accounting I, Apuntes de Contabilidad

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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 Advanced Accounting , Updated 6/e 13- 1

Chapter 13

Accounting for legal reorGANIZATIONS

AND LIQUIDATIONS

ANSWERS TO

QUESTIONS

1. "Insolvent" refers to a state of financial position whereby a company (or individual) is unable to pay debts as they come due.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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),

16. 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.
17. 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.
18. To become effective, a reorganization plan must be accepted by all interested parties. For approval, each class of creditors (more than two 0 0 1 Ethirds in dollar amount and one 0 0 1 Ehalf in number) must vote for the proposal. Each group of stockholders (two 0 0 1 Ethirds 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.
19. 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.
20. 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.
21. 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.
22. Professional fees incurred during a reorganization must be expensed as incurred.
23. 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 company’s 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.

24. 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.
25. 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.
26. 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.

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

Free Assets: Current Assets $ 35, Buildings and Equipment 110, Total $145,

Liabilities with Priority: Administrative Expenses $ 20, Salary Payable (only $3,000 per employee) 6, Income Taxes 8, Total $ 34,

Free Assets After Payment of Liabilities with Priority 0 0 ($145,000 (^) 1 E $34,000) $111,

Unsecured Liabilities Notes Payable (in excess of value of security) $ 30, Accounts Payable 85, Bonds Payable 70, Total $185,

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

Payment On Notes Payable: Value of Security (land) $ 90, 60% of Remaining $30,000 18, Total Collected $108,

23. (5 Minutes) (Distribution of assets in a liquidation).

Liabilities with Priority

Paid first – administrative expense $3, Paid second – wages up to a maximum of $4,300 each 8, Remaining money – government claims to unpaid taxes 400 Total of free assets $12,

The 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, Excess from Assets Pledged with fully Secured Creditors 0 0 ($116,000 (^) 1 E $70,000) 46, Total $126,

Liabilities with Priority $ 42,

Free Assets after Payment of Liabilities with Priority 0 0 ($126,000 (^) 1 E $42,000) $ 84,

Unsecured Liabilities: Excess of Partially Secured Liabilities Over Pledged 0 0 Assets ($130,000 (^) 1 E $50,000) $ 80, Unsecured Creditors 200, Total $280,

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

Payment On Partially Secured Debt: Value of Pledged Asset $ 50, 30% of Remaining $80,000 24, Total to be Collected $ 74,

26. (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, Excess Liability of Debt One in Excess of Pledged Asset 0 0 ($210,000 (^) 1 E $180,000) 30, Excess Liability of Debt Two in Excess of Pledged Asset 0 0 ($170,000 (^) 1 E $100,000) 70, Total Unsecured Liabilities $330, Necessary Percentage 60 % Cash Needed For These Liabilities $198,

In 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, x 60%) from the free assets.

27. (^) (8 Minutes) (Payments to be made on unsecured and partially secured

liabilities) a. The unpledged assets of $300,000 must be added to any excess to be 0 0 received from assets pledged on fully secured debts ($200,000 (^) 1 E $150, = $50,000) to get amount of free assets available of $350,000. Amount Available $350, Liabilities with Priority (160,000) Available for Unsecured Creditors $190, Accounts Payable $390, Excess of Partially Secured Debt in Excess of Pledged Assets ($490,000 - $380,000) (110,000) Unsecured Liabilities $500, Distribution to Unsecured Creditors: $190,000/$500,000 = 38% unsecured creditor to whom $3,000 is owed can expect to receive $1,140 ($3,000 x 38%). b. 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.

29. (^) (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, Note payable A – unsecured portion 10, Note payable B 250, Total $440,

Free Assets (except for equipment): Cash $24, Accounts receivable 28, Inventory 56, Land (value does not cover related debt) — 0— Buildings ($320,000 less coverage of $300, in bonds) 20, Total $128,

Less: Liabilities with Priority:

Estimated administrative expenses (12,000) Taxes payable to government (20,000) Total free assets except for equipment $96,

In order for unsecured creditors to receive 50 percent of their claims, $220, 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, Receivables (30 percent collectible) 15, Inventory 39, Land (value in excess of secured note: $120,000 - $110,000) 10, Total $94, Less: Liabilities with priority Salary payable (below maximum) (10,000) Free assets available $84,

Unsecured Liabilities: Accounts payable $90, Bonds payable (less secured interest in building: $300,000 - $180,000) 120, Unsecured liabilities $210,

Percentage 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, Accounts payable (unsecured – will collect 40% of debts of $90,000) $36, Note payable (fully secured by land – will collect entire balance) $110, Bonds payable (partially secured – will collect $180,000 from building and 40 percent of the remaining $120,000) $228,

31. (^) (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

32. (^) (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, stockholder’s 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, Inventory ($210,000 - $200,000) 10, Buildings ($400,000 - $300,000) 100, Reorganization value in excess of amount allocated to identifiable assets 60, Retained Earnings (eliminate deficit) 70, Additional Paid-in Capital ($130,000 - $20,000) 110,

(15 Minutes) (Prepare Income statement for company going through

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

a. SOP 90 0 01 E 7 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).

he second criterion is that the original owners must be left with less than 50 percent of the voting stock of the emerging company.

henever 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 entity’s 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 0 0 amortized to expense over a period of up to 40 years. SOP 90 (^) 1 E 7 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, Inventory 45, $ 68,

Land, buildings, and equipment: Land 140, Buildings 220, Equipment 154, 514, Total assets $582,

Liabilities not subject to compromise Current liabilities: Accounts payable $ 60, Long-term liabilities: Note payable (due 2003) $110, Note payable (due

2004. 100,000 210,000^ $ 270,

Liabilities subject to compromise Accounts payable 123, Accrued expenses 30, Income taxes payable 22, Note payable (due

2006. 170,000 345, Total liabilities 615,

Stockholders' (equity) Common stock 200, Retained earnings (deficit) (233,000) Total liabilities and shareholders' (deficit) $ 582,