Chapter Five: Accounting for Legal Liquidations and Reorganizations

Introduction:
A basic assumption of accounting is that a business
is considered a going concern unless evidence to
the contrary is discovered.

Unfortunately, not all companies prove to be going

concerns.
Cont...
What happens to these businesses after they fail?
Is bankruptcy the equivalent of a death sentence?
Who gets the assets?
 Are the creditors protected?
How does the accountant reflect the economic
plight/risk of the company?
Virtually all businesses undergo financial difficulties at
various times.
 Economic downturns,
 poor product performance, and
 litigation losses can create cash flow difficulties
for even the best-managed organizations.
 Cont…
Most companies take remedial actions and work
to return their operations to normal profitability.
However not all companies are able to solve their
monetary difficulties.
If problems persist, a company can eventually
become insolvent, unable to pay debts as the
obligations come due.
When creditors are not paid, they obviously
attempt to protect their financial interests in hope
of reducing the possibility of loss.
Cont...
They may seek recovery from the distressed company in
several ways:
 repossessing assets,
 filing lawsuits,
 foreclosing on loans (to repossess a mortgaged
property whose owner failed to make the necessary
payments), and so on.
An insolvent company can literally become
besieged/overwhelmed by its creditors.
If left unchecked, pandemonium/Chaos would be the
possible outcome of a company’s insolvency.
As a result, some of the creditors and stockholders as well as
the company itself could find themselves treated unfairly.
 Cont…
One party might be able to collect in full while
another is left with a total loss.
Not surprisingly, bankruptcy laws have been
established to structure this process, provide
protection for all parties, and ensure fair and
equitable treatment.
Although a complete coverage of bankruptcy
statutes is more appropriate for a business law
textbook, significant aspects of this process
directly involve accountants.
Liquidation versus Reorganization
The most important decision in any bankruptcy filing (either
voluntary or involuntary) is the method by which the
debtor/defaulter will be discharged from its obligations.
One obvious option is to liquidate the company’s assets with
the proceeds distributed to creditors based on their secured
positions and the priority ranking system just outlined.
However, a very important alternative to liquidation does
exist. The debtor/defaulter company may survive insolvency
and continue operations if the parties involved accept a
proposal for reorganization.
 Not everyone agrees with the wisdom of allowing
reorganization. This argument holds that keeping inefficient
organizations alive and competing does not serve the
industry or the economy well.
Cont...
There are many reasons why a business gets sick,
but they don’t necessarily mean it should be
destroyed.
Hundreds of thousands of businesses that at one
time or another had financial difficulties survive
today. They continue to contribute to employment,
to tax revenues, to overall growth.
It’s counter productive to destroy the business
value of an asset by liquidating it and paying it out if
that company shows signs of being able to recover
in a reorganization
Statement of Financial Affairs
At the start of bankruptcy proceedings, the debtor
normally prepares a statement of financial affairs.
 to file schedules of
 assets and liabilities,
 of executory contracts and unexpired leases,
 lists of shareholders, and
 statements of financial affairs
This schedule provides information about the company’s
current financial position and helps all parties as they
consider what actions to take.
This statement is especially important in assisting
unsecured creditors as they decide whether to push for
reorganization or liquidation.
Cont...
 The debtor’s assets and liabilities are reported according
to the classifications relevant to a liquidation.
 Consequently, assets are labeled as follows:
1. Pledged with fully secured creditors.
2. Pledged with partially secured creditors.
3. Available for priority liabilities and unsecured creditors
(often referred to as free assets).
 The company’s debts are then listed in a parallel fashion:
1. Liabilities with priority.
2. Fully secured creditors.
3. Partially secured creditors.
4. Unsecured creditors.
Stockholders are included in this final group.
Cont...
The statement of financial affairs is produced under the
assumption that liquidation will occur.
Thus, historical cost figures are not relevant.
The various parties to the bankruptcy desire information that
reflects
(1) the net realizable value of the debtor’s assets and
(2) the ultimate application of these proceeds to specific
liabilities.
 With this knowledge, both creditors and stockholders can
estimate
 the monetary resources that will be available after all
secured claims and priority liabilities have been settled.
 interested parties can approximate the potential loss they
face.
 Cont…
The information found in a statement of financial affairs
can affect the outcome of the bankruptcy.
 If the statement indicates that unsecured creditors are
destined to suffer a material loss in a liquidation, this
group will probably favor reorganizing the company in
hope of averting such a consequence.
Conversely, if the statement shows that all creditors will
be paid in full and that a distribution to the stockholders
is also possible, liquidation becomes a much more viable
option.
Thus, all parties involved with an insolvent company
should consult a statement of financial affairs before
deciding the fate of the operation.
 LIQUIDATION—BANKRUPTCY

When an insolvent company is to be liquidated, the

provisions established regulate the process.
This set of laws was written to provide an orderly and
equitable structure for selling assets and paying debts.
To this end, several events occur after the court has entered
an order for relief in either a voluntary or involuntary
liquidation.
To begin, the court appoints an interim trustee to oversee
the company and its liquidation.
This individual is charged with preserving the assets and
preventing loss of the estate.
Thus, creditors are protected from any detrimental actions
that management, the ownership, or any of the other
creditors might undertake.
Cont...
The interim trustee (as well as the permanent trustee, if
the creditors subsequently select one) must perform a
number of tasks shortly after being appointed. These
functions include (but are not limited to):
 Changing locks and moving all assets and records to
locations the trustee controls.
 Posting notices that the trustee now possesses all
business assets and that tampering with or removing any
contents is a violation of federal law.
 Compiling all financial records and placing them in the
custody of the trustee’s own accountant.
 Obtaining possession of any corporate records including
minute books and other official documents.
Role of the Trustee
 In the liquidation of any company, the trustee is a central figure.
This individual must recover all property belonging to the
insolvent company, preserve the estate from any further
deterioration, liquidate noncash assets, and make distributions to
the proper claimants.
 Additionally, the trustee may need to continue operating the
company to complete business activities that were in progress
when the order for relief was entered.
 To accomplish such a multitude of objectives, this individual holds
wide-ranging authority in bankruptcy matters, including the right
to obtain professional assistance from attorneys and
accountants.
 The trustee can also void any transfer of property (known as a
preference) made by the debtor within 90 days prior to filing the
bankruptcy petition if the company was already insolvent at the
time.
Cont...
a wide variety of statements and reports may be
encountered in liquidations. However, the trustee
commonly uses a statement of realization and liquidation
to report the major aspects of the liquidation process. This
statement is designed to convey the following
information:
 Account balances reported by the company at the date on
which the order for relief was filed.
 Cash receipts generated by the sale of the debtor’s
property.
 Cash disbursements the trustee made to wind up the
affairs of the business and to pay the secured creditors.
 Any other transactions such as the write-off of assets and
the recognition of unrecorded liabilities.
 REORGANIZATION—BANKRUPTCY
Reorganization a way to salvage a company rather than
liquidate it.
Although the original owners of a company rescued in this
way are often left without anything, others whose
livelihoods depend on the company’s fortunes may come out
with their interests intact.
The company’s creditors, for example, may take over as the
new owners.
 Its suppliers might be able to maintain the company as a
customer.
 Its customers still may count on the company as a supplier.
 And perhaps most important, many of its employees may be
able to keep the jobs that otherwise would have been
sacrificed in a liquidation
Cont...
Obviously, the activities and events surrounding a reorganization
differ significantly from a liquidation.
One important distinction is that control over the company is
normally retained by the ownership (referred to as a debtor in
possession). However, if fraud or gross mismanagement can be
proven, the court has the authority to appoint an independent
trustee to assume control.
Unless replaced, the debtor in possession continues to operate the
company and has the primary responsibility for developing an
acceptable plan of reorganization.
While a reorganization is in process, the owners and managers are
legally required to preserve the company’s estate as of the date that
the order for relief is entered.
In this way, the bankruptcy regulations seek to reduce the losses
that creditors and stockholders may have to absorb when either
reorganization or liquidation eventually occurs.
The Plan for Reorganization
The plan is the heart of every reorganization. The provisions of the plan
specify the treatment of all creditors and equity holders upon its approval
by the Bankruptcy Court.
Moreover, the plan shapes the financial structure of the entity that emerges.
A reorganization plan may contain an unlimited number of provisions:
 proposed changes in the company,
 additional financing arrangements,
 alterations in the debt structure, and the like.
Regardless of the specific contents, the intent of all such plans is to provide
a feasible long-term solution to the company’s monetary difficulties.
However, to gain acceptance by the parties involved, a plan must present
convincing evidence that it will enable the business to emerge from
bankruptcy as a viable going concern.
Although a definitive(explicitly defined) list of elements that could be
included in a reorganization proposal is not possible, some of the most
common follow:
Cont...
1. Plans proposing changes in the company’s operations. In hope of
improving liquidity, officials may decide to introduce new product lines
or sell off unprofitable assets or even entire businesses. Closing failing
operations is especially common. A debtor in possession bears the
burden of proving that it can eliminate the problems that led to
insolvency and then avoid them in the future.
Movie Gallery sought court protection in October 2007 after two years of
losses. The company cut 1,000 stores, saving more than $130 million in
rent. The chain also amended agreements with major film studios and
cut its debt.
2. Plans for generating additional monetary resources. Companies facing
insolvency must develop new sources of cash, often in a short time
period. Loans and the sale of both common and preferred stocks are
frequently negotiated during reorganization to provide funding to
continue the business.
“The U.S. government will take about a 61 percent stake in the new GM
after lending the automaker more than $50 billion.”
Cont...
3. Plans for changes in company management. Frequently, a
financial crisis is blamed on poor leadership. In that situation,
proposing to reorganize a company with the management
team intact is probably not a practical suggestion. Therefore,
many plans include hiring new individuals to implement the
reorganization and run important aspects of the company.
These changes may even affect the board of directors elected
by the stockholders to oversee the company and its
operations:
Chicago-based Tribune Co. and its creditors are in the early
stages of negotiating a plan of reorganization in U.S.
Bankruptcy Court that sources say likely will transfer control of
the troubled media conglomerate from Chicago billionaire Sam
Zell to a group of large banks and investors that hold $8.6
billion in senior debt.
Cont...
4. Plans to settle the debts of the company that existed when the order for relief was
entered.
No element of a reorganization plan is more important than the proposal for satisfying the
company’s various creditors. In most cases, their agreement is necessary before the court
will confirm any plan of reorganization.
Actual proposals to settle these debts may take one of several forms:
 Assets can be transferred to creditors who accept this payment in exchange for
extinguishing a specified amount of debt. The book value of the liability being canceled is
usually higher (often substantially higher) than the fair value of the assets rendered.
Dow Corning Corp. made public a $4.4 billion bankruptcy-reorganization plan, its third attempt
to forge a solution for exiting from bankruptcy court and hammering out a way to resolve
thousands of claims that silicone breast implants cause diseases and injuries. The company,
which for years was the leading maker of silicone implants in the United States, offered $3
billion of that total to resolve an estimated 200,000 existing silicone claims.
 An equity interest (such as common stock, preferred stock, or stock rights) can be conveyed
to creditors to settle an outstanding debt.
For example, the announcement that Garden Ridge was moving to exit from bankruptcy
indicated that the “reorganization plan will call for the distribution of preferred stock to
general unsecured creditors.”
 The terms of the outstanding liabilities can be modified: maturity dates extended, interest
rates lowered, face values reduced, accrued interest forgiven, and so on.
Acceptance and Confirmation of Reorganization Plan
The creation of a plan for reorganization does not guarantee its
implementation.
must be voted on by both the company’s creditors and
stockholders before the court confirms.
To be accepted, each class of creditors must vote for the plan.
 requires the approval of two-thirds in dollar amount and more
than one-half in the number of claims that cast votes.
A separate vote is also required of each class of shareholders. For
approval, at least two-thirds (measured by the number of shares
held) of the owners who vote must agree to the proposed
reorganization.
 In fact, convincing any of the parties to support a specific plan is
not an easy task because agreement often means accepting a
significant loss. Eventually, though, acceptance is necessary if
progress is ever to be made.
Cont...
Although the plan may gain creditor and
stockholder approval, court confirmation is still
required.
 The court reviews the proposal and can reject the
reorganization plan if a claimant (who did not vote
for acceptance) would receive more through
liquidation.
Financial Reporting during Reorganization

Students: Reading assignment

End of Chapter Four