Accounting for Liquidation of a Company | Accounting

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

Liquidation— Bankruptcy:

When an insolvent company is to be liquidated, the provisions established by Chapter 7 of the Bankruptcy Reform Act regulate the process. This set of laws was written to provide an orderly and equitable structure for selling assets and paying debts. To this end, several events occur after the court has entered an order for relief in either a voluntary or involuntary liquidation.

To begin, the court appoints an interim trustee to oversee the company and its liquidation. This individual is charged with preserving the assets and preventing loss of the estate. Thus, creditors are protected from any detrimental actions that management, the ownership, or any of the other creditors might undertake. The interim trustee (as well as the permanent trustee, if the creditors subsequently select one) must perform a number of tasks shortly after being appointed.

These functions include (but are not limited to):

i. Changing locks and moving all assets and records to locations the trustee controls.

ii. Posting notices that the U.S. trustee now possesses all business assets and that tampering with or removing any contents is a violation of federal law.

iii. Compiling all financial records and placing them in the custody of the trustee’s own accountant.

iv. Obtaining possession of any corporate records including minute books and other official documents.

The court then calls for a meeting of all creditors who have appropriately filed a proof of claim against the debtor. This group may choose to elect a permanent trustee to replace the person temporarily appointed by the court. A majority (in number as well as in dollars due from the company) of the unsecured, non-priority creditors must agree to this new trustee. If the credi­tors cannot reach a decision, the interim trustee is retained.

As an additional action taken to ensure fairness, a committee of between 3 and 11 unse­cured creditors is selected to help protect the group’s interests.

This committee of creditors does the following:

i. Consults with the trustee regarding the administration of the estate.

ii. Makes recommendations to the trustee regarding the performance of the trustee’s duties.

iii. Submits to the court any questions affecting the administration of the estate.

Role of the Trustee:

In the liquidation of any company, the trustee is a central figure. This individual must recover all property belonging to the insolvent company, preserve the estate from any further deterio­ration, liquidate noncash assets, and make distributions to the proper claimants.

Additionally, the trustee may need to continue operating the company to complete business activities that were in progress when the order for relief was entered. To accomplish such a multitude of objectives, this individual holds wide-ranging authority in bankruptcy matters, including the right to obtain professional assistance from attorneys and accountants.

The trustee can also void any transfer of property (known as a preference) made by the debtor within 90 days prior to filing the bankruptcy petition if the company was already insol­vent at the time. The recipient must then return these payments so that they can be included in the debtor’s free assets.

This rule is intended to prevent one party from gaining advantage over another in the some­times hectic period just before a bankruptcy petition is filed. Return of the asset is not neces­sary, however, if the transfer was for no more than would have been paid to this party in a liquidation.

Not surprisingly, the trustee must properly record all activities and report them periodically to the court and other interested parties. The actual reporting rules that the Bankruptcy Reform Act created are quite general- “Each trustee, examiner, and debtor-in-possession is required to file ‘such reports as are necessary or as the court orders.’ In the past there have been no specific guidelines or forms used in the preparation of these reports.”

Consequently, a wide variety of statements and reports may be encountered in liquidations. However, the trustee commonly uses a statement of realization and liquidation to report the major aspects of the liquidation process.

This statement is designed to convey the following information:

i. Account balances reported by the company at the date on which the order for relief was filed.

ii. Cash receipts generated by the sale of the debtor’s property.

iii. Cash disbursements the trustee made to wind up the affairs of the business and to pay the secured creditors.

iv. Any other transactions such as the write-off of assets and the recognition of unrecorded lia­bilities.

Any cash that remains following this series of events is paid to the unsecured creditors after the priority claims have first been settled.

Statement of Realization and Liquidation Illustrated:

To demonstrate the production of a statement of realization and liquidation, the information previously presented for Chaplin Company will be used again. Assume that company officials have decided to liquidate the business, a procedure regulated by Chapter 7 of the Bankruptcy Reform Act. The court appointed an interim trustee whom the creditors then confirmed to oversee the liquidation of assets and distribution of cash.

The dollar amounts resulting from this liquidation will not necessarily agree with the bal­ances used in creating the statement of financial affairs in Exhibit 13.2. The previous state­ment was based on projected sales and other estimations, whereas a statement of realization and liquidation reports the actual transactions and other events as they occur. Consequently, discrepancies should be expected.

Assume the following transactions occur in liquidating this company:

Liquidation Transactions of Chaplin Company—2009:

July 1 – The accounting records in Exhibit 13.1 are adjusted to the correct balances as of June 30, 2009, the date on which the order for relief was entered. Hence, the dividends receivable, interest payable, and additional payroll tax liability are recognized.

July 23 – The trustee expends $7,000 to dispose of the company’s inventory at a negoti­ated price of $51,000. The net cash results are applied to the notes payable for which the inventory served as partial security.

July 29 – Cash dividend of $500, accrued as of June 30, is collected. The related invest­ments (reported at $15,000) are then sold for $19,600.

Aug. 17 – Accounts receivable of $16,000 are collected. The remaining balances are all written off as bad debts.

Aug. 30 – The trustee determines that no refund is available from any of the company’s prepaid expenses. The intangible assets also are removed from the financial records because they have no cash value. The land and building are sold for $208,000. The trustee immediately uses $205,000 of this money to pay off the secured creditors.

Oct. 9 – After an extended search for a buyer, the equipment is sold for $42,000 in cash.

Nov. 1 – A $24,900 invoice is received for various administrative expenses incurred in liquidating the company. The trustee also reclassifies the remaining portion of the partially secured liabilities as unsecured.

Nov. 9 – Noncash assets have now been converted into cash and all secured claims settled, so the trustee begins to distribute any remaining funds. The liabilities with priority are paid first. The excess is then applied to the claims of unsecured non-priority creditors.

The physical structure used to prepare a statement of realization and liquidation can vary sig­nificantly. One popular form presents the various account groups on a horizontal plane with the liquidating transactions shown vertically. In this manner, accountants can record the events as they occur to show and their effects on each account classification. Exhibit 13.3 has been constructed in this style to display the liquidation of Chaplin Company.

Probably the most significant information presented in this statement is the measurement and classification of the insolvent company’s liabilities. In the same manner as the statement of financial affairs, fully and partially secured claims are reported separately from liabilities with priority and unsecured non-priority claims.

For Chaplin Company, Exhibit 13.3 discloses that $135,900 in debts remain as of November 9 ($39,900 in priority claims and $96,000 in unsecured non-priority liabilities). Unfortunately, after satisfying all secured liabilities, the company retains only $83,100 in cash.

The trustee must first use this money to pay the three liabilities with priority according to the fol­lowing ranking:

Because all liabilities have not been paid in full, the stockholders receive nothing from the liq­uidation process.

Interestingly, the unsecured non-priority creditors are receiving a smaller percentage of their claims than the 60 percent figure projected in the statement of financial affairs (produced in Exhibit 13.2). Although this earlier statement plays an important role in bankruptcy planning and proceedings, the preparer’s ability to foretell future events limits the statement’s accuracy.