Quasi reorganization: fresh or false start.

This article looks at quasi reorganizations by summarizing current generally accepted accounting principles, evaluating the theoretical underpinnings and reporting on a survey of quasi reorganizations in practice. It is our conclusion that the quasi reorganization concept has little theoretical validity, and we urge the Financial Accounting Standards Board to delete it from GAAP. If retained, the concept's intended significance in an entity's history demands strengthening the related accounting procedures and financial statement disclosures.

Hard Times Company has weathered some difficult years; losses have not only wiped out retained earnings but also have created a large deficit. Hard Times has slashed personnel and has identified unprofitable divisions and subsidiaries it could sell. Management is convinced the company can turn the corner and return to profitability. One problem remains: Although stockholders' equity is positive, the large deficit in retained earnings will take years to wipe out, preventing the company from paying dividends and possibly hampering its ability to raise new capital. What can Hard Times do?

An infrequently used provision of Accounting Research Bulletin no. 43, Restatement and Revision of Accounting Research Bulletins, may offer a solution. Cited in the 1991 FASB discussion memorandum (DM), New Basis Accounting, ARB no. 43 reinforced an earlier rule permitting an accounting procedure known as a corporate readjustment--or more commonly, a quasi reorganization.

FRESH-START ACCOUNTING

The FASB DM, which examines situations that may require companies to adopt a new basis for assets and liabilities, says AP-B no. 43 allows the company to "accomplish, in its books of account, substantially what might be accomplished in a reorganization by legal proceedings--that is, elimination of a deficit in retained earnings and establishment of a new basis of accounting for its assets and liabilities." The new basis results from adjusting assets and liabilities to their current fair value.

Adjusting the books in this way has led to the notion of fresh-start accounting, as it allows a company to "wipe clean its prior accounting records and start anew," according to the DM. Because of the limited incidence of quasi reorganizations in practice and the fact the underlying concepts are far from pervasive, relatively little literature on the subject has appeared since a comprehensive study by James S. Schindler in 1958. (See exhibit 1, page 80, for a review of selected quasi reorganization literature.

The renewed interest in quasi reorganizations that followed a 1988 American Institute of CPAs issues paper, Quasi-Reorganizations, is both reinforced and challenged in the FASB DM. On the one hand the DM acknowledges that quasi reorganizations provide a reference point for exploring the appropriateness of new basis accounting. On the other, the DM says some observers question whether a quasi reorganization is good accounting and whether it should result in a new basis of accounting.

APPROPRIATE OR NOT?

Although APB no. 43 provides guidance for the accounting procedures in a quasi reorganization, it does not specify the conditions under which one is appropriate. Instead, section 210 of the Securities and Exchange Commission Codification of Financial Reporting Policies requires that, at a minimum, these four conditions exist before a quasi reorganization can be considered effective.

1. Retained earnings are exhausted.

2. No capital account has a deficit after the quasi reorganization.

3. Parties entitled to vote on corporate policy are informed of the quasi reorganization and approvals required by state law and corporate charter are obtained.

4. The accounting for the quasi reorganization reflects substantially what might be accomplished in a reorganization by legal proceedings." This includes restating assets to current value and making appropriate modifications to the capital accounts, such as eliminating a deficit in retained earnings to minimize the need for similar reorganizations in the future.

Section 210 also requires the new retained earnings account, now purged of its deficit, to be dated and that a quasi reorganization occur "only uncumstances which should justify an actual reorganization or formation of a new corporation The financial reporting surveys cited in exhibit 1 noted many instances of deficit eliminations alone (the second condition) without asset restatement (the fourth condition). In response to a query, the SEC staff said in Staff Accounting Bulletin (SAB) no. 78 that a deficit elimination alone does not constitute a quasi reorganization; SEC registrants must satisfy all of the conditions in section 210.

SAB no. 78 also addresses a loophole in the rules. Although the spirit of a quasi reorganization suggests a write-down will occur when net assets are adjusted to fair value, we found several companies that reported net write-ups. SAB no. 78 prohibits this outcome. Because the published quasi reorganization surveys were conducted before the August 25, 1988, issuance of SAB no. 78, reorganizations completed after that date must be examined to determine whether the bulletin has had any effect on practice.

IS A QUASI REORGANIZATION AN ACCOUNTING EVENT?

Although quasi reorganizations are included in GAAP, their theoretical justification as accounting events is tenuous. They are not traditional accounting events or transactions because external parties are not involved and resources are not transferred, consumed or generated. Since only accounting events are recognized in financial statements, recognition of a quasi reorganization is suspect if its status as an accounting event is suspect.

The fact that a quasi reorganization is not a normal transaction does not automatically disqualify it as an accounting event. FASB Concepts Statement no. 6, Elements of Financial Statements, says An event is a happening of consequence to an entity" (emphasis added). It could be argued a quasi reorganization leading to a fresh start is a happening of consequence. However, Concepts Statement no. 6 further classifies events as internal or external. A quasi reorganization does not qualify, as an external event--it does not result from an outside interaction. The only examples of internal events given in the statement involve consumption or transfer of resources in production processes. Although a quasi reorganization is an internal procedure, the lack of resource changes or transformations suggests it is not an internal accounting event.

A quasi reorganization perhaps should be viewed as a "synthetic" accounting event. Although such events are not mentioned in FASB concepts statements, synthetic is gaining recognition as a way to describe certain financial instruments.

A quasi reorganization could represent the formal mechanism for recognizing the overall impact of several negative internal and external events; each may be insignificant and not material to periodic accounting reports. At some point, however, the combined effect on an entity of these past negative developments, such as loss of asset utility and continued operating losses, reaches overwhelming significance. When this occurs, the entity may elect a discretionary quasi reorganization to trigger the desired financial statement adjustments and achieve the intended accounting fresh start.

Overshadowing this issue, however, is FASB Concepts Statement no. 5, Recognition and Measurement in Financial Statements of Business Enterprises, which requires an event to satisfy four recognition criteria to support inclusion in an entity's financial statements.

* Financial statement element.

* Measurability.

* Relevance.

* Reliabihty.

Although the last three criteria can be satisfied in a quasi reorganization, the first cannot. It demands the item meet the definition of "an element of financial statements" A quasi reorganization is not a financial statement element--asset, liability or change in equity--as defined in Concepts Statement no. 6.

Quasi reorganizations, as currently allowed, satisfy pragmatic considerations: Dividend distributions are facilitated when negative retained earnings vanish, new stock or debt is easier to issue and subsidiaries with clean balance sheets are more readily sold. Perhaps the practical benefits of a fresh start override the questionable theoretical basis for its use in a quasi reorganization.

SURVEY OF QUASI REORGANIZATIONS IN PRACTICE

We searched the national automated accounting research system (NAARS) database, which covers fiscal years ending July 1, 1964, to June 20, 1992, and found reports of 164 quasi reorganizations with enough information to be analyzed; 142 occurred before the August 25, 1988, issuance of SAB no. 78. Exhibit 2, below, plots the quasi reorganizations reported by year. Many are concentrated between 1979 and 1988, when corporate restructurings were more common.

Nature of accounting adjustments reported. Exhibit 3, below, tabulates the accounting adjustments made in the identified quasi reorganizations and the number associated with Chapter 11 bankruptcy reorganizations, both before and after August 25, 1988. About 64% of the quasi reorganizations before SAB no. 78 was issued involved deficit elimination only; this number dropped to 23% after that date, strongly suggesting SAB no. 78 has affected practice. Some 52% of the companies reporting quasi reorganizations said nothing at ah about their assets or liabilities. Although some companies reporting only a deficit elimination said their assets or liabilities already were at fair value, exhibit 3 shows that more than 81% (52% divided by 64%) did not reveal whether their assets and liabilities were at or near fair value.

A few companies said the quasi reorganization's sole purpose was to enable rapid accumulation of the positive retained earnings required for dividend payments. One company used the technique to clean up its balance sheet before it became a separately traded public entity. Similarly, another company reported a quasi reorganization by a subsidiary just before selling a 50% interest in that subsidiary, now blessed with a clean balance sheet.

As noted earlier, rules before SAB no. 78 did not strictly prohibit net write-ups in net assets. We found three companies with net write-ups, all before SAB no. 78, but did not identify any reporting a net write-up after SAB no. 78.

Quasi reorganizations and Chapter 11 reorganizations. Exhibit 3 also shows about 23% of the quasi reorganizations occurred in connection with Chapter 11 reorganizations. This finding, puzzling because a quasi reorganization and Chapter 11 seem redundant, involved quasi reorganizations reported before AICPA Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code, was issued. No formal guidance on this subject had existed previously and many companies, upon emerging from Chapter 11, apparently used a quasi reorganization to justify fresh-start accounting.

Such use is no longer permitted under SOP 90-7. Fresh-start accounting is now appropriate only when both of the following conditions are met:

* The reorganized entity's reorganization value (the fair value of its assets) is less than all postpetition liabilities and allowed claims.

* A new control group holding more than 50% of the voting shares exists.

SOP 90-7 explicitly prohibits use of a quasi reorganization to obtain fresh-start accounting by entities not satisfying these conditions.

WHITHER QUASI REORGANIZATIONS?

Quasi reorganizations have been an infrequently used but a frequently abused accounting procedure. It would be easy to argue they are an internal action recorded at management's discretion, are not bona fide internal or external accounting events and can be only marginally justified by resorting to a new kind of synthetic accounting event. Although interest rate swaps have been described as synthetic financial instruments and puts and calls can be combined to create synthetic futures contracts, we are unaware of previously created synthetic accounting events.

Synthetic issues aside, why should management be able to select the time at which an entity's balance sheet is adjusted to fair value? A deficit elimination alone--ostensibly to allow payment of dividends without having to generate enough income to remove the deficit--hardly seems a sufficient reaction to the major economic changes underlying justification of a fresh start. This concern disappears immediately if the current discussion of fair value accounting leads to widespread adoption of that concept.

FALSE START?

Even though quasi reorganizations are intuitively appealing and SAB no. 78 is likely to lead to more faithful application of the concept, we believe the FASB, should remove them from GAAP. In practice, many are dominated by pragmatic rather than theoretical considerations and can better be described as false starts rather than fresh starts.

If quasi reorganizations are retained and included as a scenario in a new basis accounting standard, conditions must be strengthened. A key condition should be that assets and liabilities must be so grossly misstated that the unadjusted financial statements no longer have relevance to user groups. Adjustments to fair value would then be sufficiently material to justify freshstart accounting. Companies electing a quasi reorganization should disclose why their balance sheets need to be revamped and summarize the revaluation adjustments.

RELATED ARTICLE: Exhibit 1: Nonauthoritative Literature on

Quasi Reogranizations

Issues Paper 88-1, Quasi-Reorganization American Institute of CPAs accounting standards division, 1988. This document addresses theoretical and practical issues related to quasi reorganizations.

Quasi-Reorganizations: A Survey of Quasi-Reorganizations Disclosed in Corporate Annual Reports to Shareholders, by Hal G. Clark and Leonard Lorensen, AICPA, 1989. This report covers a variety of financial statement disclosures showing quasi reorganizations arising under different circumstances.

"Quasi-Reorganizations in Practice," by Charles H. Gibson, Accounting Horizons 2 (September) 83-89, 1988. This article summarizes information on 22 quasi reorganizations reported from 1981 to 1986.

Quasi-Reorganizations by James S. Schindler, Bureau of Business Research, University of Michigan, Ann Arbor, 1958. Although dated in its references to practice, this remains the most comprehensive and relevant study of quasi reorganizations.

RELATED ARTICLE: EXECUTIVE SUMMARY

[] COMPANIES WITH LARGE DEFICITS in retained earnings that would prevent the payments of dividends and possibly hamper their ability to raise capital may be able to use an accounting procedure known as a corporate readjustment, more commonly called a quasi reorganization, to correct the situation.

[] A FINANCIAL ACCOUNTING STANDARDS Board discussion memorandum, New Basis Accounting, talks about quasi reorganization. It questions whether the procedure is good accounting and if it therefore should result in a new basis of accounting.

[] THE SECURITIES AND EXCHANGE Commission requires that four conditions exist before a quasi reorganization can be effective: Retained earnings must be exhausted; after the reorganization, no capital account can have a deficit; appropriate parties are allowed to vote on the reorganization; the accounting must reflect substantially what would be accomplished in a reorganization by legal proceedings.

[] IN PRACTICE, 64% OF QUASI reorganization before the SEC issued Staff Accounting Bulletin no. 78 involved only deficit elimination. This dropped to 23% after the bulletin was issued, suggesting SAB no. 78 has affected practice.

[] DESPITE THEIR INFREQUENT USE, quasi reorganizations often are abused. Since they are better described as false starts rather than fresh starts, the FASB should remove them from generally accepted accounting principles. If they are retained, conditions must be strengthened.

MICHAEL L. DAVIS, CPA, PhD, is associate professor of accounting at Lehigh University, Bethlehem, Pennsylvania. He is a member of the American Institute of CPAs and the American Accounting Association. JAMES A. LARGAY III, CPA, PhD, is Arthur Andersen & Co. Alumni Professor of Accounting at Lehigh University. He is a member of the AICPA, the AAA and the Financial Executives