Accounting for Legal Reorganization and Liquidations

Centuries ago in Italy the bankrupt merchant would be forced into an odd form of pillory. He would have the table he did business at in the town square broken. At least one source says the word bankruptcy derives from the Italian words for this practice, which translate to broken bench.

A basic assumption of accounting is that a business is considered a going concern unless evi­dence to the contrary is discovered. As a result, assets such as inventory, land, buildings, and equipment are traditionally reported based on historical cost rather than net realizable value. Unfortunately, not all companies prove to be going concerns.

Since the beginning of 2001, more than 60,000 companies have sought bankruptcy protection, and the number of affected employees is rising fast. In 2001, the 10 largest companies filing for bankruptcy reported employing about 140,500 people in their most recent annual report before the filing.

Not only is the number of bankruptcies increasing but also the size of some bankruptcies is becoming astronomical.

Notice how many of the largest U.S. bankruptcies have occurred since 2001:

i. WorldCom, Inc., July 21, 2002; $103.9 billion in assets.

ii. Enron Corp., December 2, 2001; $63.4 billion.

iii. Conseco, Inc., December 18, 2002; $61.4 billion.

iv. Texaco, Inc., April 12, 1987; $35.9 billion.

v. Financial Corp. of America, September 9, 1988; $33.9 billion.

vi. Refco Inc., October 17, 2005; $33.3 billion.

vii. Global Crossing Ltd., January 28, 2002; $30.2 billion.

viii. Pacific Gas and Electric Co., April 6, 2001; $29.8 billion.

ix. Calpine Corp., December 20, 2005; $27.2 billion.

x. UAL Corp., December 9, 2002; $25.2 billion.

xi. Delta Air Lines Inc., September 14, 2005; $21.8 billion.

xii. Adelphia Communications, June 25, 2002; $21.5 billion.

xiii. MCorp., March 31, 1989; $20.2 billion.

xiv. Mirant Corporation, July 14, 2003; $19.4 billion.

xv. Delphi Corporation, October 8, 2005; $16.6 billion.

xvi. First Executive Corp., May 31, 1991; $15.2 billion.

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 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. Most companies take remedial actions and work to return their operations to normal profitability.

However, as the preceding list indicates, 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.

They may seek recovery from the distressed company in several ways- repossessing assets, fil­ing lawsuits, foreclosing on loans, and so on. An insolvent company can literally become besieged by its creditors.

If left unchecked, pandemonium 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. One party might be able to collect in full while another is left with a total loss. Not surprising, bankruptcy laws have been established in the United States 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.

In many small business situations, the company accountant is the sole outside financial adviser and the first to recognize that the deteriorating financial picture mandates consideration of bank­ruptcy in one form or another. In many such situations, the accountant’s role in convincing man­agement that a timely reorganization under the bankruptcy law is the sole means of salvaging any part of the business may be critical.

Bankruptcy Reform Act of 1978:

Over the ages debtors who found themselves unable to meet obligations were dealt with harshly. Not only were all their assets taken from them, but they were given little or no relief through legal forgiveness of debts. Many of them ended up in debtors’ prisons with all means of rehabili­tation removed. A large number of the early settlers in this country left their homelands to escape such a fate.

Based on an original provision of the U.S. Constitution, Congress is responsible for creating bankruptcy laws. However, virtually no federal bankruptcy laws were actually passed until the Bankruptcy Act of 1898 (subsequently revised in 1938 by the Chandler Act). Later, following a decade of study and debate by Congress, the Bankruptcy Reform Act of 1978 replaced these laws. Congress subsequently revised and updated that act by passing the Bankruptcy Reform Act of 1994.

The adoption of the Bankruptcy Abuse and Prevention and Consumer Protection Act of 2005 made additional changes to the law. Most regulations in this latest act dealt with personal bankruptcy provisions because of the significant and steady increase in such cases. A few provisions applied to business bankruptcy cases although little push for sweeping changes in this area of bankruptcy law has been evident.

Consequently, the Bankruptcy Reform Act of 1978 as amended continues to provide the legal structure for most bankruptcy proceedings.

It strives to achieve two goals in connection with insolvency cases:

(1) The fair distribution of assets to creditors, and

(2) The discharge of an honest debtor from debt.

Voluntary and Involuntary Petitions:

When insolvency occurs, any interested party has the right to seek protection under the Bank­ruptcy Reform Act. Thus, the company itself can file a petition with the court to begin bank­ruptcy proceedings. If the company is the instigator, the process is referred to as a voluntary bankruptcy. In such cases, the company’s petition must be accompanied by exhibits listing all debts and assets (reported at fair value). Company officials also must respond to questions concerning various aspects of the business’s affairs.

Such questions include:

i. When did the business commence?

ii. In whose possession are the books of account and records?

iii. When was the last inventory of property taken?

Creditors also can seek to force a debtor into bankruptcy (known as an involuntary bank­ruptcy) in hope of reducing their potential losses. To avoid nuisance actions, bankruptcy laws regulate the filing of involuntary petitions. If a company has 12 or more unsecured creditors, at least 3 must sign the petition. In addition, under current rules, the creditors that sign must have unsecured debts of at least $13,475. If fewer than 12 unsecured creditors exist, only a single signer is required but the $13,475 minimum debt limit remains.

“A bankruptcy judge has approved an involuntary Chapter 7 petition against Folio Group Inc., a corporate trade show exhibit company that once operated in Northboro. Folio did not respond to the involun­tary petition, which was approved Jan. 28 by U.S. Bankruptcy Judge Henry J. Bo raff. The peti­tion was filed in December by three creditors who claim they are owed a total of $290,000.”

Neither a voluntary nor an involuntary petition automatically creates a bankruptcy case. The court rejects voluntary petitions if the action is considered detrimental to the creditors. Involuntary petitions also can be rejected unless evidence exists to indicate that the debtor is not actually able to meet obligations as they come due. Merely being slow to pay is not suffi­cient. The debtor may well fight an involuntary petition fearing that its reputation will be tainted in the business community.

If the court accepts the petition, it grants an order for relief. This order halts all actions against the debtor, thus providing time for the various parties involved to develop a course of action. In addition, the company comes under the authority of the bankruptcy court so that any distributions must be made in a fair manner.

To prevent creditors from seizing whatever is handy once the bankruptcy is filed, the Bankruptcy Code provides for an automatic stay or injunction that prohibits actions by creditors to collect debts from the debtor or the debtor’s property without the court’s permission. The automatic stay bars any creditor (including governmental creditors such as the Internal Revenue Service) from taking any action against the debtor or the debtor’s property.

Classification of Creditors:

Following the issuance of an order for relief, the possible risk of loss obviously influences each creditor’s view of a bankruptcy case. However, many creditors may have already obtained some measure of security for themselves. When a debt is created, the parties can agree to attach a mortgage lien or security interest to specified assets (known as collateral) owned by the debtor. Such action is most likely when the amounts involved are great or the debtor is experiencing financial difficulty.

In the event that the liability is not paid when due, the cred­itor has the right to force the sale (or, in some cases, the return) of the pledged property with the proceeds being used to satisfy all or part of the obligation. Thus, in bankruptcy proceed­ings, a secured creditor holds a much less vulnerable position than an unsecured creditor.

Because of the possible presence of liens, all loans and other liabilities are reported to the court according to their degree of protection against loss. Some debts are identified as fully secured to indicate that the net realizable value of the collateral exceeds the amount of the obligation. Despite the debtor’s insolvency, these creditors will not suffer loss; they are com­pletely protected by the pledged property. Any money received from the asset that is in excess of the balance of the debt is then used to pay unsecured creditors.

Conversely, if a liability is partially secured, the value of the collateral covers only a por­tion of the obligation. The remainder is considered unsecured so that the creditor risks losing some or all of this additional amount. As an example, a bank might have a $90,000 loan due from an insolvent party that is protected by a lien attached to land valued at $64,000. This debt is only partially secured; the asset would not satisfy $26,000 of the balance so that this resid­ual portion is reported to the court as unsecured.

All other liabilities are unsecured; these creditors have no legal right to any of the debtor’s specific assets. They are entitled to share only in any funds that remain after all secured claims have been settled. Obviously, unsecured creditors are in a precarious position.

Unless a debtor’s assets greatly exceed secured liabilities (which is unlikely in most insolvency cases), these creditors can expect significant losses if liquidation proves to be necessary. Hence, one of the most important aspects of the bankruptcy laws is the ranking of unsecured claims. Only in this manner is a systematic distribution of any remaining assets possible.

The Bankruptcy Reform Act identifies several types of unsecured liabilities that have pri­ority and must be paid before other unsecured debts are settled. These obligations are ranked with each level having to be satisfied in full before any payment is made to the next.

Unsecured Liabilities Having Priority:

The following liabilities have priority:

1. Claims for administrative expenses such as the costs of preserving and liquidating the estate. All trustee expenses and the costs of outside attorneys, accountants, or other con­sultants are included in this category. Without this high-priority ranking, insolvent compa­nies would have difficulty convincing qualified individuals to serve in these essential positions.

In recent years, the amounts assessed for such services have come under fire from many critics- “The protests follow a recent court filing by Enron, the fallen energy company, projecting that professional fees for the first 13 months of the bankruptcy will total $306 million. All told, according to the projections, administrative costs during the period will be $773 million, or nearly $60 million a month.”

2. Obligations arising between the date that a petition is filed with the bankruptcy court and the appointment of a trustee or the issuance of an order for relief. In voluntary cases, such claims are quite rare because an order for relief is usually entered when the petition is filed. This provision is important, however, in helping the debtor continue operations if an invol­untary petition is presented but no legal action is immediately taken.

Without this ranking, suppliers would stop providing merchandise to the debtor until the matter was resolved. With this high ranking, the debtor can continue to buy goods and stay in business while resisting an involuntary petition.

3. Employee claims for wages earned during the 180 days preceding the filing of a petition. The amount of this priority is limited, though, to $10,950 per individual. This priority rank­ing does not include officers’ salaries. It is designed to prevent employees from being too heavily penalized by the company’s problems and encourages them to continue working until the bankruptcy issue is settled.

In addition, employees are not company creditors in the traditional sense of that term. They did not enter employment to serve as lenders to the corporation. However, employees can still be financially damaged by bankruptcy.

4. Employee claims for contributions to benefit plans earned during the 180 days preceding the filing of a petition. Again, a $10,950 limit per individual (reduced by certain specified payments) is enforced.

5. Claims for the return of deposits made by customers to acquire property or services that the debtor never delivered or provided. The priority figure, in this case, is limited to $2,425. These claimants did not intend to be creditors; they were merely trying to make a purchase.

6. Government claims for unpaid taxes.

All other obligations of an insolvent company are classified as general unsecured claims that can be repaid only after the creditors with priority have been satisfied. If the funds that remain for the general unsecured debts are not sufficient to settle all claims, the available money must be divided proportionally.

Periodic changes in this priority listing are made and can impact the amounts various types of creditors will receive. For example, in 2005, Congress reclassified prior rent still due as an administrative expense rather than as an unsecured claim as it had been previously classified. Consequently, such rental debts are now more likely to be paid in full, leaving less for the remaining unsecured creditors.

Liquidation versus Reorganization:

The most important decision in any bankruptcy filing (either voluntary or involuntary) is the method by which the debtor 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 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.

Under most reorganization plans, creditors agree to absorb a partial loss rather than force the insolvent company to liquidate. Before accepting such an arrangement, the creditors (as well as the bankruptcy court) must be convinced that helping to rehabilitate the debtor will lead to a higher return. One benefit associated with reorganizations is that the creditor may be able to retain the insolvent company as a customer.

In many cases, continuation of this rela­tionship is an important concern if the debtor historically has been a good client. Furthermore, the priority ranking system often leaves the general unsecured creditors very little to gain by trying to force a liquidation.

Legal guidelines for the liquidation of a debtor are contained in Chapter 7 of Title I of the Bankruptcy Reform Act; Chapter 11 describes the reorganization process. Consequently, the proceedings have come to be referred to as a Chapter 7 bankruptcy (liquidation) or a Chapter 11 bankruptcy (reorganization). Accountants face two entirely different reporting situations depending on the type of bankruptcy encountered. However, in both cases, accountants must obtain sufficient data and report them adequately to keep all parties informed about relevant events as they occur.

Statement of Financial Affairs:

Like other companies in bankruptcy, WorldCom is required to file schedules of assets and liabil­ities, of executory contracts and unexpired leases, lists of shareholders, and statements of finan­cial affairs within 15 days of its Chapter 11 filing.

At the start of bankruptcy proceedings, the debtor normally prepares a statement 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 the unsecured creditors as they decide whether to push for reorganization or liqui­dation. 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.

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. By comparing this total with the amount of unsecured liabilities, interested parties can approximate the potential loss they face.

The information found in a statement of financial affairs can affect the outcome of the bankruptcy. If, for example, 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.

Statement of Financial Affairs Illustrated:

Chaplin Company recently experienced severe financial difficulties and is currently insolvent. It will soon file a voluntary bankruptcy petition, and company officials are trying to decide whether to seek liquidation or reorganization. Consequently, they have asked their accountant to produce a statement of financial affairs to assist them in formulating an appropriate strat­egy. A current balance sheet for Chaplin, prepared as if the company were a going concern, is presented in Exhibit 13.1.

Prior to the creation of a statement of financial affairs, additional data must be ascertained concerning the insolvent company and its assets and liabilities.

In this illustration, the follow­ing information about Chaplin Company has been accumulated:

i. The investment reported on the balance sheet has appreciated in value since being acquired and is now worth $20,000. Dividends of $500 are currently due from this investment, although Chaplin has not yet recognized the revenue.

ii. Officials estimate that $12,000 of the company’s accounts receivable can still be collected despite the bankruptcy proceedings.

iii. By spending $5,000 for repairs and marketing, Chaplin can sell its inventory for $50,000.

iv. The company will receive a $1,000 refund from the various prepaid expenses, but its intan­gible assets have no resale value.

v. The land and building are in an excellent location and can be sold for a figure 10 percent more than book value. However, the equipment was specially designed for Chaplin. Com­pany officials anticipate having trouble finding a buyer unless the price is reduced consid­erably. Hence, they expect to receive only 40 percent of current book value for these assets.

vi. Administrative costs of $21,500 are projected if the company does liquidate.

vii. Accrued expenses include salaries of $13,000. Of this figure, one person is owed a total of $11,950 but is the only employee due an amount in excess of $10,950. Payroll taxes with­held from wages but not yet paid to the government total $3,000. However, company records currently show only a $1,000 portion of this liability.

viii. Interest of $5,000 on the company’s long-term liabilities has not been accrued for the first six months of 2009.

From this information, the statement of financial affairs presented in Exhibit 13.2 for Chaplin Company was prepared.

Several aspects of this statement should be specifically noted:

1. The current and long-term distinctions usually applied to assets and liabilities are omitted. Because the company is on the verge of going out of business, such classifications are mean­ingless. Instead, the statement is designed to separate the secured and unsecured balances.

2. Book values are included on the left side of the schedule but only for informational pur­poses. These figures are not relevant in a bankruptcy. All assets are reported at esti­mated net realizable value, whereas liabilities are shown at the amount required for settlement.

3. Both the dividend receivable and the interest payable are included in Exhibit 13.2, although neither has been recorded on the balance sheet. The payroll tax liability also is reported at the amount the company presently owes. The statement of financial affairs must disclose currently updated figures.

4. Liabilities having priority are individually identified within the liability section (point A). Because these claims will be paid before other unsecured creditors, the $36,500 total also is subtracted directly from the free assets (point B). Although not yet incurred, estimated administrative costs are included in this category because such expenses will be necessary for a liquidation. Salaries are also considered priority liabilities. However, the $1,000 owed to one employee in excess of the individual $10,950 limit is separated as an unsecured claim (point C).

5. According to this statement, if liquidation occurs, Chaplin expects to have $57,000 in free assets remaining after settling all liabilities with priority (point D). Unfortunately, the lia­bility section shows unsecured claims with a total of $95,000. These creditors, therefore, face a $38,000 loss ($95,000 – $57,000) if the company is liquidated (point E).

This final distribution is often stated as a percentage:

Thus, unsecured creditors can anticipate receiving only 60 percent of their claims. An individual, for example, to whom this company owes $400 should anticipate collecting $240 ($400 × 60%) following liquidation.

6. If the statement of financial affairs had shown the company with more free assets (after subtracting liabilities with priority) than unsecured claims, all creditors could expect to be paid in full with any excess money going to Chaplin’s stockholders.