Accounting for companies in Chapter 11 reorganization.
Reorganizations under the Bankruptcy Code are one of the few areas in financial reporting still untouched by standard setters. Recognizing this void in the face of increased bankruptcy filings, the American Institute of CPAs accounting standards executive committee (AsSEC) issued an exposure draft of a statement of position (SOP) on the subject in April 1990. The final version has now been issued and will mean unique reporting treatment for these reorganizations.
Bankruptcy filings for both individuals and businesses in the United States are increasing, due in large part to rising interest rates and consumer debt. New filings are expected to increase 8% this year, to 810,000 cases; a 9.8% increase, to 890,000 cases, is expected in 1992. This prediction comes from the Administrative Office of the U.S. Courts in Washington, D.C.
When many individuals hear the word bankruptcy, they think of people losing their homes, cars and life savings - virtually everything except the clothes on their backs - in the face of mounting debts. They also may think of companies being liquidated and creditors paid 10 cents on the dollar - if they're lucky. Many accountants have similar negative perceptions about bankruptcy.
Until now, the accounting literature has provided little guidance about how to report on a liquidation. And it has provided no guidance at all on how to report on reorganizations. Accountants for companies being reorganized under the Bankruptcy Code, or for those just coming out of such reorganizations, had to prepare, review and audit the financial reports of these companies without authoritative guidelines.
Reorganization under the federal Bankruptcy Code is a way to salvage a company, not liquidate it. While it's true that 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 still may count on 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.
THE FOUR Ps OF REORGANIZATION
The Bankruptcy Reform Act of 1978, which is currently`effective, gives a company in reorganization a better break than previous U.S. laws or the laws`of other countries. Unlike the United States, in most foreign jurisdictions, for example, secured creditors have veto power over debtor activities. The 1978 act established a new federal Bankruptcy Code for the United States. Key chapters are chapter 7 on liquidations and chapter 11 on reorganizations. The SOP relates solely to chapter 11, which describes the four Ps of reorganization: the petition, protection, the plan and the proceedings.
A company in distress petitions the bankruptcy court to obtain protection from its creditors. If granted protection, the company or its trustees can continue to operate while a plan of reorganization is devised, avoiding the substantial additional losses that usually result from liquidation. What happens to a company from the acceptance of the petition until it comes out of reorganization is called the proceedings. See the sidebar on page 78 for the characteristics of a chapter 11 reorganization.
CHARACTERISTICS OF A CHAPTER 11
* The bankrupt entity (the debtor) usually controls the business during reorganization.
* The business continues to operate while in reorganization.
* The debtor attempts to formulate a plan of reorganization.
* Once a plan is adopted by the court, the debt payments are limited to the schedule and amounts provided in the plan.
* The proceedings can be complex (depending, for example, on the number and classes of creditors or the amount of assets) and may last several years.
* The debtor eventually emerges from protection of the Bankruptcy Code and, while legally the same company, operates as a restructured economic entity, usually under different control than when it entered the proceedings.
FINANCIAL REPORTING DURING
AsSEC was faced with creating financial reporting standards for companies under two unusual sets of circumstances: those companies in chapter 11 proceedings and those coming out of such proceedings. The committee had to make its recommendations without the benefit of prior literature on the subject. And standard generally accepted accounting principles had been used to report on reorganizations in situations where specialized GAAP was needed.
The committee decided an objective of financial statements issued by an entity in chapter 11 proceedings should be to reflect its financial evolution during that period. To that end, the financial statements for periods during the proceedings should distinguish transactions and events directly associated with the reorganization from those associated with ongoing operations.
Making this distinction requires special treatment in each of the financial statements prepared by an entity in reorganization in order to reflect its unique circumstances. The balance sheet would be affected as follows:
* Debts ordinarily classified as current generally can't be paid before the plan is confirmed. They should be classified as noncurrent while the bankrupt entity is in reorganization.
* Liabilities subject to compromise - unsecured and undersecured liabilities incurred before the entity entered reorganization - should be reported on the balance sheet during reorganization separate from liabilities not subject to compromise. (Liabilities not subject to compromise are those secured liabilities incurred before the entity entered reorganization and all liabilities incurred after it entered reorganization.) Liabilities should be reported at amounts expected to be allowed by the court. Those subject to compromise, the amounts of which can't be reasonably estimated, should be disclosed in the notes.
* Liabilities not subject to compromise should be classified as current or noncurrent in a classified balance sheet.
STATEMENT OF INCOME
The income statement would be affected as follows:
* Income statement amounts directly associated with the reorganization - including interest income, professional fees and losses on executory contracts - don't result in deferrals (that is, assets or liabilities). Instead, they should be reported in the income statement when incurred, separate from other income statement amounts, except for those required to be reported as part of discontinued operations.
* Under the code, the entity may be excused from paying some of its interest obligations - for example, if the entity is insolvent. The extent to which reported interest expense differs from contractual interest should be disclosed.
* Much of the interest income earned by an entity during reorganization is earned because it is not currently paying its debts. Such income should be reported separately as a reorganization amount.
* Earnings per share should be reported as usual while the entity is in reorganization. If it is probable the plan will require the issuance of common stock or common stock equivalents, diluting current equity interests, that should be disclosed as well.
STATEMENT OF CASH FLOWS
The information in this statement is the most revealing information that can be provided in the financial statements of an entity in reorganization. The cash flows statement would be affected as follows:
* The direct method of reporting net cash flows from operating activities is the better method to provide such information.
* Cash flow items related to the reorganization should be reported separately from those from regular operations under the direct method. For example, interest received might be segregated between estimated normal recurring interest received and interest received on cash accumulated because of the reorganization.
* If the indirect method of reporting is used, details of operating cash receipts and payments resulting from the reorganization should be disclosed in a supplementary schedule or in the notes to the financial statements.
SUPPLEMENTARY COMBINED FINANCIAL
If the entity in reorganization is one of a consolidated group of companies, preparing financial statements can be even more complicated. Regular consolidated financial statements don't tell the whole story. Condensed combined statements of the entity or entities in reorganization would be helpful, so the SOP would mandate them. Also, intercompany receivables and payables must be disclosed, with extra scrutiny needed to determine if intercompany receivables are worth their carrying amounts.
FINANCIAL REPORTING AFTER CHAPTER 11
Once an entity survives reorganization, it is faced with a new set of financial reporting issues. These relate to the fundamental issue in financial reporting: What is the entity? Until the entity is identified, no other decisions can be made on its reporting.
When a company goes through reorganization, it comes out looking quite different. If nothing else, its relationship with its debt and equity holders before reorganization bears little resemblance to that after reorganization. And realistic amounts ascribed to its assets also bear little resemblance to the amounts carried over from before the reorganization.
One benefit of having financial statements for more than one reporting period is being able to compare them and identify trends. However, if the company goes through an upheaval such as reorganization, comparisons can be misleading. Financial statement users might be able to get some useful information by comparing the statements of entities in reorganization with their financial statements before reorganization. But unless a company doesn't reorganize very much, little useful information is likely to be obtained. The company is in effect a new entity. But how much reorganization must take place before there is a new entity?
In financial reporting, drawing some arbitrary lines can't be avoided. AcSEC had to make such a choice in deciding when an entity has reorganized to the point that it becomes a new entity. In drawing the lines, the committee said an entity is new and should adopt fresh start reporting if both of the following occur:
* The reorganization value of the entity's assets (the amount a willing buyer would pay a willing seller) immediately before it emerges from reorganization is less than the total of all its liabilities incurred after entering reorganization plus the claims existing on entering reorganization and allowed by the court.
* Holders of existing voting shares immediately before emerging from reorganization retain less than 50% of the voting shares of the emerging entity. (The loss of control by the existing shareholders must be substantive and not temporary.)
FRESH START REPORTING
Some would conclude that the combination of a change in majority ownership and voting control, a court-approved reorganization and a reliable measure of the entity's fair value results in a fresh start, creating a new reporting entity. Others believe a change in control and the exchange of debt and equity based on reorganization value are an acquisition of the entity at fair value by the new shareholders in exchange for extinguishing their debt. The former shareholders have lost their rights to any equity interest in the reorganized entity and receive such interest only with the consent of the real owners, the creditors who have become the new shareholders.
The task force concluded that under each view a new reporting entity is created, and assets and liabilities should be reported at their fair values at the date the plan is confirmed by the court, or the effective date if there is a material unsatisfied condition on which the plan is dependent. That is, assets should be reported based on reorganization value, and liabilities should be reported at current amounts.
Entities that adopt fresh start reporting should allocate the reorganization value among their assets in conformity with the procedures specified by Accounting Principles Board Opinion no. 16, Business Combinations, for reported transactions based on the purchase method. Those amounts should be reflected in a "wrap-up" set of financial statements prepared by the entity while in reorganization. The effects of the adjustments on the reported amounts of individual assets and liabilities resulting from the adoption of fresh start reporting and the effects of the forgiveness of debt should be reflected in the final statement of operations. The final balance sheet of the old entity should be the same as the opening balance sheet of the new entity.
Even though fresh start reporting is adopted by the new entity, the notes to its initial financial statements should disclose the adjustments to the historical amounts of individual assets and liabilities, the amount of the forgiveness of debt, elimination of prior retained earnings or deficit and significant factors relating to the determination of reorganization value.
REPORTING BY ENTITIES NOT ADOPTING
Entities emerging from reorganization that don't qualify for fresh start reporting should report the amounts of liabilities compromised at present values of amounts to be paid, determined at appropriate interest rates. Forgiveness of debt, if any, should be reported as an extraordinary item. Because the new SOP provides specific guidance for all reorganizations under chapter 11, financial reporting for quasi-reorganizations should not be applied to entities that don't qualify for fresh start reporting when they emerge from reorganization.
THE GAPING HOLE
With the issuance of the SOP outlining specialized reporting treatment for reorganizations, the accounting profession has plugged a gaping hole in its literature. Practitioners now are equipped with guidelines to help them cope with the increase in bankruptcy filings. And unlike standards in other areas of financial reporting, such as pensions and income taxes, the new SOP for reorganizations under the Bankruptcy Code should stand the test of time and isn't likely to require frequent revisions.
MILESTONES IN A CHAPTER 11
* A petition is filed with a federal district court seeking protection under the Bankruptcy Code. (Either the debtor or a creditor may file such a petition. Which one files does not affect financial reporting under GAAP.)
* The court either appoints a trustee to run the business during reorganization proceedings or allows the debtor, as debtor in possession, to operate the business.
* Automatic stay provisions of the code take effect, preventing creditors from collecting debts incurred before the petition was filed.
* The clerk of the court notifies creditors of the reorganization.
* The debtor files schedules of assets and debts.
* The creditors hold their first meeting.
* Each creditor files its claims against the company.
* Creditor and stockholder committees may be formed.
* The court allows or disallows creditor claims.
* When creditors have agreed to a plan of reorganization, the debtor, creditors or other interested parties may file the details with the court in a document known as a disclosure statement, which the court may or may not approve.
* Creditors and stockholders vote on the plan of reorganization.
* The court closes the case if it determines the plan is fair and equitable; if not, a new plan must be devised that is acceptable to the court.
JOHN ROBBINS, CPA, is managing partner of Kenneth Leventhal & Co., New York City. He is chairman of the American Institute of CPAs task force on financial reporting by entities in reorganization under the Bankruptcy Code and is a member of the Financial Accounting Standards Board emerging issues task force. AL GOLL, CPA, is a technical manager in the AICPA accounting standards division. He is involved with the AICPA accounting standards executive committee (AcSEC) and the stockbrokerage and investment banking committee. PAUL ROSENFIELD, CPA, is director of the AICPA accounting standards division and is responsible for the technical and administrative activities of AcSEC. He is a member of the American Accounting Association.
Mr. Goll and Mr. Rosenfield are employees of the AICPA. Their views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.
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|Publication:||Journal of Accountancy|
|Date:||Jan 1, 1991|
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