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  1. 1. Chapter 20 - Corporations in Finanacial Difficulty 1 CHAPTER 20 CORPORATIONS IN FINANCIAL DIFFICULTY ANSWERS TO QUESTIONS Q20-1 The nonjudicial actions available to a financially distressed company are debt restructuring arrangements and creditor's committee management. The judicial actions available are corporate liquidation (Chapter 7) and corporate reorganization (Chapter 11). Q20-2 The major difference between a Chapter 7 action and a Chapter 11 action is that the debtor continues as a business after a Chapter 11 reorganization whereas the business does not survive a Chapter 7 liquidation. Q20-3 Under two circumstances an involuntary petition for relief may be filed. The first circumstance is that the debtor is generally not paying debts as they become due. The second circumstance is that within the last 120 days a custodian has been appointed by other creditors, by the debtor, or by some other agency to take possession of the debtor's assets. If more than 12 creditors exist, then three or more creditors must combine to file the petition. These three or more creditors must have aggregate unsecured claims of at least $5,000. Q20-4 The following items are usually included in the Plan of Reorganization filed as part of a Chapter 11 reorganization: All major actions to be taken during the reorganization: (1) Discontinuances of unprofitable operations (2) Restructuring of debt with specific creditors (3) Revaluation of assets and liabilities (4) Changes in the par value of outstanding stock, or realignment of stockholders' equity with newly issued shares of voting common stock. Q20-5 The account Reorganization Value in Excess of the Amount Assigned to Identifiable Assets is established during a Chapter 11 fresh start accounting to record the excess of the reorganization value that is not assigned to specific assets. The account is an intangible asset and is accounted for in accordance with FASB 142. Q20-6 A company in Chapter 11 reorganization qualifies for fresh start accounting if both of the following occur: 1. The reorganization value of the entity's assets of the emerging entity immediately before the date of confirmation is less than the total of all post-petition liabilities and allowed claims; and 2. Holders of existing voting shares immediately before confirmation receive less than 50% of the voting shares of the emerging entity. Companies using fresh start accounting revalue their assets to fair values, using the procedures in FASB 141. An account called Reorganization Value in Excess of the Amount Assigned to Identifiable Assets is used to record any excess in reorganization value not assigned to specific assets. 20-1
  2. 2. Chapter 20 - Corporations in Finanacial Difficulty Q20-7 The financial statements that must be filed by a company during a Chapter 11 reorganization include a complete set of audited financial statements. SOP 90-7 established specific guidelines for these statements, noting that amounts associated with reorganization should be reported separately. Q20-8 The rights of creditors with priority in a Chapter 7 liquidation are to receive any assets available to unsecured creditors after the secured creditors have been satisfied. Q20-9 The statement of affairs is the basic accounting report made at the beginning of the liquidation process to present the expected realizable amounts from disposal of the assets, the order of creditors' claims, and the expected amount unsecured creditors will receive as a result of the liquidation. In addition, the statement of affairs presents the book values of the debtor company's balance sheet accounts and the estimated deficiency to the general unsecured creditors. As a final point, the statement of affairs is not a going concern report. Q20-10* A trustee who takes title to the debtor's assets in a liquidation must make a periodic financial report to the bankruptcy court reporting on the progress of the liquidation and on the fiduciary relationship held. When the trustee accepts the assets, a new set of books is opened for the debtor and a new account is created to recognize the debtor's interest in the net assets accepted by the trustee. A statement of realization and liquidation is prepared on a monthly basis for the bankruptcy court showing the results of the trustee's fiduciary actions’ beginning at the point the trustee accepts the debtor's assets. Q20-11* Sales of assets are reported in the statement of realization and liquidation as assets realized in the assets section of the statement. 20-2
  3. 3. Chapter 20 - Corporations in Finanacial Difficulty SOLUTIONS TO CASES C20-1 Creditors' Alternatives The options to the creditors are (1) form a creditors' committee, (2) a Chapter 11 reorganization, and (3) a Chapter 7 liquidation. The eventual decision must rest upon the creditors' assessment of the viability of the rehabilitation of the debtor versus the liquidation values of the debtor's assets. Most creditors do not want to see the liquidation of a debtor because, as creditors, they are in the business of loaning monies, not trying to manage a business or attempting to obtain as much of a liquidation dividend as possible in a liquidation. Most creditors will work with the debtor's management as long as possible. Secured creditors have greater protection of their receivables than do unsecured creditors. However, even most secured creditors prefer to see a debtor company be rehabilitated after a time of financial difficulty rather than see the debtor liquidated. The timing of the cash flows is somewhat dependent on the amount of reduction in debt the creditors are willing to absorb. If the creditors are willing to work with the debtor, the creditors may eventually realize a greater percentage of their debt, but it usually takes a longer time to receive the payments from the debtor. The creditors' committee is a nonjudicial action that provides for flexibility to both the creditors and the debtor. The creditors' committee typically works with the debtor company to enact a plan of settlement of the debtor's indebtedness. In some cases, the creditors may assume management control of the company, but most creditors are reluctant to do this because of the added risk of legal action if the company does enter bankruptcy. Creditors may eventually receive a substantial part, or possibly all, of their receivables as the debtor is able to "work down" its debt over time. Chapter 11 reorganization offers the creditors a chance to continue having a customer once the customer solves its immediate financial problems. A reorganization is an acceptable option if the creditors feel the company would have the basic operating and financial foundations after the reorganization to become a going concern. Creditors often accept reduced amounts as settlements of their receivables, or will modify the terms of existing debt as part of the reorganization agreement. Chapter 7 liquidations are the final step. The creditors must go through the judicial process that may take a long time to complete. Liquidation should be used only if no other alternative is viable. Creditors often receive a smaller portion of their receivables because of the forced liquidation of the assets and the extensive legal and administrative costs involved in a liquidation. 20-3
  4. 4. Chapter 20 - Corporations in Finanacial Difficulty C20-2 Research Related to Bankruptcy The website for the U.S. Bankruptcy Courts is: www.uscourts.gov/bankruptcycourts.html a. The Frequently Asked Questions (FAQs) for the U.S. Bankruptcy Courts state that a U.S. bankruptcy judge is a district court judicial officer who is appointed by the majority of judges of the U.S. appeals court to have jurisdiction over bankruptcy matters. As bankruptcy cases come before a district court, a bankruptcy judge is assigned to the case. Some courts assign judges based on random assignment while other courts have a chief judge who seeks to select a judge to assign based on a judge’s experience or special expertise relevant to the case. Each court will have a written plan or system for assigning cases. b. The U.S. Bankruptcy Court’s Website has a link to Official Bankruptcy Forms to be used in filings before the courts. The forms and instructions for a Voluntary Petition are available in Part I of the Bankruptcy Forms Manual page. The official form is FORM B1 for a voluntary petition. A voluntary petition is initiated by the debtor and therefore the information required is principally related to the debtor, such as name, address, and location of the principal assets of the debtor. The debtor must declare such items as the number of creditors, the estimated assets, the estimated debts, the type of petition (i.e., Chapter 7, Chapter 11, etc.), if sufficient funds will be available to satisfy the unsecured creditors. The debtor may also be required to file additional exhibits (Exhibit A for publicly traded companies, Exhibit B is used in personal filings and Exhibit C to describe any property that might pose a threat of identifiable harm to public health or safety). c The United States Bankruptcy Courts Website presents a link to Bankruptcy Statistics that are presented in .pdf format. Statistics are presented for various time periods such as quarters, fiscal years and calendar years. Note that Case 20-3 asks for the most recent calendar year ending on December 31. (1) Total business filings are presented at the top of the form for business and nonbusiness filings for the twelve month period ended for the most recent year. Statistics for prior years are also available. Business filings are typically about 34,000 but do fluctuate slightly based on economic conditions. Approximately sixty percent of these filings are under Chapter 7, about twenty-eight percent under Chapter 11, and the remainder under various other chapters of the Bankruptcy Code. (2) Students should find the Federal judicial district in which their educational institution is located. The larger states typically have several districts and students may have to make an assumption for which district they are located. It is instructive to see that the numbers of filings vary widely by district. The number of filings may differ due to different economic factors for specific parts of the United States, the nature of the industrial base in a specific district, the size of a district, and other factors reflecting business factors across court districts. Students might reflect on why the number of filings in their Federal court district are different from those in other districts in other circuits. 20-4
  5. 5. Chapter 20 - Corporations in Finanacial Difficulty C20-3* Selection of Bankruptcy Trustee and Trustee’s Responsibilities Title 11 of the United States Code may be obtained from several sources through using a web browser and the search term, “Title 11 of the U.S. Code.” The case asks about trustees for a Chapter 7 bankruptcy filing. a. Subchapter 1 of Chapter 7 of Title 11 of the U.S. Code specifies the administration of a Chapter 7 bankruptcy filing. Section 701 states that the United States Trustee shall appoint an interim trustee who is a member of the panel of private trustees established under federal law. Private trustees are persons who have prior financial expertise and experience and have been approved by a formal review process. After the appointment of an interim trustee, Section 702 describes how creditors may elect a trustee under the circumstances in which creditors holding at least twenty percent of the unsecured claims request that an elected trustee administer the Chapter 7 bankruptcy. A candidate must receive the votes of creditors holding a majority of the claims of the unsecured creditors. b. Section 704 of Subchapter 1 of Chapter 7 of Title 11 of the U.S. Code defines the duties of the trustee. The trustee is responsible for administering the business, is accountable for all property received, and must evaluate the claims of the creditors to make sure the claims are valid prior to settlement. The trustee also prepares periodic reports and summaries of the operations of the business which it provides to the United States Trustee or Bankruptcy Court. Upon completion of the operations, the trustee must file a final report on the administration of the estate with the court and with the United States Trustee. 20-5
  6. 6. Chapter 20 - Corporations in Finanacial Difficulty 1C20-4 The Bankruptcy of WorldCom Overall, the 2002 bankruptcy of WorldCom resulted in a cumulative net reduction to their shareholders’ equity of $70.8 billion as of December 31, 2001, and a reduction in previously reported net income of $17.1 billion and $53.1 billion for the years ended December 31, 2001, and 2000 respectively. Goodwill of $44.9 billion was reduced to zero at December 31, 2001. The WorldCom bankruptcy and resultant adjustments made during the reorganization process are certainly one of the most significant bankruptcies in U.S. business history. The following information is taken from WorldCom Inc.’s 10-K for the fiscal year 2002 that was filed with the SEC on March 12, 2004. a. (Source: Item 3, Legal Proceedings) WorldCom filed a voluntary petition for bankruptcy on July 21, 2002, under Chapter 11, Reorganization. b. (Source: Item 3, Legal Proceedings and the MD&A) The primary reason seems to be that management and the Board of Directors had been informed of very significant accounting irregularities and needed time to investigate the possible irregularities, and to protect the company from lawsuits from creditors and others. For example, on June 26, 2002, the SEC filed a civil suit against the company for its past financial reports. On April 29, 2002, Bernard Ebbers resigned as President and Chief Executive Officer. The company undoubtedly felt it needed the protection of bankruptcy to give it time to study the breadth of its financial and accounting problems and to reorganize to recover from those problems without additional legal pressure from its creditors. c. (Source: Item 3, Legal Proceedings) On June 25, 2002, the company publicly announced that an internal audit found a number of transfers from line cost expenses (referred to as access cost expenses) to capital accounts, thus decreasing expenses and increasing assets. For the year 2001 and the first quarter of 2002, this amount of transfer was $3.9 billion. In addition to this item, the company was improperly accounting for impairment tests on its long-lived assets, its acquisitions, its revenue contracts and several other irregularities. However, it was the accounting for the access costs as assets when they were clearly expenses that were the primary accounting irregularity that initiated the internal review. d. (Source: Item 7, Management’s Discussion and Analysis) Item 7 of the company’s 2002 10-K presents a section titled “Restatements and Reclassifications of Previously Issued Consolidated Financial Statements”. A table is presented that summarizes the restatement items on revenue and pre-tax income or loss for the years ended December 31, 2001 and 2000. The major categories of income statement restatement adjustments are presented below (in $millions), with a brief explanation of each category following the table: (Parentheses used for decreases in reported amounts) 20-6
  7. 7. Chapter 20 - Corporations in Finanacial Difficulty C20-4 (continued) Item: Previously reported Restatement adjustments: 1. Impairment 2. Improper reduction of access costs 3. Purchase accounting 4. Long lived asset adjustments 5. International adjustments 6. Revenue related adjustments 7. Adjustments to accrued liabilities 8. Embratel and Avantel acquisitions 9. Unclassified income/ (expense) 10. Other Total adjustment items Discontinued Operations Adjustment Revenue, as restated Minority interest adjustment Pre-tax loss, as restated Year Ended December 31, 2001 Pre-tax Revenue income (loss) 35,121 2,375 Year Ended December 31, 2000 Pre-tax Revenue income (loss) 39,020 7,581 ----- (12,592) (2,933) --6 (47,180) (1,827) 14 --- (2,273) 2,750 (193) --- (3,567) (1,713) (749) (1,204) (899) (575) 18 (36) (487) (995) --- (823) --- (732) 5,268 (35) 1,127 (325) --- 383 --- (426) (7) 3,322 (775) (506) (17,503) 1,323 4 926 (602) (750) (58,002) 449 37,668 39,344 (669) (14,474) 52 (49,920) Because most of the accounting personnel, including the Chief Financial Officer and the controller, were terminated shortly after the large scope of the accounting irregularities were discovered, the company determined that it could not objectively restate periods prior to the 2000 fiscal year. However, a minor adjustment decrease of $.7 billion was made to the ending shareholders’ equity as of December 31, 1999. A brief explanation of each of the 10 adjustment categories above is summarized from the disclosures in Item 6 of WorldCom’s 2002 10-K. 1. Impairment: The company discovered that impairment tests had not been performed for goodwill and long-lived assets even though FASB 121 triggers had occurred. The application of these impairment tests resulted in very significant writedowns for both 2000 and 2001. 2. Improper reduction of access costs: The primary adjustments for this item were due to the improper capitalization of access costs that should have been expensed as incurred in accordance with GAAP. 3. Purchase accounting: The company made numerous acquisitions, including the MCI acquisition, between 1993 and 2001 and a review of these acquisitions concluded that a number of errors were found in the application of purchase accounting valuations and procedures that overstated the amounts capitalized for the acquisitions. 20-7
  8. 8. Chapter 20 - Corporations in Finanacial Difficulty C20-4 (continued) 4. Long lived asset accounting: This item includes adjustments to depreciation and amortization, changes in the estimated useful lives of long-lived assets, including those acquired in the MCI combination, and other costs that had been inappropriately capitalized as long-lived assets that should have been expensed. 5. International: Adjustments were made for correcting the U.S. GAAP-based statements from the foreign accounting principles. In addition, a review of the functional currency rules resulted in changing the functional currencies for many of the international subsidiaries from the local currency to the U.S. dollar. 6. Revenue related adjustments: A number of adjustments were made because of lack of documentation to support the company’s deferral of income under SAB 101. In addition, the company had incorrectly accounted for some contracts as sales when in fact the company had acted as an agent and should have recorded just the net of the amounts as income rather than record gross sales and gross costs. 7. Adjustments to accrued liabilities: Adjustments were made to eliminate improper accruals of liabilities for items such as legal reserves, employee benefits and tax liabilities. 8. Embratel and Avantel acquisitions: A review of the Embratel acquisition showed an incorrect interpretation with regard to not having control over Embratel and that Embratel should have been consolidated rather than reported net as an investment. A review of the Avantel relationship to WorldCom resulted in changing the accounting from an equity investment to a full consolidation. 9. Unclassified income/ (expense): A review of several accrued liability accounts showed that there was inadequate documentation to support the accruals. Also, there were other accrued assets and some liabilities recorded on the historical balance sheet for which there was either no, or inadequate, documentation to support that the company owned the assets or owed the liabilities. 10. Other: The company made a number of reclassifications, revaluations of derivatives, intercompany balances, and certain capitalized costs such as interest, labor and overhead for capital projects. These adjustments were also carried through the restated balance sheet and statement of cash flows for 2001 and 2000. e. (Source: Item 7 of WorldCom’s 2002 10-K) From the date the bankruptcy petition was filed, July 21, 2002, through the entire reorganization period, the company used the provisions of SOP 90-7 for accounting and financial reporting purposes. The “Debtors-In-Possession” heading informs readers of the financial statements that the company is in bankruptcy reorganization but management still controls the company under the administration of a bankruptcy trustee. The balance sheet reports prepetition liabilities separately from others and liabilities not subject to compromise are reported separately in both the current and noncurrent sections of the balance sheet. The income statement separately reports the reorganization gain or loss realized during the reorganization period. f. (Source: Item 7 of WorldCom’s 2002 10-K) Towards the beginning of Item 7, the 10K reports that the company will adopt fresh-start accounting under the provisions of SOP 90-7 as of the fresh-start reporting date. The company will revalue its assets and liabilities, allocate the reorganization value to the assets and liabilities, eliminate the accumulated deficit in shareholders’ equity, and the company’s new debt and equity will be recorded. 20-8
  9. 9. Chapter 20 - Corporations in Finanacial Difficulty SOLUTIONS TO EXERCISES E20-1 Multiple-Choice Questions on Chapter 11 Reorganizations [AICPA Adapted] 1. c 2. d 3. c 4. d 5. c 20-9
  10. 10. Chapter 20 - Corporations in Finanacial Difficulty E20-2 Recovery Analysis for a Chapter 11 Reorganization a. Recovery analysis for plan of reorganization: Taylor Companies, Inc. Plan of Reorganization Recovery Analysis December 31, 20X1 Recovery Elimination of Debt and Equity Post-petition liabilities (30,000) Claims/Interest: Accounts Payable (80,000) 8,000 Notes Payable, 10% Related Interest Payable (150,000) (16,000) 25,000 16,000 Bonds Payable, 12% Related Interest Payable (200,000) (24,000) 18,000 (470,000) (100,000) 171,000 178,000 (622,000) (178,000) (40,000) Reduction of Taylor's Common Assets % $2 par Stock Value Total Common shareholders: Common Stock Additional Paid-In Retained Earnings Deficit Total (30,000) Total $ 67,000 (100,000) (200,000) Surviving Debt Recovery % 100% (72,000) (72,000) 90 (125,000) (200,000) (30,000) (125,000) -0- 83 0 (200,000) (6,000) 100 25 (6,000) 100% (230,000) Note: Parentheses indicate credit amount. 20-10 (203,000) (200,000) (29,000) (200,000) (29,000) 100% (229,000) (662,000)
  11. 11. Chapter 20 - Corporations in Finanacial Difficulty E20-2 (continued) b. Journal entries to record reorganization: (1) (2) Accounts Payable Notes Payable, 10% Interest Payable Cash Accounts Receivable (net) Land Gain on Disposal of Land Gain on Discharge of Debt Record discharge of debt. 80,000 150,000 40,000 Common Stock ($1 par) Additional Paid-In Capital Gain on Disposal of Land Gain on Discharge of Debt Common Stock ($2 par) Retained Earnings Record change in par value of stock and elimination of deficit. 100,000 171,000 40,000 67,000 E20-3 Multiple-Choice Questions on Chapter 7 Liquidations 1. c 2. a 3. d 4. a 5. c 20-11 6,000 72,000 85,000 40,000 67,000 200,000 178,000
  12. 12. Chapter 20 - Corporations in Finanacial Difficulty E20-4 Chapter 7 Liquidation a. Schedule to calculate amount available for general unsecured creditors: Total estimated fair values Claims of secured creditors: Notes payable and interest (Receivables and Inventory) Bonds payable and interest (Land and Building) $471,000 $115,000 231,000 Claims of creditors with priority: Wages payable Taxes payable Available to general unsecured creditors b. Accounts payable Notes payable and interest Less: Secured by receivables and inventory Total unsecured claims Estimated dividend: c. $ 9,500 14,000 $195,000 (115,000) (346,000) $125,000 (23,500) $101,500 $ 95,000 80,000 $175,000 $101,500 = 58% $175,000 Group Credit Percentage Distributed Accounts Payable Wages Payable Taxes Payable Notes Payable and Interest Bonds Payable and Interest $ 95,000 9,500 14,000 80,000 115,000 58% 100 100 58 100 $ 55,100 9,500 14,000 46,400 115,000 231,000 100 231,000 $471,000 20-12
  13. 13. Chapter 20 - Corporations in Finanacial Difficulty E20-5* Statement of Realization and Liquidation Pace Corporation Statement of Realization and Liquidation Assets Assets to be Realized Old Receivables, net Marketable Securities Old Inventory Depreciable Assets, net Assets Realized $ 38,000 12,000 60,000 96,000 Assets Acquired Old Receivables New Receivables Marketable Securities Sales of Inventory $ 21,000 47,000 10,500 75,000 Assets Not Realized New Receivables 75,000 Old Receivables, net New Receivables, net Depreciable Assets 17,000 28,000 80,000 Supplementary Items Supplementary Charges Trustee's Fee Supplementary Credits $ 4,300 Net Loss $ 6,800 Liabilities Liabilities Liquidated Old Current Payables Liabilities to be Liquidated $ 22,000 Liabilities Not Liquidated Old Current Payables Old Current Payables $ 48,000 Liabilities Incurred 26,000 $333,300 20-13 $333,300
  14. 14. Chapter 20 - Corporations in Finanacial Difficulty SOLUTIONS TO PROBLEMS P20-6 Chapter 11 Reorganization a. Recovery analysis for plan of reorganization: Polydorous Corporation Plan of Reorganization Recovery Analysis Recovery PreConfirmation Elimination of Debt and Equity Surviving Debt Cash Post-petition liabilities (10,000) Claims/Interest: Accounts Payable (160,000) 20,000 (40,000) Interest Payable (20,000) 10,000 60,000 (10,000) (520,000) (100,000) Common Shareholders Stock Value Notes Payable, 10% Total Retained Earnings Deficit Total (10,000) Total $ 90,000 Preferred Shareholders Common % (10,000) (340,000) 12% Secured Notes (10,000) (140,000) 50 82 (30,000) (280,000) 50,000 50 (50,000) (50,000) (150,000) 130,000 20 (20,000) (20,000) 80,000 (80,000) (700,000) 190,000 100% (100,000) 510,000 (60,000) (240,000) 88 (10,000) (100,000) 100% 30 (10,000) Recovery % (340,000) Pre-confirmation total equities of $700,000 includes $690,000 pre-petition and $10,000 post-petition increase. Note: Parentheses indicate credit amount. 20-14
  15. 15. Chapter 20 - Corporations in Finanacial Difficulty P20-6 (continued) b. Analysis for evaluating qualifications for fresh start accounting: First condition: Post-petition liabilities Liabilities deferred pursuant to Chapter 11 proceedings Total post-petition liabilities and allowed claims Reorganization value Excess of liabilities over reorganization value Second condition: Holders of existing voting shares immediately before confirmation receive 20% of voting shares of emerging entity. Therefore, both conditions for a fresh start occur, and fresh start accounting is used to account for the company. 20-15 $ 10,000 520,000 $530,000 (510,000) $ 20,000
  16. 16. Chapter 20 - Corporations in Finanacial Difficulty P20-6 (continued) c. Entries for execution of plan of reorganization: (1) Liabilities Subject to Compromise Cash Notes Payable, 12%, secured Common Stock (new) Gain on Debt Discharge Record debt discharge. 520,000 (2) Preferred Stock Common Stock (old) Common Stock (new) Additional Paid-In Capital Record exchange of stock for stock. 100,000 150,000 (3) Reorganization Value in Excess of Amounts Allocable to Identifiable Assets Gain on Debt Discharge Additional Paid-In Capital Accounts Receivable (net) Inventory Property, Plant, and Equipment Retained Earnings - Deficit Record fresh start accounting and eliminate deficit. 60,000 340,000 30,000 90,000 70,000 180,000 30,000 90,000 180,000 30,000 7,000 183,000 80,000 Schedule to support allocation of reorganization value: Book Value Cash Accounts Receivable (net) Inventory Property, Plant, and Equipment (net) Reorganization Value in Excess of Amounts Allocable to Identifiable Assets Total Note: Fair Value Difference $ 30,000 140,000 25,000 $ 30,000 110,000 18,000 $ -0(30,000) (7,000) 445,000 262,000 (183,000) -0$640,000 30,000 $450,000 30,000 $(190,000) The post-reorganization total fair value is the reorganization value of $510,000 less the $60,000 paid to fulfill the plan of reorganization. 20-16
  17. 17. Chapter 20 - Corporations in Finanacial Difficulty P20-6 (continued) d. Fresh start balance sheet workpaper for company emerging from reorganization: (Worksheet not required) Preconfirmation Assets: Cash Accounts Receivable (net) Inventory Property, Plant, and Equipment (net) Reorganization Value In Excess of Amounts Allocable to Identifiable Assets Total Assets Liabilities: Liabilities Not Subject to Compromise: Current Liabilities Liabilities Subject to Compromise Notes Payable, 12%, secured Total Liabilities Shareholders' Equity: Preferred Stock Common Stock (old) Common Stock (new) Additional Paid-In Capital Retained Earnings Total Shareholders' Equity Total Liabilities and Shareholders’ Equity 90,000 140,000 25,000 255,000 Adjustments to Record Confirmation of Plan Debt Exchange Fresh Discharge of Stock Start (60,000) -0- (60,000) -0- (30,000) (7,000) (37,000) 30,000 110,000 18,000 158,000 (183,000) (60,000) 445,000 700,000 262,000 30,000 (190,000) 30,000 450,000 (10,000) (520,000) (530,000 ) (100,000) (150,000) Company's Reorganized Balance Sheet (10,000) 520,000 (340,000) 180,000 (30,000) -0- 100,000 150,000 (70,000) (180,000) -0- 80,000 (90,000) (170,000 ) (120,000) -0- 180,000 90,000 (80,000) 190,000 (700,000 ) 60,000 -0- 190,000 Note: Parentheses indicate credit amount. 20-17 (340,000) (350,000) (100,000) -0(100,000) (450,000)
  18. 18. Chapter 20 - Corporations in Finanacial Difficulty P20-6 (continued) d. Balance sheet for company emerging from Chapter 11 reorganization with fresh start accounting: Polydorous Company Balance Sheet Emerging Date Assets: Cash Accounts Receivable (net) Inventory Total Current Assets $ 30,000 110,000 18,000 $158,000 Property, Plant, and Equipment (net) Reorganization Value In Excess of Amounts Allocable to Identifiable Assets Total Assets 30,000 $450,000 Liabilities: Accounts Payable Notes Payable, 12%, secured Total Liabilities $ 10,000 340,000 $350,000 Shareholders' Equity: Common Stock Total Shareholders' Equity Total Liabilities and Shareholders' Equity 100,000 $100,000 $450,000 20-18 262,000
  19. 19. Chapter 20 - Corporations in Finanacial Difficulty P20-7 Chapter 7 Liquidation, Statement of Affairs a. Name Brand Company Statement of Affairs July 31, 20X1 Assets Estimated Current Values Book Value (1) $ 50,000 80,000 162,000 Assets pledged with fully secured creditors: Accounts receivable (net) Less: 12% note payable and interest Land Plant and equipment (net) Less: Mortgages payable and interest (2) 79,000 5,000 55,000 81,000 7,000 250,000 72,000 $871,000 (3) (44,000) $ 6,000 $110,000 150,000 $260,000 (234,600) Assets pledged with partially secured creditors: Marketable securities Less: 10% note payable and interest $ $ 75,000 (105,000) (8,000) (29,400) $ 5,000 55,000 76,000 1,500 190,000 30,000 (4,000) 5,000 55,000 76,000 1,500 190,000 30,000 Estimated amount available Less: Creditors with priority Net available to unsecured creditors Estimated deficiency $388,900 (45,000) $343,900 82,500 Total unsecured debt $426,400 20-19 30,000 (12,000) 25,400 $ 22,000 Free assets: Cash Accounts receivable (net) Inventory Prepaid insurance Plant and equipment (net) Franchises Estimated Gain (Loss) on Realization $ 50,000 Inventory Less: Accounts payable 30,000 Estimated Amount Available to Unsecured Claims (5,000) (5,500) (60,000) (42,000) $(106,500)
  20. 20. Chapter 20 - Corporations in Finanacial Difficulty P20-7 (continued) Equities Estimated Amount Unsecured Book Value $ 44,000 234,600 29,400 (1) Fully secured creditors: 12% note payable and interest Mortgages payable and interest (2) Partially secured creditors: 10% note payable and interest Less: Marketable securities 105,000 -020,000 12,000 160,000 212,000 17,000 240,000 (203,000) $871,000 b. Accounts payable Less: Inventory $ 44,000 234,600 $278,600 $ 29,400 (22,000) $105,000 (75,000) (3) Creditors with priority: Estimated liquidation expenses Wages payable Taxes payable (4) Unsecured creditors: Accounts payable Notes payable Interest payable (5) Stockholders' equity: Common stock Retained earnings (deficit) $ 7,400 30,000 $ 13,000 20,000 12,000 $ 45,000 160,000 212,000 17,000 Percentage to unsecured creditors: $426,400 $343,900 = 80.65% $426,400 20-20
  21. 21. Chapter 20 - Corporations in Finanacial Difficulty P20-8 Chapter 7 Liquidation, Statement of Affairs [AICPA Adapted] a. Tower, Inc. Statement of Affairs December 31, 20X1 Assets Book Value (1) $ 40,000 13,000 90,000 140,000 Assets pledged with fully secured creditors: Accounts receivable Land Building (net) Machinery (net) Less: Fully secured claims from liability side: Note payable-bank $ 30,000 Mortgage payable and related interest 132,400 (2) 20,200 Assets pledged with partially secured creditors: Marketable securities Accrued interest Less: Notes payable (to bank) 1,500 35,000 60,000 40,000 5,000 $444,700 (3) Free assets: Cash Accounts receivable (after reclassifying $5,000 of credit balances to accounts payable) Finished goods Raw materials (net of $10,000 of conversion costs) Prepaid expenses Estimated Current Values $ 40,000 25,000 110,000 75,000 $250,000 (162,400) $ $ 87,600 (1,000) 1,500 1,500 35,000 50,000 35,000 50,000 60,000 -0- 60,000 (10,000) 20,000 (5,000) $234,100 (41,500) $192,600 18,200 $210,800 20-21 Estimated Gain (Loss) on Realization $ 12,000 20,000 (65,000) $ 19,000 200 $ 19,200 (20,000) Estimated amount available for unsecured creditors, including creditors with priority Less: Liabilities with priority Estimated amount available for unsecured creditors Estimated deficiency to unsecured creditors (plug) Total unsecured debt Estimated Amount Available to Unsecured Claims $(29,000)
  22. 22. Chapter 20 - Corporations in Finanacial Difficulty P20-8 (continued) Book Value $ 30,000 132,400 20,000 Amount Unsecured Liabilities and Stockholders' Equity (1) Fully secured creditors: Notes payable- bank Mortgage payable and interest Total (deducted on asset side) (2) Partially secured creditors: Notes payable-bank Less: Pledged marketable securities and interest (from asset side) $ 30,000 132,400 $162,400 $ 20,000 (19,200) (3) Liabilities with priority: Estimated liquidation expenses Wages payable Payroll taxes payable Total (deducted on asset side) (4) Unsecured creditors: Accounts payable (after excluding $15,000 of payroll taxes payable and including $5,000 of credit balances reclassified from accounts receivable) Notes payable Audit fee of prior year Contingent liability on damage suit 15,000 15,500 70,000 85,000 5,000 50,000 21,800 (5) $ 800 $ 11,000 15,000 15,500 $ 41,500 70,000 85,000 5,000 50,000 Stockholders' equity, after giving effect to unrecorded items that are properly bookable as of December 31, 20X1* ($100,000 - $20,000 - $500 + $200 - $500 - $2,400 - $5,000 - $50,000) $444,700 Total unsecured debt * b. $210,800 Common stock, $100,000; retained earnings deficit, ($20,000); cash expended for travel, ($500); accrued interest receivable, $200; unrecorded employer's payroll taxes, ($500); unrecorded interest on mortgage, ($2,400); bill for last year's audit, ($5,000); and probable damage suit judgment, ($50,000). Estimated settlement per dollar of unsecured liabilities: Estimated amount available for unsecured creditors Total unsecured debt 20-22 $192,600 = $0.914 $210,800
  23. 23. Chapter 20 - Corporations in Finanacial Difficulty P20-9 Financial Statements for a Firm in Chapter 11 Proceedings a. Income statement for a company in reorganization proceedings: Hobbes Company (Debtor-in-Possession) Income Statement For the Year December 31, 20X2 Revenue: Sales $246,000 Cost and Expenses: Cost of Goods Sold Selling, Operating, and Administrative Interest (contractual interest $51,000) 170,000 50,000 4,000 $224,000 Earnings before Reorganization Items and Income Taxes Reorganization Items: Professional Fees Interest Earned on Accumulated Cash Resulting from Chapter 11 Proceeding Total Reorganization Items $ 22,000 $(15,000) 3,000 Income before Income Tax and Discontinued Operations (12,000) $ 10,000 Income Tax (5,000) Income before Discontinued Operations $ Discontinued Operations: Operating Loss, Net-of-Tax Gain on Sale of Assets, Net-of-Tax Net Discontinued Operations $(16,000) 9,000 Net Loss 5,000 (7,000) $ (2,000) 20-23
  24. 24. Chapter 20 - Corporations in Finanacial Difficulty P20-9 (continued) b. Statement of cash flows for a company in reorganization proceedings: Hobbes Company (Debtor-in-Possession) Statement of Cash Flows For the Year December 31, 20X2 Cash Flows from Operating Activities: Cash Received from Customers Cash Paid to Suppliers and Employees Interest Paid Net Cash Provided by Continuing Operating Activities before Reorganization Items Operating Cash Flows from Reorganization Activities: Professional Fees Interest Received on Cash Accumulated Because of Chapter 11 Proceeding Net Cash Used by Reorganization Items $ 264,000 (206,000) (4,000) $ 54,000 $ (15,000) 3,000 $ (12,000) Operating Cash Flows from Discontinued Operations: Net Cash Used by Discontinued Operations $ Net Cash Provided by Operating Activities $ 39,000 Cash Flows Provided by Investing Activities: Proceeds from Sale of Assets Due to Chapter 11 Proceeding Net Cash Provided by Investing Activities $ 18,000 $ 18,000 Cash Flows Provided by Financing Activities: Net Borrowings under Short-Term Financing Plan Principal Payments on Pre-petition Debt Authorized by Court (Bonds Payable) Net Cash Provided by Financing Activities Net Increase in Cash Cash at January 1, 20X2 Cash at December 31, 20X2 (3,000) $ 10,000 $ (10,000) -0- $ 57,000 15,000 $ 72,000 20-24
  25. 25. Chapter 20 - Corporations in Finanacial Difficulty P20-9 (continued) c. Balance sheet for a company in reorganization proceedings: Hobbes Company (Debtor-in-Possession) Balance Sheet December 31, 20X2 Cash Accounts Receivable (net) Inventory Total Current Assets Property, Plant, and Equipment (net) Total Assets Assets Liabilities Liabilities Not Subject to Compromise: Current Liabilities (post petition): Short-Term Borrowings Accounts Payable - Trade Total Liabilities Not Subject to Compromise Liabilities Subject to Compromise (pre-petition): Accounts Payable Notes Payable, 10% Bonds Payable, 12% Accrued Interest Payable Total Liabilities Subject to Compromise Total Liabilities Shareholders' Equity Preferred Stock Common Stock ($1 par) Additional Paid-In Capital Retained Earnings (Deficit) Total Shareholders' Equity Total Liabilities and Shareholders' Equity * $ 72,000 47,000 88,000 $207,000 460,000 $667,000 $ 10,000 7,000 $ 138,000 170,000 240,000* 47,000 $ 50,000 50,000 75,000 (120,000) $ 17,000 595,000 $612,000 $ 55,000 $667,000 $10,000 payment approved by the Court, reducing pre-petition bonds payable from $250,000 to $240,000. 20-25

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