Accounting for Reorganization of a Company

In this article we will discuss about the accounting for reorganization of a company.

Reorganization – Bankruptcy:

Reorganization under the federal Bankruptcy Code is 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.

For the 12 months ended December 31, 2006, 5,163 Chapter 11 reorganizations were begun in the United States. Reorganizations attempt to salvage the company so that operations can continue. Although this legal procedure offers the company hope of survival, reorganization is certainly not a guarantee of future prosperity. Most companies that attempt to reorganize even­tually are liquidated. In practice, however, reorganization appears to be biased in favor of large organizations. One expert estimates that 90 percent of big corporations that attempt to reorganize emerge as functioning entities but fewer than 20 percent of smaller companies survive.

Many reorganizations may actually fail because the debtor struggles too long before filing a petition:

Seeking bankruptcy because disaster looms—not after it has arrived—helps (gives the corpora­tion time and provides equality of treatment). Once a company files under the bankruptcy laws, suppliers are likely to demand cash on delivery. So management that moves before liquid assets are depleted has a better chance of making a go of reorganization.

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. Not everyone, though, agrees with the wisdom of leaving the ownership in charge of the company- “One philosophical objection raised increasingly often is the rule that puts the debtor in control of the bankruptcy process, an idea that often leaves foreigners ‘stunned,’ says one bankruptcy lawyer. This typically means that the managers who bankrupt a firm can have a go at restruc­turing it to keep it alive.”

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.

For this reason, a newslet­ter distributed by the A. H. Robins Company to employees a few days after the corporation filed for Chapter 11 protection specified that “the company cannot pay any creditor or supplier for goods delivered or services rendered before August 21, 1985. The company is prohibited from making such payments unless there is a special court order. Monthly bills will have to be prorated to assure all creditors are treated the same.”

The Plan for Reorganization:

The most intriguing aspect of a Chapter 11 bankruptcy is the plan developed to rescue the com­pany from insolvency. Initially, only the debtor in possession can file proposals with the court. However, if a plan for reorganization is not put forth within 120 days of the order for relief or accepted within 180 days (unless the court grants an extension although the debtor’s exclusivity to propose a plan cannot be extended beyond 18 months), any interested party has the right to prepare and file a proposal.

Creditors of Revco D. S., Inc., had the quandary of choosing between three different reorganization plans- one backed by the company’s management, one proposed by Rite Aid Corporation, and one submitted by Jack Eckerd Corporation.

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 list of elements that could be included in a reorganization proposal is not possible, some of the most common follow:

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. As an example, before emerging from Chapter 11 reorganization.

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. For example, as part of the initial reorganization plan put forth by Orion Pictures, its majority owner, Metromedia Company, agreed to invest $15 million in cash. With­out the willingness of the owners to back the company, creditors would probably have been hesitant to agree to a reorganization.

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- “Manville Corporation agreed to let creditors have the final say in any board appointments, eliminating the last major obstacle in gaining approval of its 3½ year bankruptcy-law reorganization.”

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:

i. 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.

ii. 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.”

iii. The terms of the outstanding liabilities can be modified- maturity dates extended, interest rates lowered, face values reduced accrued interest forgiven, and so on.

One recent development is the use of prepackaged or prearranged bankruptcies. In such cases, the company and its debtors agree on some or all of the terms of the reorganization plan before a bankruptcy petition is signed. Thus, the parties go into the bankruptcy with a com­plete or partial agreement to present to the court. In this manner, extensive legal fees can be avoided.

Furthermore, the parties have more protection because the Bankruptcy Court is likely to accept the plan without requiring extensive changes or revisions. Note the timing of the negotiations in this announcement that Trump Hotels & Casino Resorts had won confirmation of its plan to exit Chapter 11- “Bondholders who negotiated the Chapter 11 restructuring before the Nov. 21 filing for bankruptcy protection voted overwhelmingly in favor of the Chapter 11 plan.”

Acceptance and Confirmation of Reorganization Plan:

The creation of a plan for reorganization does not guarantee its implementation. The Bank­ruptcy Reform Act specifies that a plan 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. Acceptance 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.

On December 19, 2006, Delta Air Lines, Inc. filed a Plan of Reorganization and a related Disclosure Statement with the U.S. Bankruptcy Court. Delta’s Board of Directors concluded that the Company’s creditors, as well as its other stakeholders, are best served by moving for­ward with the Company’s standalone Plan of Reorganization. Delta intends to emerge from Chapter 11 by mid-2007. On January 31, 2007, the Unsecured Creditors’ Committee in Delta’s Chapter 11 proceedings announced its support for Delta’s Plan of Reorganization.

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. The court also has the authority to confirm a reorganization plan that was not accepted by a particular class of creditors or stockholders.

This provision is referred to as a cram down; it occurs when the court determines that the plan is fair and equitable. As an alternative, the court may convert a Chapter 11 reorganization into a Chapter 7 liquidation at any time if the development of an acceptable plan does not appear to be possible. That threat often encourages the parties to work together to achieve a workable resolution.

Financial Reporting during Reorganization:

Developing and gaining approval for a reorganization plan can take years. During that period, the company continues operating under the assumption that it will eventually emerge from the bankruptcy proceedings.

While going through reorganization, the company faces several spe­cific accounting questions:

i. Should the income effects resulting from operating activities be differentiated from trans­actions connected solely with the reorganization process?

ii. How should liabilities be reported? Because some debts may not be paid for years and then may require payment of an amount considerably less than face value, how should this information be conveyed?

iii. Does reorganization necessitate a change in the reporting basis of the company’s assets?

In 1990, the AICPA Task Force on Financial Reporting by Entities in Reorganization Under the Bankruptcy Code issued Statement of Position 90-7 (“Financial Reporting by Entities in Reorganization Under the Bankruptcy Code”) (referred to as SOP 90-7).

This pronouncement provides standards for preparing of financial statements at two times:

1. During the period when a company is going through reorganization.

2. At the point that the company emerges from reorganization.

The Income Statement during Reorganization:

According to SOP 90-7, any gains, losses, revenues, and expenses resulting from the reorga­nization of the business should be reported separately. Such items are placed on the income statement before any income tax expense or benefits.

These separately reported reorganization items include any gains and losses on the sale of assets necessitated by the reorganization. In addition, enormous amounts of professional fees may be incurred. SOP 90-7 requires that these costs be expensed as incurred.

SOP 90-7 also established the proper reporting of interest expense and interest revenue. Dur­ing reorganization, interest expense usually does not accrue on debts owed at the date on which the order for relief is granted. The amount of liability on that date is frozen.

Thus, recog­nition of interest is necessary only if payment will be made during the proceeding (for exam­ple, on debts incurred during the bankruptcy) or if the interest will probably be an allowed claim (for example, if the amount was owed but unrecorded prior to the granting of the order for relief). Any interest expense to be recognized is not really a result of the reorganization process and should not be separately reported as a reorganization item.

In contrast, interest revenue can increase to quite a substantial amount during reorganiza­tion. Because the company is not forced to pay debts incurred prior to the date of the order for relief, cash reserves can grow so that the resulting interest becomes a significant source of income. Any interest revenue that would not have been earned except for the proceeding is reported separately as a reorganization item.

For example. Delta Air Lines Inc. reported the following amounts as reorganization items within its income statement for the six months ended June 30, 2006 (in millions):

To illustrate, assume that Crawford Corporation files a voluntary bankruptcy petition and is granted an order for relief on January 1, 2009. Thereafter, the company’s ownership and man­agement begin to- (1) work on a reorganization plan and (2) rehabilitate the company. It closes several branch operations and hires accountants, lawyers, and other professionals to assist in the reorganization.

At the end of 2009, the bankruptcy is still in progress. The company prepares an income statement which is structured so that the reader can distinguish the results of oper­ating activities from the reorganization items (see Exhibit 13.4).

The Balance Sheet during Reorganization:

A new entity is not created when a company moves into reorganization. Therefore, traditional generally accepted accounting principles continue to apply. Assets, for example, should still be reported at their book values. However, the final reorganization plan will likely reduce many liabilities. In addition, because of the order for relief, the current/noncurrent classification sys­tem is no longer applicable; payments may be delayed for years.

Thus, in reporting the liabilities of a company in reorganization, debts subject to compro­mise (possible reduction by the court through acceptance of a reorganization plan) must be disclosed separately. Unsecured and partially secured obligations existing as of the granting of the order for relief fall into this category. Fully secured liabilities and all debts incurred since that date are not subject to compromise and must be reported in a normal manner as either a current or noncurrent liability.

According to SOP 90-7, liabilities subject to compromise “should be reported on the basis of the expected amount of the allowed claims as opposed to the amounts for which those allowed claims may be settled.” Thus, the company does not attempt to anticipate the payment required by a final plan but simply discloses the amount of these claims. For example, the December 31, 2002, balance sheet for US Airways Group, Inc. reported current liabilities of $2.2 billion and noncurrent liabilities of $3.7 billion. It then reported also having liabilities of $5.5 billion subject to compromise.

Financial Reporting for Companies Emerging from Reorganization:

Is a company that successfully leaves Chapter 11 status considered a new entity so that fair values should be assigned to its asset and liability accounts (referred to as fresh start report­ing)? Or is the company simply a continuation of the organization that entered bankruptcy so that historical figures are still applicable?

SOP 90-7 holds that these accounts should be adjusted to fair value if two criteria are met:

i. The reorganization (or fair) value of the assets of the emerging company is less than the total of the allowed claims as of the date of the order for relief plus the liabilities incurred subsequently.

ii. The original owners of the voting stock are left with less than 50 percent of the voting stock of the company when it emerges from bankruptcy.

Meeting the first criterion shows that the old company could not have continued in busi­ness as a going concern. The second criterion indicates that control of the company has changed.

Many, if not most, Chapter 11 bankruptcies meet these two criteria. Consequently, the entity is reported as if it were a brand new business. For example, note 1 to the year 2000 con­solidated financial statements of Golden Books Family Entertainment reported that-

On January 27, 2000, the Company formally emerged from protection under the Bankruptcy Code upon the consummation of the Amended Joint Plan of Reorganization. The Company has applied the reorganization and fresh-start reporting adjustments as required by SOP 90-7 to the consolidated balance sheet as of December 25, 1999. Under fresh start accounting, a new reporting entity is deemed to be created and the recorded amounts of assets and liabilities are adjusted to reflect their estimated fair values.

In applying fresh start accounting, the reorganization value of the entity that emerges from bankruptcy must first be determined. According to paragraph 9 of SOP 90-7, “reorganization value generally approximates fair value of the entity before considering liabilities and approx­imates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring generally it is determined by discounting future cash flows for the reconsti­tuted business that will emerge.”

This total value is then assigned to the specific tangible and intangible assets of the company in the same way as in a combination.

Unfortunately, determining the reorganization value for a large and complex corporation can be a difficult assignment.

After the reorganization value has been determined, an allocation to individual asset accounts should be carried out in the same manner as with the purchase price that establishes a business combination. In applying fresh start accounting, the assets held by a company on the day when it exits from reorganization should be reported based on individual current val­ues, not historical book values.

The entity is viewed as a newly created organization. That is the reason that the 10-K for Kmart Holdings went on to indicate that the “fair value adjust­ments included the recognition of approximately $2.2 billion of intangible assets that were pre­viously not recorded in the Predecessor Company’s financial statements, such as favorable leasehold interests, Kmart brand rights, pharmacy customer relationships and other lease and license agreements.” As with a consolidation, any unallocated portion of the total value is reported as goodwill.

Reporting liabilities following a reorganization also creates a concern because many of these balances will be reduced and the payment period extended. SOP 90-7 requires reporting all liabilities (except for deferred income taxes, which should be accounted for according to the provisions of FASB SFAS 109) at the present value of the future cash payments.

To make the necessary asset adjustments to fresh start accounting, Additional Paid-in Capital is normally increased or decreased. However, any write-down of a liability creates a recognized gain. Finally, because the company is viewed as a new entity, it must leave reorganization with a zero balance reported for retained earnings.

Fresh Start Accounting Illustrated:

Assume that a company has the following trial balance just prior to emerging from bankruptcy:

Other Information:

i. Assets:

The company’s land has a fair value of $120,000; the building is worth $500,000. Other assets are valued at their book values. The reorganization value of the company’s assets is assumed to be $1,000,000 based on discounted future cash flows.

ii. Liabilities:

The $100,000 of accounts payable incurred after the order for relief was granted must be paid in full as the individual balances come due. The accounts payable and accrued expenses that were owed when the order for relief was granted will be converted into one-year notes payable of $70,000, paying interest of 10 percent. The $300,000 in notes payable on the trial balance will be converted into a 10-year $100,000 note paying annual interest of 8 percent.

These creditors also get 20,000 shares of stock that the common stockholders are to turn in to the company. Finally, the $600,000 of bonds payable will be converted into eight-year, 9 percent notes totaling $430,000. The bondholders also get 15,000 shares of common stock turned in by the current owners.

iii. Stockholders’ Equity:

The common stock owners will return 70 percent of their stock (35,000 shares) to the company to be issued. The reorganization value of the assets is $1,000,000, and the debts of the company after the proceeding total $700,000 ($100,000 + $70,000 + $100,000 + $430,000). Thus, stockholders’ equity must be the $300,000 difference. Because shares with a $50,000 par value will still be outstand­ing, Additional Paid-in Capital (APIC) needs to be adjusted to $250,000.

In accounting for this reorganization, the initial question to be resolved is whether fresh start accounting is appropriate. The first criterion is met because the reorganization value of the assets ($1,000,000) is less than the sum of all post-petition liabilities ($100,000 in Accounts Payable) plus allowed claims (the $1,010,000 total of liabilities remaining from the date of the order for relief before any write-down). The second criterion is also met because the original stockholders retain less than 50 percent of the shares after the plan takes effect. At that point, they will hold only 15,000 of the 50,000 outstanding shares.

Because fresh start accounting is appropriate, the assets must be adjusted to fair value rather than retain their historical book value. The reorganization value is $1 million, but the individual assets’ fair value totals only $920,000 (current assets $50,000, land $120,000 [adjusted], buildings $500,000 [adjusted], and equipment $250,000). Therefore, goodwill is recognized for the $80,000 reorganization value of the company in excess of the value assigned to these specific assets.

The two remaining debts (the note payable and the bond payable) will be exchanged, at least in part, for shares of common stock. Each of these entries will require a computation of the amount to be assigned to additional paid-in capital (APIC). The calculated total of APIC for the company was derived previously as $250,000.

Because the holders of the notes receive 20,000 shares of stock (or 40 percent of the company’s 50,000 share total), this stock is assigned APIC of $1, 00,000 (40 percent of that total). The holders of the bonds are to receive 15,000 shares (30 percent of the total). Hence, APIC of $75,000 (30 percent) is recorded. Gains are entered for the differences.

At this point, all asset, liability, and common stock amounts are reported based on the amounts for the company as it leaves reorganization. Only additional paid-in capital and retained earnings remain to be finalized. Additional paid-in capital now has a balance of $450,000 ($40,000 beginning balance plus $200,000 for adjusting assets plus $35,000 for shares returned by owners plus $100,000 because of shares issued for note and $75,000 because of shares issued for bonds).

Therefore, this balance is $200,000 more than the amount to be reported as established through the provisions of the reorganization agreement. In addi­tion, the Gain on Debt Discharge account has a balance of $200,000 ($40,000 + $80,000 + $80,000), a figure that must be closed out.

Adjusting and closing these accounts eliminates the $400,000 deficit shown previously in retained earnings so that the emerging company has no balance in this equity account:

After posting these entries, this company emerges from bankruptcy with the following:

1. Its assets are reported at fair value except for goodwill, which is a residual figure.

2. Its debts equal the present value of the future cash payments (except for any deferred income taxes).

3. It has no deficit balance.