecured creditors.

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Which of the following is NOT one of the classes of creditors that could be paid in a Chapter 7 liquidation?

a. Secured creditors.b. Unsecured creditors.c. Creditors in jeopardy.d. Creditors with priority.


PRACTICE—E20-4

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a. Schedule to calculate amount available for general unsecured creditors:

Total estimated fair values $471,000

Claims of secured creditors:

Notes payable and interest

(Receivables and Inventory) $115,000

Bonds payable and interest

(Land and Building) 231,000 (346,000)

$125,000

Claims of creditors with priority:

Wages payable $ 9,500

Taxes payable 14,000 (23,500)

Available to general unsecured creditors $101,500

E20-4 Solution

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b. Accounts payable $ 95,000 Notes payable and interest $195,000 Less: Secured by receivables and inventory

(115,000) 80,000

Total unsecured claims $175,000

Estimated dividend:

$101,500= 58%$175,000

E20-4 Solution

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b. Accounts payable $ 95,000 Notes payable and interest $195,000

Less: Secured by receivables and inventory

(115,000) 80,000

Total unsecured claims $175,000

Estimated dividend:

$101,500= 58%$175,000

c. Group Credit Percentage Distributed

Accounts Payable $ 95,000 58% $ 55,100

Wages Payable 9,500 100 9,500Taxes Payable 14,000 100 14,000Notes Payable 80,000 58 46,400 and Interest 115,000 100 115,000

Bonds Payable and Interest 231,000 100 231,000

$471,000

E20-4 Solution

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Book Values Fair Values

Amt Avail to Unsecured

ClaimsEstimated G/L on Realization

ASSETS:(1) Assets pledged with fully secured creditors

100,000Land 80,000 (20,000)220,000Building (net) 160,000 (60,000)

240,000 Less Bond Payable (220,000)Less Interest on Bonds Payable (11,000) 9,000

(2) Assets pledged with partially secured creditors60,000Receivables 50,000 (10,000)90,000Inventory 65,000 (25,000)

115,000 Less Notes Payable (190,000)Less Interest on Notes Payable (5,000)

(3) Free assets:16,000Cash 16,000 16,000 0

250,000Equipment 100,000 100,000 (150,000)Estimated Amount Available 125,000 Less Creditors with Priority (23,500)

(a) Net estimated amount available to unsecured creditors: 101,500 Estimated Deficiency 73,500

736,000 (265,000)Total Unsecured Debt from liabilities 175,000

(b) Percent paid out to unsecured creditors: 0.58cents on the dollar

E20-4 Solution

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Estimated Amount

UnsecuredLIABIITLIES AND STOCKHOLDERS' EQUITY:

(1) Fully Secured Creditors220,000 Bond Payable 220,000 11,000 Interest Payable 11,000

(2) Partially secured creditors190,000 Notes Payable 190,000

5,000 Interest Payalbe 5,000

Less receivables and inventory (115,000)

80,000

(3) Creditors with Priority9,500 Wages Payable 9,500

14,000 Taxes Payable 14,000 23,500

(4) Remaining unsecured creditors

95,000 Accounts Payable

95,000

(5) Stockholders' equity191,500 BV of Stockholders' Equity (736,000 - 544,500)

736,000 (Carry up to asset section) 175,000

E20-4 Solution

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PRACTICE—P20-7

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Assets EstimatedAmount

Available Estimated Estimated to Gain

Book Current Unsecured (Loss) on Value Values Claims Realization

(1) Assets pledged with fully secured creditors:

$ 50,000 Accounts receivable (net) $ 50,000 Less: 12% note payable and interest (44,000) $ 6,000

80,000 Land $110,000 $ 30,000 162,000 Plant and equipment (net) 150,000 (12,000)

$260,000 Less: Mortgages payable and interest (234,600) 25,400

(2) Assets pledged with partially secured creditors:

30,000 Marketable securities $ 22,000 (8,000) Less: 10% note payable and interest (29,400)

79,000 Inventory $ 75,000 (4,000) Less: Accounts payable (105,000)

(3) Free assets:5,000 Cash $ 5,000 5,000

55,000 Accounts receivable (net) 55,000 55,000 81,000 Inventory 76,000 76,000 (5,000)

7,000 Prepaid insurance 1,500 1,500 (5,500)250,000 Plant and equipment (net) 190,000 190,000 (60,000)

72,000 Franchises 30,000 30,000 (42,000)

Estimated amount available $388,900 Less: Creditors with priority (45,000)Net available to unsecured creditors $343,900

Estimated deficiency 82,500 $871,000 $(106,500)

Total unsecured debt $426,400

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Liabilities and EquitiesEstimated

Book Amount Value Unsecured

(1) Fully secured creditors:$ 44,000 12% note payable and interest $ 44,000

234,600 Mortgages payable and interest 234,600 $278,600

(2) Partially secured creditors:29,400 10% note payable and interest $ 29,400

Less: Marketable securities (22,000) $ 7,400

105,000 Accounts payable $105,000 Less: Inventory (75,000) 30,000

(3) Creditors with priority:-0- Estimated liquidation expenses $ 13,000

20,000 Wages payable 20,000 12,000 Taxes payable 12,000

$ 45,000

(4) Unsecured creditors:160,000 Accounts payable 160,000212,000 Notes payable 212,000

17,000 Interest payable 17,000

(5) Stockholders' equity:240,000 Common stock

(203,000) Retained earnings (deficit) $871,000 $426,400

b. % to unsecured creditors:

$343,900 = 80.65%

$426,400

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Understand trustee accounting and reporting.

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Additional Considerations

Trustee accounting and reporting Chapter 11 reorganization: Bankruptcy courts

appoint trustees to manage a company under Management fraud,

Dishonesty,

Incompetence, or

Gross mismanagement

The trustee then attempts to rehabilitate the business

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Trustee accounting and reporting Chapter 7 liquidations: the trustee

expeditiously Liquidates the company and

Pays creditors in conformity with the legal status

In some cases, the court appoints a trustee to operate the company for a short time in an effort to obtain a better price for the company in entirety rather than selling it piecemeal

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Trustee accounting and reporting Trustees examine the proof of all creditors’

claims against the debtor company Sometimes the trustee receives title to all assets

as a receivership, Becomes responsible for the actual management of

the debtor, and

must direct a plan of reorganization or liquidation

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Trustee accounting and reporting The general form of the trustee’s opening entry,

accepting the assets of the debtor company, is as follows:

Assets XXXDebtor Company – In Receivership XXX

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Trustee accounting and reporting Statement of realization and liquidation

a monthly report prepared for the bankruptcy court

shows the results of the trustee’s fiduciary actions

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Sections of the statement of realization and liquidation

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Which of the following is NOT true about bankruptcy trustees?

a. Trustees are often appointed in a Chapter 11 bankruptcy when management cannot be trusted.

b. Trustees can be considered voluntary employees of the company.

c. In a Chapter 7 bankruptcy, the trustee liquidates the company and pays the creditors.

d. In a Chapter 11 bankruptcy, the trustee attempts to rehabilitate the business.

Conclusion

The EndThe End

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corporations in financial difficulty

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