Accounting for bankruptcies: implementing SOP 90-7.
* The SOP's applicability to entities that emerge from reorganization under chapter 11 of the Bankruptcy Code and fail to meet the criteria for fresh-start reporting.
* The SOP's applicability to prepackaged chapter 11 bankruptcies.
* The meaning of reorganization value as used in the SOP.
* Accounting for deferred taxes in fresh-start reporting, particularly to determine reorganization value. This article discusses these implementation issues, many of which were debated by the task force that drafted the SOP.
APPLICABILITY WHEN FRESH-START REPORTING IS NOT REQUIRED
To what extent should the SOP be applied when an entity does not meet the requirements for fresh-start reporting and limited adjustments have been made to the emerging entity's debt? Paragraphs 18 and 19 of SOP no. 90-7 outline the scope of its application in such cases.
Entities operating under chapter 11 with the expectation of reorganizing as going concerns and entities emerging from chapter 11 pursuant to court-confirmed plans should follow the SOP's guidance in preparing financial statements based on generally accepted accounting principles, either during court proceedings or on emerging from chapter 11. Thus, the SOP applies to all financial statements such entities intend to prepare in conformity with GAAP.
Paragraph 19 of the SOP says it does not apply to government organizations, entities that liquidate or adopt plans of liquidation under the Bankruptcy Code and entities that restructure debt outside chapter 11. Because of this last provision, an entity issuing GAAP financial statements either during or on completion of a nonjudicial bankruptcy workout does not follow SOP no. 90-7. This is true even if the workout plan meets all requirements of the Bankruptcy Code (including issuance of a disclosure statement). Conversely, we believe a not-for-profit organization (one not owned by a government unit) would be covered by the SOP when it issues GAAP-based financial statements during a chapter 11 bankruptcy case and when it is emerging from bankruptcy.
POTENTIAL CONFLICT WITH FASB 15--THE DISCOUNTING CONTROVERSY
For entities emerging from chapter 11 bankruptcy and not meeting the criteria for fresh-start accounting, paragraph 41 of SOP no. 90-7 says "liabilities compromised by confirmed plans should be stated at present values of amounts to be paid, determined at appropriate current interest rates" (emphasis added).
Some argue this requirement conflicts with Financial Accounting Standards Board Statement no. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, and in particular FASB Technical Bulletin no. 81-6, Applicability of Statement 15 to Debtors in Bankruptcy Situations. They point to paragraph 5 of the bulletin: "Statement no. 15 would apply to an isolated troubled debt restructuring by a debtor involved in bankruptcy proceedings if such restructuring did not result in a general restatement of the debtor's liabilities."
Thus, if Statement no. 15 applies to entities emerging from chapter 11 that do not qualify for fresh-start reporting, the carrying amount of liabilities compromised by confirmed plans would not be adjusted unless future cash payments designated as either principal or interest were less than the compromised liability's carrying amount. As a result, future interest expense of entities emerging from chapter 11 could be materially different from that of entities restructuring their debts outside chapter 11.
Given the choice, most debtors would not want to reflect a market-rate interest expense in subsequent reporting periods. Those debtors argue a general restructuring of liabilities in a chapter 11 proceeding may not always occur, and Statement no. 15 therefore should apply. They contend the gain recognition on debt discharge that occurs in the discounting of liabilities compromised by a confirmed bankruptcy plan may result in the debtor emerging with positive retained earnings, which is an anomalous result for an entity emerging from bankruptcy. The dilemma involves the intended meaning of general restructuring, as used in the Statement no. 15 accounting model.
Technical Bulletin no. 81-6 was issued to clarify Statement no. 15's footnote 4, which says in part that the statement's provisions do not apply if there is a general restructuring of liabilities under federal statutes. Therefore, footnote 4 essentially maintains that Accounting Principles Board Opinion no. 21, Interest on Receivables and Payables, applies to liabilities restructured under the Bankruptcy Code. As a result, the face value of affected liabilities would be discounted to an amount necessary for the debtor to report a market rate of interest expense in subsequent reporting periods.
Paragraph 63 of SOP no. 90-7 says that "in a typical chapter 11 reorganization there is a general restructuring of liabilities." The task force intended this statement to be more than a presumption; it is a given. In a typical chapter 11 proceeding most of the debtor's liabilities are subject to compromise. That some of the liabilities subject to compromise are not in fact compromised by a confirmed plan is not the measure of whether a general restructuring occurs. Rather, filing a reorganization petition begins a negotiating process for what is, at least at the outset, a general restructuring of the debtor's liabilities. This conclusion means debt should be reflected at the present value of amounts to be paid if such debt is compromised by a confirmed plan and the debtor does not meet the requirements for fresh-start reporting. The task force concluded an adjustment to debt not compromised is unnecessary for entities emerging from chapter 11 that do not meet fresh-start reporting requirements.
APPLICABILITY TO PREPACKAGED BANKRUPTCIES
In a prepackaged bankruptcy, a debtor restructures outstanding debt, often through a creditor's committee, before filing a chapter 11 bankruptcy petition. Once agreement is reached with creditors and shareholders and the plan is approved, the debtor files a petition hoping the court will confirm its restructuring plan. Debtors are aware certain benefits may be realized if the court approves the plan.
Certain high-interest subordinated debt agreements, for example, require all debt holders to approve any amendments to the agreements. However, approval of only two-thirds in amount and of a majority in number of each class of creditors voting is required under a court-approved chapter 11 reorganization. Certain tax benefits may be available if the reorganization plan is approved by the court instead of settled out of court. Further, the prepackaged approach generally is less disruptive to the debtor's operations and costs less than an extended chapter 11 case.
Some believe debtors emerging from a prepackaged chapter 11 reorganization should be exempt from SOP no. 90-7's financial reporting guidance. They argue the debt restructuring took place outside chapter 11, the chapter 11 filing was merely a formality to achieve certain advantages not available outside chapter 11 and thus Statement no. 15 should apply.
We do not agree an event such as a prepackaged bankruptcy should exempt a debtor from SOP no. 90-7's financial reporting requirements. These requirements do not apply to entities that restructure their debt outside chapter 11; that is, SOP no. 90-7 does not apply to nonjudicial workouts. However, a prepackaged bankruptcy is not a nonjudicial workout. A plan developed and voted on before the petition is filed must meet the same content and confirmation standards as a plan voted on after the chapter 11 petition is filed.
Proper disclosure must be based on non-bankruptcy laws or regulations governing the solicitation or on section 1125 of the Bankruptcy Code. Thus, prepackaged bankruptcy negotiations ultimately are subject to the court's scrutiny. The negotiations are disciplined by the Bankruptcy Code as well as the adversarial nature of negotiations between the parties-in-interest. Further, a prepackaged bankruptcy is not a certainty--a number of prepackaged deals have unraveled in court.
DEFINITION OF REORGANIZATION VALUE
The meaning of reorganization value, as used in SOP no. 90-7, is the subject of some confusion. The SOP is fairly clear in its explanation; the appendix defines it as "the value attributed to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. Therefore, this value is viewed as the 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 restructuring."
Reorganization value represents the fair value of the reconstituted business. It is difficult to imagine how an insolvent debtor could successfully negotiate a reorganization plan and have that plan approved by the court without the parties-in-interest knowing the value of the company expected to emerge from chapter 11.
Reorganization value is present in every chapter 11 reorganization, although it may not be labeled as such. That is, when the parties-in-interest agree to a reconstituted debt and equity structure for an emerging debtor, they do so with some idea of the reorganized entity's ability to repay the debt and provide a fair return to both debtors and new equity holders. Thus, the quantification of the debtor's reorganized value is implicitly evidenced by the reconstituted debt and equity structure.
DETERMINING THE DEBTOR'S REORGANIZATION VALUE
Reorganization value represents the fair value of the assets that will become part of the reorganized entity plus the net realizable value of assets that will be disposed of before the reorganization. Under the SOP no. 90-7 definition, reorganization value does not consider liabilities; it is a debt-off valuation measure.
The task force concluded the left side of the balance sheet should not be driven by the right side. Rather, the asset side should define the composition of the equity side. In fresh-start accounting for entities emerging from chapter 11, reorganization value should be viewed as equivalent to purchase price in a purchase business combination. The purchase business combination analogy is drawn from the bankruptcy insolvency test, which, if met, triggers the absolute priority doctrine.
Under that doctrine, the creditors become the new owners of the debtor company, leading to the conclusion reorganization value represents the value of the assets effectively purchased. (An insolvency condition is present when the debtor's liabilities--allowed claims plus postpetition liabilities--exceed the entity's reorganization value immediately before plan confirmation.) An underlying tenet of the fresh-start model is reorganization value is akin to fair value or the equivalent of purchase price in a business combination. In most large chapter 11 cases in which the debtor is insolvent, an investment banker is engaged by one or more of the parties-in-interest to determine the entity's reorganization value.
ACCOUNTING FOR DEFERRED TAXES IN FRESH START-FASB 109
In determining an entity's reorganization value, an estimate of taxes to be paid is used to calculate future net cash flow. Depreciation and amortization expense expected to be allowed for tax purposes are used to determine the tax benefit of these noncash deductions. Also, the tax effect of net operating losses that survive the reorganization is considered. Thus the reorganization value represents an economic value; it is the present value of the aftertax future cash flows expected to be generated by the assets making up the reconstituted entity that emerges and the net realizable value of those assets that will be disposed of.
We believe, as a result of the transaction that is in effect a purchase of the debtor by creditors, any difference between the assigned values of assets and liabilities and their respective tax bases becomes a permanent difference. Therefore, an adjustment to record a deferred tax asset or liability as a result of such a difference should not be made when recording a fresh start. However, the FASB rejected this view in its Statement no. 109, Accounting for Income Taxes.
Under Statement no. 109, differences between the GAAP basis of depreciable assets and their corresponding tax bases in a purchase business combination are considered temporary differences, the tax effect of which should be recognized in a deferred tax account. Some have questioned the appropriate accounting for the difference between the GAAP basis (allocated reorganization value) and the corresponding tax basis of assets and liabilities of an entity that has emerged from chapter 11 and records a fresh start. Through analogy, such an entity may look to the purchase business combination guidance included in Statement no. 109, which is not explicit about the manner in which deferred taxes should be recorded in a fresh start.
A question has arisen in practice about the proper account to debit as an offset to the deferred tax liability recorded under Statement no. 109 when the emergence is accounted for as a fresh start. The offset to the recording of the deferred tax liability must be made either to the assets or to stockholders' equity. If the former approach is taken, total assets are presented at an amount in excess of reorganization value. If the latter approach is taken, stockholders' equity is presented at an amount less than that determined by the parties-in-interest in valuing the business. Neither approach is desirable. The exhibit on page 52 illustrates the dilemma.
Reorganization value in excess of amounts allocable to identifiable assets are amortized over a period not to exceed 40 years. Paragraph 38 of SOP no. 90-7 suggests pertinent factors should be considered in determining the proper amortization period for this asset that generally would resuit in a useful life of less than 40 years.
In the exhibit, the journal entry to record the tax consequences of the fresh start resuits in a $4.8 million increase to the reorganization value in excess of amounts allocable to the identifiable assets account. Since almost half of this amount is attributable to deferred taxes, that account's amortization period should be linked (at least partially) to the reversal of the temporary differences representing the deferred tax liability account created on recording the fresh start.
MYRIAD ACCOUNTING ISSUES
As with any new accounting standard, CPAs will continue to encounter implementation questions about SOP no. 90-7. This article has addressed the more pervasive questions posed since the SOP was issued. The task force that drafted SOP no. 90-7 avoided creating a "cookbook" standard. It would be impossible to provide accounting guidance for the myriad accounting issues arising between the time a bankruptcy case begins and the entity's ultimate emergence from chapter 11. Thus, preparer judgment and auditor judgment are essential to applying the SOP's provisions.
GEORGE F. PATTERSON, JR., CPA, is a partner of Kenneth Leventhal & Company in Los Angeles. He is a member of the American Institute of CPAs auditing standards board, the California Society of CPAs and the Arizona Society of CPAs and advised the AICPA task force that drafted SOP no. 90-7. GRANT W. NEWTON, CPA, PhD, is a professor of accounting at Pepperdine University, Malibu, California. He served on the AICPA task force that drafted SOP no. 90-7 and is a member of the California Society of CPAs and the Association of Insolvency Accountants.
* SINCE SOP no. 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code, was issued in November 1990, implementation questions have arisen in practice. Among them are the SOP's applicability to entities emerging from chapter 11 that fail to meet fresh-start reporting criteria as well as to prepackaged bankruptcies.
* OTHER QUESTIONS HAVE arisen about the meaning of reorganization value in the SOP and how to account for deferred taxes in fresh-start reporting. Many of the questions can be answered by referring to the work of the task force that drafted the SOP.
* ENTITIES OPERATING UNDER chapter 11 with the expectation of reorganizing as going concerns and entities emerging from chapter 11 under court-confirmed plans should follow SOP no. 90-7 in preparing GAAP-based financial statements.
* A PREPACKAGED bankruptcy should not exempt a debtor from SOP no. 90-7's financial reporting requirements. Because prepackaged bankruptcies are subject to court scrutiny, they are not a certainty; a number have unraveled in court.
* WHILE THE MEANING of reorganization value has been the subject of some confusion, the term is clearly defined in the SOP's appendix. Reorganization value represents the fair value of the assets that will become part of the reorganized entity plus the net realizable value of assets that will be
disposed of before the reorganization.
* AN ENTITY THAT HAS emerged from chapter 11 and records a fresh start can look to the purchase business combination guidance in FASB Statement no. 109, which considers differences between the GAAP basis of depreciable assets and their corresponding tax bases in a purchase business combination to be temporary differences, the tax effect of which should be recognized in a deferred tax account.