Bankruptcy: Liquidation and Reorganization

Chapter Fourteen Bankruptcy: Liquidation and Reorganization Scope of Chapter Business failures are a common occurrence in the U.S. economy. Poor management, excessive debt, and inadequate accounting are the most commonly cited causes of business failures. The situation that precedes the typical business failure is inability of a business enterprise to pay liabilities as they become due. Unsecured creditors often resort to lawsuits to satisfy their unpaid claims against a business enterprise. Secured creditors may force foreclosure proceedings for real property or may repossess personal property that collateralizes a security agreement. The Internal Revenue Service may seize the assets of a business enterprise that has failed to pay FICA and income taxes withheld from its employees. A business enterprise may be unable to pay its liabilities as they become due even though the current fair values of its assets exceed its liabilities. For example, an enterprise may experience a severe cash shortage in times of price inflation because of the lag between the purchase or production of goods at inflated costs and the recovery of the inflated costs through increased selling prices. More typical of the failing business enterprise than the conditions described in the foregoing paragraph is the state of insolvency. Insolvent is defined in the Bankruptcy Code as follows: insolvent means (A) with reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity s debts is greater than all of such entity s property, at a fair valuation, exclusive of (i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity s creditors; and (ii) property that may be exempted from property of the estate under... this title; and (B) with reference to a partnership, financial condition such that the sum of such partnership s debts is greater than the aggregate of, at a fair valuation (i) all of such partnership s property, exclusive of property of the kind specified in subparagraph (A) (i) of this paragraph; and 607

608 Part Four Accounting for (ii) the sum of the excess of the value of each general partner s nonpartnership property, exclusive of property of the kind specified in subparagraph (A) (ii) of this paragraph, over such partner s nonpartnership debts; 1 The terms insolvent and bankrupt often are used as interchangeable adjectives. Such usage is technically incorrect; insolvent refers to the financial condition of a person or business enterprise, and bankrupt refers to a legal state. In this chapter, various legal and accounting issues associated with bankruptcy liquidations and reorganizations are discussed and illustrated. THE BANKRUPTCY CODE The U.S. Constitution (Article 1, Section 8) authorizes Congress to establish uniform laws on the subject of bankruptcies throughout the United States. For the first 89 years under the Constitution, the United States had a national bankruptcy law for a total of only 16 years. During the periods in which national bankruptcy laws were not in effect, state laws on insolvency prevailed. In 1898 a Bankruptcy Act was enacted that, as amended, remained in effect for 80 years. Enactment of the Bankruptcy Act caused state laws on insolvency to be relatively dormant. In 1978 the Bankruptcy Reform Act established the present Bankruptcy Code; in 1980 the Bankruptcy Tax Act established a uniform group of income tax rules for bankruptcy and insolvency; and in 1994 the Bankruptcy Code was amended by the Bankruptcy Reform Act of 1994. The U.S. Supreme Court may prescribe by general rules the various legal practices and procedures under the Bankruptcy Code. Thus, the Federal Rules of Bankruptcy Procedure established by the Supreme Court constitute important interpretations of provisions of the Bankruptcy Code. BANKRUPTCY LIQUIDATION The process of bankruptcy liquidation under Chapter 7 of the Bankruptcy Code involves the realization (sale) of the assets of an individual or a business enterprise and the distribution of the cash proceeds to the creditors of the individual or enterprise. Creditors having security interests collateralized by specific assets of the debtor generally are entitled to obtain satisfaction of all or part of their claims from the assets pledged as collateral. The Bankruptcy Code provides for priority treatment for certain unsecured creditors; their claims are satisfied in full, if possible, from proceeds of realization of the debtor s noncollateralized assets. Unsecured creditors without priority receive cash, in proportion to the amounts of their claims, from proceeds available from the realization of the debtor s assets. Thus, there are four classes of creditors in a bankruptcy liquidation: fully secured creditors, partially secured creditors, unsecured creditors with priority, and unsecured creditors without priority. Debtor s (Voluntary) Petition The Bankruptcy Code provides that any person, except certain entities such as a railroad, an insurance company, a bank, a credit union, or a savings and loan association, 1 Bankruptcy Code, sec. 101 (32).

Chapter 14 Bankruptcy: Liquidation 609 may file a petition in a federal bankruptcy court for voluntary liquidation under Chapter 7 of the Code. The official form for a debtor s bankruptcy petition, also known as a voluntary petition, must be accompanied by supporting exhibits of the petitioner s debts and property. The debts are classified as follows: (1) creditors having priority; (2) creditors holding security; and (3) creditors having unsecured claims without priority. The debtor s property is reported as follows: real property, personal property, and property claimed as exempt. Valuations of property are at market or current fair values. Also accompanying the debtor s bankruptcy petition is a statement of financial affairs (not to be confused with the accounting statement of affairs illustrated on page 614 of this chapter), which contains a series of questions concerning all aspects of the debtor s financial condition and operations. Creditors (Involuntary) Petition If a debtor other than a farmer, a nonprofit organization, or one of the types precluded from filing voluntary petitions owes unpaid amounts to 12 or more unsecured creditors who are not employees, relatives, stockholders, or other insiders, three or more of the creditors having unsecured claims totaling $10,000 or more may file in a federal bankruptcy court a creditors petition for bankruptcy, also known as an involuntary petition. If fewer than 12 creditors are involved, one or more creditors having unsecured claims of $10,000 or more may file the petition. The creditors petition for bankruptcy must claim either (1) the debtor is not paying debts as they come due or (2) within 120 days prior to the date of the petition, a custodian was appointed for or had taken possession of the debtor s property. Unsecured Creditors with Priority The Bankruptcy Code provides that the following unsecured debts are to be paid in full, in the order specified if adequate cash is not available for all, out of a debtor s estate before any cash is paid to other unsecured creditors: 1. Administrative costs. 2. Claims arising in the course of the debtor s business or financial affairs after the commencement of a creditors bankruptcy proceeding but before appointment of a trustee or order for relief. 3. Claims for wages, salaries, and commissions, including vacation, severance, and sick leave pay not in excess of $4,000 per claimant, earned within 90 days before the date of filing the petition for bankruptcy or cessation of the debtor s business. 4. Claims for contributions to employee benefit plans arising within 180 days before the date of filing the petition for bankruptcy or cessation of the debtor s business. The limit of such claims is $4,000 times the number of employees covered by the plans, less the aggregate amount paid to the covered employees under priority 3 above. 5. Claims by producers of grain against a grain storage facility or by fishermen against a fish storage or processing facility, not in excess of $4,000 per claimant. 6. Claims for cash deposited for goods or services for the personal, family, or household use of the depositor, not in excess of $1,800 per claimant. 7. Claims for alimony, maintenance, or support of a spouse, former spouse, or child of the debtor, under a separation agreement, divorce decree, or court order. 8. Claims of governmental entities for various taxes or duties, subject to varying time limitations.

610 Part Four Accounting for Property Claimed as Exempt Certain property of a bankruptcy petitioner is not includable in the debtor s estate. The Bankruptcy Code excludes from coverage of the Code the various allowances provided in the laws of either the United States or the state of the debtor s residence, whichever is more beneficial to the debtor. Typical of these allowances are residential property exemptions provided by homestead laws and exemptions for life insurance policies payable on death to the spouse or a relative of the debtor. (Bills introduced in Congress in 2001 would modify these allowances.) Role of Court in Liquidation The federal bankruptcy court in which a debtor s or creditors petition for bankruptcy liquidation is filed oversees all aspects of the bankruptcy proceedings. One of the first acts of the court is either to dismiss the debtor s or creditors bankruptcy petition or to grant an order for relief under the Bankruptcy Code. The filing of a debtor s petition in bankruptcy is in effect an order for relief; in a creditors petition, order for relief is made by the court after a hearing at which the debtor may attempt to refute the creditors allegations that the debtor was not paying debts as they came due. Any suits that are pending against a debtor for whom a debtor s or creditors bankruptcy petition is filed generally are stayed until order for relief or dismissal of the petition; after order for relief such suits are further stayed until the question of the debtor s discharge is determined by the court. Further, the court appoints an interim trustee after the order for relief, to serve permanently or until a trustee is elected by the creditors. Role of Creditors Within a period of 10 to 30 days after an order for relief, the bankruptcy court must call a meeting of the creditors. At the meeting, the outsider creditors appoint a trustee to manage the debtor s estate. A majority vote in number and amount of claims of all unsecured and nonpriority creditors present is required for actions by creditors. Role of Trustee The trustee elected by the creditors or appointed by the court assumes custody of the debtor s nonexempt property. The principal duties of the trustee are to continue operating the debtor s business if directed by the court, realize the free assets of the debtor s estate, and pay cash to unsecured creditors. The trustee is responsible for keeping accounting records to enable the filing of a final report with the bankruptcy court. The Bankruptcy Code empowers the trustee to invalidate a preference, defined as the transfer of cash or property to an outsider creditor for an existing debt, made while the debtor was insolvent and within 90 days of filing of the bankruptcy petition, provided the transfer caused the creditor to receive more cash or property than would be received in the bankruptcy liquidation. The trustee may recover from the creditor the cash or property constituting the preference and include it in the debtor s estate. Discharge of Debtor Once the debtor s property has been liquidated, all secured and priority creditor claims have been paid, and all remaining cash has been paid to unsecured, nonpriority creditors, the

Chapter 14 Bankruptcy: Liquidation 611 debtor may receive a discharge, defined as the release of the debtor from all unliquidated debts except debts such as the following: 1. Taxes payable by the debtor to the United States or to any state or subdivision, including taxes attributable to improper preparation of tax returns by the debtor. 2. Debts resulting from the debtor s obtaining money or property under false pretenses or representations, or willful conversion of the property of others. 3. Debts not scheduled by the debtor in support of the bankruptcy petition, such creditors not being informed of the bankruptcy proceedings. 4. Debts arising from embezzlement or other fraudulent acts by the debtor acting in a fiduciary capacity. 5. Amounts payable for alimony, maintenance, or child support. 6. Debts for willful and malicious injuries to the persons or property of others. 7. Debts for fines, penalties, or forfeitures payable to governmental entities, other than for tax penalties. 8. With certain exceptions, debts for educational loans made, insured, or guaranteed by governmental entities or by nonprofit universities or colleges. (In 1997, a National Bankruptcy Review Commission recommended discharge of educational loans other than for medical schools.) A debtor will not be discharged if any crimes, misstatements, or other malicious acts were committed by the debtor in connection with the court proceedings. In addition, a debtor will not be discharged if the current bankruptcy petition was filed within six years of a previous bankruptcy discharge to the same debtor. Role of Accountant in Bankruptcy Liquidation The accountant s role in liquidation proceedings is concerned with proper reporting of the financial condition of the debtor and adequate accounting and reporting for the trustee for the debtor s estate, as described in the following sections. Financial Condition of Debtor Enterprise: The Statement of Affairs A business enterprise that enters bankruptcy liquidation proceedings is a quitting concern, not a going concern. Consequently, a balance sheet, which reports the financial position of a going concern, is inappropriate for an enterprise in liquidation. The financial statement designed for a business enterprise entering liquidation is the statement of affairs (not to be confused with the legal bankruptcy form with a similar title described on page 609). The purpose of the statement of affairs is to display the assets and liabilities of the debtor enterprise from a liquidation viewpoint, because liquidation is the outcome of the Chapter 7 bankruptcy proceedings. Thus, assets displayed in the statement of affairs are valued at current fair values; carrying amounts of the assets are presented on a memorandum basis. In addition, assets and liabilities in the statement of affairs are classified according to the rankings and priorities set forth in the Bankruptcy Code; the current/noncurrent classification used in a balance sheet for a going concern is not appropriate for the statement of affairs. Illustration of Statement of Affairs The balance sheet of Sanders Company on June 30, 2006, the date that Sanders filed a debtor s (voluntary) bankruptcy petition, is as follows:

612 Part Four Accounting for SANDERS COMPANY Balance Sheet (prior to filing of debtor s bankruptcy petition) June 30, 2006 Assets Current assets: Cash $ 2,700 Notes receivable and accrued interest, less allowance for doubtful notes, $6,000 13,300 Trade accounts receivable, less allowance for doubtful accounts, $23,240 16,110 Inventories, at first-in, first-out cost: Finished goods 12,000 Goods in process 35,100 Material 19,600 Factory supplies 6,450 Short-term prepayments 950 Total current assets $106,210 Plant assets, at cost: Land $ 20,000 Buildings (net) 41,250 Machinery (net) 48,800 Tools (net) 14,700 Net plant assets 124,750 Total assets $230,960 Liabilities and Stockholders Equity Current liabilities: Notes payable: Pacific National Bank, including accrued interest (due June 30, 2007) $ 15,300 Suppliers, including accrued interest (due May 31, 2007) 51,250 Trade accounts payable 52,000 Salaries and wages payable 8,850 Property taxes payable 2,900 Interest payable on first mortgage bonds 1,800 FICA and income taxes withheld and accrued 1,750 Total current liabilities $133,850 First mortgage bonds payable 90,000 Total liabilities $223,850 Stockholders equity: Common stock, $100 par; 750 shares authorized, issued, and outstanding $ 75,000 Deficit (67,890) 7,110 Total liabilities and stockholders equity $230,960

Chapter 14 Bankruptcy: Liquidation 613 Other information available from notes to financial statements and from estimates of current fair values of assets follows: 1. Notes receivable with a face amount plus accrued interest totaling $15,300, and a current fair value of $13,300, collateralize the notes payable to Pacific National Bank. 2. Finished goods are expected to be sold at a markup of 33 1 3% over cost, with disposal costs estimated at 20% of selling prices. Estimated cost to complete goods in process is $15,400, of which $3,700 would be cost of material and factory supplies used. The estimated selling price of goods in process when completed is $40,000, with disposal costs estimated at 20% of selling prices. Estimated current fair values for material and factory supplies not required to complete goods in process are $8,000 and $1,000, respectively. All short-term prepayments are expected to be consumed in the course of liquidation. 3. Land and buildings, which collateralize the first mortgage bonds payable, have a current fair value of $95,000. Machinery with a carrying amount of $18,200 and current fair value of $10,000 collateralizes notes payable to suppliers in the amount of $12,000, including accrued interest. The current fair value of the remaining machinery is $9,000, net of disposal costs of $1,000, and the current fair value of tools after the amounts used to complete the goods in process inventory is $3,255. 4. Salaries and wages payable are debts having priority under the Bankruptcy Code. 5. Costs of administering the bankruptcy liquidation are estimated at $1,905. The statement of affairs for Sanders Company on June 30, 2006, is as shown on page 614. The following points should be stressed in the review of the June 30, 2006, statement of affairs for Sanders Company: 1. The Carrying Amount columns in the statement of affairs serve as a tie-in to the balance sheet of Sanders on June 30, 2006, as well as a basis for estimating expected losses or gains on realization of assets. 2. Assets are assigned to one of three groups: pledged for fully secured liabilities, pledged for partially secured liabilities, and free. This grouping of assets facilitates the computation of estimated amounts available for unsecured creditors those with priority and those without priority. 3. Liabilities are grouped in the categories reported by a debtor in the exhibits supporting a debtor s bankruptcy petition (see pages 608 609): unsecured with priority, fully secured, partially secured, and unsecured without priority. 4. An offset technique used where the legal right of setoff exists. For example, amounts due to fully secured creditors are deducted from the estimated current fair value of the assets serving as collateral; and unsecured liabilities with priority are deducted from estimated amounts available to unsecured creditors from the proceeds of free asset realization. 5. An estimated settlement per dollar of unsecured liabilities without priority is computed by dividing the estimated amount available for unsecured, nonpriority creditors by the total unsecured liabilities, thus: $60,960 64 cents on the dollar $95,250 This computation enables the bankruptcy trustee to estimate the amount of cash that will be available to unsecured, nonpriority creditors in a liquidation proceeding.

614 Part Four Accounting for SANDERS COMPANY Statement of Affairs June 30, 2006 Current Estimated Loss or Carrying Fair Amount (Gain) on Carrying Amount Amounts Assets Values Available Realization Amounts Liabilities and Stockholders Equity Unsecured Assets Pledged for Fully Unsecured Liabilities with Priority: Secured Liabilities: Estimated administrative costs $ 1,905 $ 20,000 Land f $95,000 $(33,750) $ 8,850 Salaries and wages payable 8,850 41,250 Buildings 2,900 Property taxes payable 2,900 Less: Fully secured liabilities 1,750 FICA and income taxes withheld and accrued 1,750 (contra) 91,800 $ 3,200 Total (deducted contra) $15,405 Assets Pledged for Partially Fully Secured Liabilities: Secured Liabilities: 90,000 First mortgage bonds payable $90,000 13,300 Notes and interest receivable 1,800 Accrued interest on first mortgage bonds (deducted contra) $13,300 payable 1,800 18,200 Machinery (deducted contra) $10,000 8,200 Total (deducted contra) $91,800 Free Assets: Partially Secured Liabilities: 2,700 Cash $ 2,700 2,700 15,300 Notes and accrued interest payable to Pacific 16,110 Trade accounts receivable 16,110 16,110 National Bank $15,300 Inventories: Less: Net realizable value of notes receivable 12,000 Finished goods 12,800 12,800 (800) pledged as collateral (contra) 13,300 $ 2,000 35,100 Goods in process 20,300* 20,300* 14,800 12,000 Notes and accrued interest payable to 19,600 Material 8,000 8,000 11,600 suppliers $12,000 6,450 Factory supplies 1,000 1,000 5,450 Less: Estimated realizable value of machinery 950 Short-term prepayments -0- -0-950 pledged as collateral (contra) 10,000 2,000 30,600 Machinery 9,000 9,000 21,600 14,700 Tools 3,255 3,255 11,445 Unsecured Liabilities without Priority: Total estimated amount available $76,365 $ 39,495 39,250 Notes payable to suppliers 39,250 Less: Unsecured liabilities with priority (contra) 15,405 52,000 Trade accounts payable 52,000 Estimated amount available for unsecured, 7,110 Stockholders equity nonpriority creditors (64 on the dollar) $60,960 Estimated deficiency to unsecured, nonpriority creditors (36 on the dollar) 34,290 $230,960 $95,250 $230,960 $95,250 *Estimated selling price $ 40,000 Less: Estimated out-of-pocket completion costs ($15,400 $3,700) (11,700) Estimated disposal costs ($40,000 0.20) (8,000) Net realizable value $ 20,300

Chapter 14 Bankruptcy: Liquidation 615 Estimated Amounts to Be Recovered by Each Class of Creditors By reference to the statement of affairs on page 614, the accountant for the trustee in bankruptcy for Sanders Company may prepare the summary of estimated amounts to be recovered by each class of Sanders s creditors shown below: SANDERS COMPANY Estimated Amounts to Be Recovered by Creditors June 30, 2006 Estimated Class of Creditors Total Claims Computation Recovery Unsecured with priority $ 15,405 100% $ 15,405 Fully secured 91,800 100% 91,800 Partially secured 27,300 $23,300 ($4,000 0.64) 25,860 Unsecured without priority 91,250 64% 58,400 Totals $225,755* $191,465 *$15,405 $91,800 $15,300 $12,000 $39,250 $52,000 $225,755. $95,000 $13,300 $10,000 ($76,365 $3,200) $191,465. Accounting and Reporting for Trustee Traditionally, the accounting records and reports for trustees have been extremely detailed and elaborate. However, the provisions of the applicable Federal Rule of Bankruptcy Procedure are general. Therefore, simple accounting records and reports such as the following should be adequate. 1. The accounting records of the debtor should be used during the period that a trustee carries on the operations of the debtor s business. 2. An accountability technique should be used once the trustee begins realization of the debtor s assets. In the accountability method of accounting, the assets and liabilities for which the trustee is responsible are entered in the accounting records of the trustee at their statement of affairs valuations, with a balancing debit to a memorandum-type ledger account with a title such as Estate Deficit. The amount of the debit to Estate Deficit is equal to the estimated deficiency to unsecured creditors reported in the statement of affairs. Appropriate cash receipts and cash payments journal entries are made for the trustee s realization of assets and payment of liabilities. No gain or loss ledger account is necessary because a business enterprise in liquidation does not require an income statement. Differences between cash amounts realized or paid and carrying amounts of the related assets or liabilities are debited or credited to the Estate Deficit ledger account. 3. The interim and final reports of the trustee to the bankruptcy court are a statement of cash receipts and cash payments, a statement of realization and liquidation, and, for interim reports, supporting exhibits of assets not yet realized and liabilities not yet liquidated. Illustration of Accountability Technique Assume that Arline Wells, the trustee in the voluntary bankruptcy liquidation proceedings for Sanders Company (see page 612), took custody of the assets of Sanders on

616 Part Four Accounting for June 30, 2006. The accountant for the trustee prepared the following journal entry on June 30, 2006. Journal Entry for Bankruptcy Trustee SANDERS COMPANY, IN BANKRUPTCY Arline Wells, Trustee Journal Entry June 30, 2006 Cash 2,700 Notes and Interest Receivable 13,300 Trade Accounts Receivable 16,110 Finished Goods Inventory 12,800 Goods in Process Inventory 20,300 Material Inventory 8,000 Factory Supplies 1,000 Land and Buildings 95,000 Machinery ($10,000 $9,000) 19,000 Tools 3,255 Estate Deficit 34,290 (1) Estimated Administrative Costs 1,905 Notes and Interest Payable ($15,300 $12,000 $39,250) 66,550 Trade Accounts Payable 52,000 Salaries and Wages Payable 8,850 Property Taxes Payable 2,900 FICA and Income Taxes Withheld and Accrued 1,750 Interest Payable on First Mortgage Bonds 1,800 First Mortgage Bonds Payable 90,000 To record current fair values of assets and liabilities of Sanders Company, in bankruptcy liquidation proceedings. (1) Equal to estimated deficiency to unsecured, nonpriority creditors in the statement of affairs on page 614. When the trustee realizes assets of Sanders, the appropriate journal entry is a debit to Cash, credits to the asset ledger accounts, and a debit or credit to the Estate Deficit account for a loss or gain on realization, respectively. Costs of administering the estate that exceed the $1,905 liability also are debited to the Estate Deficit ledger account. Statement of Realization and Liquidation The traditional statement of realization and liquidation was a complex and not too readable accounting presentation. A form of realization and liquidation statement that should be more useful to the bankruptcy court than the traditional statement is as follows. This financial statement is based on the assumed activities of the trustee for the estate of Sanders Company during the month of July 2006, including operating the business long enough to complete and sell the goods in process inventory.

Chapter 14 Bankruptcy: Liquidation 617 Interim Statement of Realization and Liquidation for Trustee in Bankruptcy Liquidation SANDERS COMPANY, IN BANKRUPTCY Arline Wells, Trustee Statement of Realization and Liquidation For Month Ended July 31, 2006 Estate deficit, June 30, 2006 $34,290 Assets realized: Current Fair Values, Realization Loss or June 30, 2006 Proceeds (Gain) Trade accounts receivable $14,620 $12,807 $ 1,813 Finished goods inventory 12,800 11,772 1,028 Goods in process inventory 14,820 15,075 (255) Totals $42,240 $39,654 2,586 Liabilities with priority liquidated at carrying amounts: Salaries and wages payable $ 8,850 Property taxes payable 2,900 FICA and income taxes withheld and accrued 1,750 Total liabilities with priority liquidated $13,500 Administrative costs paid, $1,867 ($1,905 had been estimated) (38) Estate deficit, July 31, 2006 $36,838 An accompanying statement of cash receipts and cash payments for the month ended July 31, 2006, would show the sources of the $39,654 total realization proceeds, and the dates, check numbers, payees, and amounts of the $13,500 paid for liabilities with priority and the $1,867 paid for administrative costs. Supporting exhibits would summarize assets not yet realized and liabilities not yet paid. Liquidation involves realization of the assets of the debtor s estate. In many cases, an insolvent debtor may be restored to a sound financial footing if it can defer payment of its debts. Chapter 11 of the Bankruptcy Code, dealing with reorganization, enables a debtor to continue operations under court protection from creditor lawsuits while it formulates a plan to pay its debts. Reorganization is discussed in the next section. BANKRUPTCY REORGANIZATION Chapter 11 of the Bankruptcy Code provides for the court-supervised reorganization of a debtor business enterprise. Typically, a reorganization involves the reduction of amounts payable to some creditors, other creditors acceptance of equity securities of the debtor for their claims, and a revision of the par or stated value of the common stock of the debtor. A debtor s (voluntary) petition for reorganization may be filed by a railroad or by any person eligible to petition for liquidation (see pages 608 609) except a stockbroker or a commodity broker. Requirements for a creditors (involuntary) petition for reorganization are the same as the requirements for a liquidation petition (see page 609).

618 Part Four Accounting for Appointment of Trustee or Examiner During the process of reorganization, management or owners of the business enterprise may continue to operate the enterprise as debtor in possession. Alternatively, the bankruptcy court may appoint a trustee to manage the enterprise. A trustee is appointed because of fraud, dishonesty, incompetence, or gross mismanagement by current owners or managers, or to protect the interests of creditors or stockholders of the enterprise. In some reorganization cases not involving a trustee, the court may appoint an examiner to investigate possible fraud or mismanagement by the current managers or owners of the enterprise; the appointment of an examiner is limited to enterprises having unsecured liabilities, other than payables for goods, services, or taxes, exceeding $5 million. Among the powers and duties of the trustee are the following: 1. Prepare and file in court a list of creditors of each class and their claims and a list of stockholders of each class. 2. Investigate the acts, conduct, property, liabilities, and business operations of the enterprise, consider the desirability of continuing operations, and formulate a plan for such continuance for submission to the bankruptcy judge if management of the debtor has not done so. 3. Report to the bankruptcy judge any facts ascertained as to fraud against or mismanagement of the debtor enterprise. Plan of Reorganization The plan of reorganization submitted by the management or the trustee to the bankruptcy court is given to the debtor enterprise s creditors and stockholders, to the U.S. Secretary of the Treasury, and possibly to the SEC. The plan must include provisions altering or modifying the interests and rights of the creditors and stockholders of the debtor enterprise, as well as a number of additional provisions. The SEC may review the plan and may be heard in the bankruptcy court s consideration of the plan. Before a plan of reorganization is confirmed by the bankruptcy court, the plan must be accepted by a majority of the creditors, whose claims must account for two-thirds of the total liabilities, and by stockholders owning at least two-thirds of the outstanding capital stock of each class. If one or more classes of stockholders or creditors has not accepted a plan, the bankruptcy court may confirm the plan if the plan is fair and equitable to the nonacceptors. Confirmation of the plan of reorganization by the bankruptcy court makes the plan binding on the debtor enterprise, on all creditors and owners of the enterprise, and on any other enterprise issuing securities or acquiring property under the plan. Accounting for a Reorganization The accounting for a reorganization typically requires journal entries for adjustments of carrying amounts of assets; reductions of par or stated value of capital stock (with recognition of resultant paid-in capital in excess of par or stated value); extensions of due dates and revisions of interest rates of notes payable; exchanges of equity securities for debt securities; and the elimination of a retained earnings deficit. The latter entry is associated with fresh start reporting for a reorganized enterprise whose liabilities exceed the reorganization value (essentially current fair value) of its assets. 2 Because of 2 Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code (New York: AICPA, 1990), par. 36.

Chapter 14 Bankruptcy: Liquidation 619 changes in the ownership of common stock of such an enterprise as a result of the reorganization, it is no longer controlled by its former stockholder group, and it essentially is a new reporting enterprise whose assets and liabilities should be valued at current fair values and whose stockholders equity consists only of paid-in capital. 3 It is important for accountants to be thoroughly familiar with the plan of reorganization, in order to account properly for its implementation. Accountants must be careful to avoid charging post-reorganization operations with losses that arose before the reorganization. To illustrate the accounting for a reorganization, assume that Sanders Company (see pages 611 615) filed a petition for reorganization, rather than for liquidation, on June 30, 2006, with Sanders management as debtor in possession. The plan of reorganization, which was approved by stockholders and all unsecured creditors and confirmed by the bankruptcy court, included the following: 1. Deposit $25,000 with escrow agent, as soon as cash becomes available, to cover liabilities with priority and costs of reorganization proceedings. 2. Amend articles of incorporation to provide for 10,000 shares of authorized common stock of $1 par. The new common stock is to be exchanged on a share-for-share basis for the 750 shares of outstanding $100 par common stock. 3. Extend due date of unsecured notes payable to suppliers totaling $15,250 for four years, until May 31, 2011. Increase the interest rate on the notes from the stated rate of 14% to 18%, the current fair rate of interest. 4. Exchange 1,600 shares of new $1 par common stock (at current fair value of $15 a share) for unsecured notes payable to suppliers totaling $24,000. 5. Pay suppliers 70 cents per dollar of trade accounts payable owed. The journal entries below and on page 620, numbered to correspond with the provisions of the reorganization plan outlined above, were recorded by Sanders Company as cash became available from operations. Assuming that fresh start reporting is appropriate for Sanders Company after the plan of reorganization has been carried out, the last journal entry on page 620 is appropriate for eliminating the $67,890 retained earnings deficit of Sanders on June 30, 2006. Journal Entries for Bankruptcy Reorganization SANDERS COMPANY Journal Entries (1) Cash with Escrow Agent 25,000 Cash 25,000 To record deposit of cash with escrow agent under terms of bankruptcy reorganization. Salaries and Wages Payable 8,850 Property Taxes Payable 2,900 FICA and Income Taxes Withheld and Accrued 1,750 Cash with Escrow Agent 13,500 To record escrow agent s payment of liabilities with priority. (continued) 3 Ibid., par. 39.

620 Part Four Accounting for SANDERS COMPANY Journal Entries (concluded) Costs of Bankruptcy Proceedings 11,000 Cash with Escrow Agent 11,000 To record escrow agent s payment of costs of bankruptcy proceedings. (2) Common Stock, $100 par 75,000 Common Stock, $1 par 750 Paid-in Capital in Excess of Par 74,250 To record issuance of 750 shares of $1 par common stock in exchange for 750 shares of $100 par common stock. (3) 14% Notes Payable to Suppliers, due May 31, 2007 15,250 18% Notes Payable to Suppliers, due May 31, 2011 15,250 To record extension of due dates of notes payable to suppliers and increase of interest rate to 18% from 14%. (4) Notes Payable to Suppliers 24,000 Common Stock, $1 par 1,600 Paid-in Capital in Excess of Par 22,400 To record exchange of 1,600 shares of $1 par common stock for $24,000 face amount of notes payable, at current fair value of $15 a share. (5) Trade Accounts Payable 52,000 Cash 36,400 Gain from Discharge of Indebtedness in Bankruptcy 15,600 To record payment of $0.70 per dollar of accounts payable to suppliers. Journal Entry to Eliminate Deficit Paid-in Capital in Excess of Par 63,290 Gain from Discharge of Indebtedness in Bankruptcy 15,600 Costs of Bankruptcy Proceedings 11,000 Retained Earnings 67,890 To eliminate deficit on June 30, 2006, and close bankruptcy gain and costs to Paid-in Capital in Excess of Par ledger account. The effect of the foregoing journal entries is to show a clean slate for Sanders Company as a result of the approved bankruptcy reorganization and the write-off of the retained earnings deficit existing on the date of the petition for reorganization. The extension of due dates of some liabilities, conversion of other liabilities to common stock, and liquidation of trade accounts payable at less than their face amount should enable Sanders to resume operations as a going concern. For a reasonable number of years following the reorganization, Sanders might date the retained earnings in its balance sheets to disclose that the earnings were accumulated after the reorganization. Disclosure of Reorganization The elaborate and often complex issues involved in a bankruptcy reorganization are disclosed in a note to the financial statements for the period in which the plan of reorganization was carried out. Examples of recent such disclosures are included in the AICPA s 1994 publication Illustrations of Financial Reporting by Entities in Reorganization under the

Chapter 14 Bankruptcy: Liquidation 621 Bankruptcy Code. In addition, the Summary of Significant Accounting Policies note to financial statements of a reorganized enterprise might include disclosures such as the following for Wang Laboratories, Inc., a publicly owned enterprise: Bankruptcy-Related Accounting The Company has accounted for all transactions related to the Chapter 11 case in accordance with Statement of Position 90-7 ( SOP 90-7 ), Financial Reporting by Entities in Reorganization under the Bankruptcy Code, which was issued by the American Institute of Certified Public Accountants in November 1990. Accordingly, liabilities subject to compromise under the Chapter 11 case have been segregated on the Consolidated Balance Sheet and are recorded for the amounts that have been or are expected to be allowed on known claims rather than estimates of the amounts those claims are to receive under the Reorganization Plan. In addition, the Consolidated Statements of Operations and Consolidated Statements of Cash Flows for the year ended June 30, 1993 separately disclose expenses and cash transactions, respectively, related to the Chapter 11 case (see Note C, Reorganization and Restructuring). In accordance with SOP 90-7, no interest has been accrued on pre-petition, unsecured debt. Additionally, interest income earned by WLI subsequent to the filing of Chapter 11 is reported as a reduction of reorganization items. The reorganized Company will account for the Reorganization Plan utilizing the Fresh-Start reporting principles contained in SOP 90-7. 4 Review Questions 1. Define insolvency as that term is used in the Bankruptcy Code for an entity other than a partnership. 2. What are Federal Rules of Bankruptcy Procedure? 3. Identify the various classes of creditors whose claims are dealt with in bankruptcy liquidations. 4. Describe the process of liquidation under Chapter 7 of the Bankruptcy Code. 5. Differentiate between a debtor s petition and a creditors petition. 6. May any business enterprise file a debtor s bankruptcy petition for liquidation? Explain. 7. Who may file a creditors petition for bankruptcy liquidation? 8. What is a statement of financial affairs under the Bankruptcy Code? 9. List the unsecured debts having priority over other unsecured debts under the provisions of the Bankruptcy Code. 10. Describe the priority of claims for wages and salaries under the Bankruptcy Code. 11. Describe the authority of a bankruptcy trustee with respect to a preference. 12. What are the effects of a discharge in bankruptcy liquidation proceedings? Explain. 13. What use is made of the accounting financial statement known as a statement of affairs? Explain. 14. Describe the accountability method of accounting used by a trustee in a bankruptcy liquidation. 15. For what types of bankruptcy reorganizations might an examiner be appointed by the bankruptcy court? 16. What is the role of the Securities and Exchange Commission in a bankruptcy reorganization? 4 AICPA, Accounting Trends & Techniques, 48th ed. (New York: 1994), p. 35.

622 Part Four Accounting for 17. Must all classes of creditors accept a reorganization plan before the plan may be confirmed by the bankruptcy court? Explain. 18. What is fresh-start reporting for a business enterprise reorganized under Chapter 11 of the Bankruptcy Code, and under what circumstances is it appropriate? Exercises (Exercise 14.1) Select the best answer for each of the following multiple-choice questions: 1. A category of assets that typically has zero in the Estimated Amount Available column of a statement of affairs is: a. Factory supplies inventory b. Tools c. Short-term prepayments d. None of the foregoing 2. In a bankruptcy proceeding, the term statement of affairs refers to: a. A document containing a series of questions concerning all aspects of the debtor s financial condition and operations. b. A financial statement prepared in lieu of a balance sheet. c. Both a and b. d. Neither a nor b. 3. The number of classes of creditors in a bankruptcy liquidation is: a. Two b. Three c. Four d. Five 4. The Paid-in Capital in Excess of Par ledger account of a debtor corporation undergoing bankruptcy reorganization typically is debited or credited for: a. Costs of bankruptcy proceedings. b. Gain from discharge of indebtedness in bankruptcy. c. Retained earnings deficit. d. All the foregoing items. e. None of the foregoing items. 5. The bankruptcy trustee for Insolvent Company sold assets having a carrying amount of $10,000 for $8,500 cash. The journal entry (explanation omitted) to record the sale is: a. Cash 8,500 Loss on Realization of Assets 1,500 Assets 10,000 b. Cash 8,500 Estate Administration Expenses 1,500 Assets 10,000 c. Cash 8,500 Cost of Goods Sold 10,000 Sales 8,500 Assets 10,000

Chapter 14 Bankruptcy: Liquidation 623 d. Cash 8,500 Estate Deficit 1,500 Assets 10,000 6. In a statement of affairs (financial statement), assets pledged for partially secured liabilities are: a. Included with assets pledged for fully secured liabilities. b. Offset against partially secured liabilities. c. Included with free assets. d. Disregarded. 7. Regis Company is being liquidated in bankruptcy. Unsecured creditors without priority are expected to be paid 50 cents on the dollar. Sardo Company is the payee of a note receivable from Regis in the amount of $50,000 (including accrued interest), which is collateralized by machinery with a current fair value of $10,000. The total amount expected to be realized by Sardo on its note receivable from Regis is: a. $35,000 b. $30,000 c. $25,000 d. $10,000 e. Some other amount 8. In journal entries for a bankruptcy reorganization, the difference between the carrying amount of a liability of the debtor and the amount accepted by the creditor in full settlement of the liability is credited to: a. Retained Earnings (Deficit). b. Paid-in Capital in Excess of Par or Stated Value. c. Paid-in Capital from Reorganization. d. Cash with Escrow Agent. e. Some other ledger account. 9. With respect to the terms bankrupt and insolvent as adjectives: a. Bankrupt refers to a legal state; insolvent refers to the financial condition of a person or a business enterprise. b. Bankrupt refers to the financial condition of a person or a business enterprise; insolvent refers to a legal state. c. Both bankrupt and insolvent refer to the financial condition of a person or a business enterprise. d. Bankrupt and insolvent properly may be used as interchangeable adjectives. 10. The accounting records of a trustee in a bankruptcy liquidation are maintained: a. Under the accrual basis of accounting. b. Under the cost basis of accounting. c. Under an accountability technique. d. In accordance with the bankruptcy court s instructions. 11. Under the Bankruptcy Code, are creditors having priority: a. b. c. d. Secured Creditors? Yes Yes No No Unsecured Creditors? Yes No Yes No

624 Part Four Accounting for 12. The period of time that must elapse before a debtor that has had a previous bankruptcy discharge may again be discharged is: a. Four years b. Five years c. Six years d. Seven years 13. The sequence of listing (1) fully secured liabilities, (2) partially secured liabilities, (3) unsecured liabilities with priority, and (4) unsecured liabilities without priority in the liabilities and stockholders equity section of a statement of affairs is: a. (1), (2), (3), (4) b. (3), (1), (2), (4) c. (1), (3), (2), (4) d. (1), (3), (4), (2) 14. The following journal entry (explanation omitted) was prepared by an enterprise that had filed a debtor s petition in bankruptcy: Cash with Escrow Agent 100,000 Cash 100,000 Such a journal entry generally is related to: a. A liquidation only. b. A reorganization only. c. Either a liquidation or a reorganization. d. Neither a liquidation nor a reorganization. 15. The estimated amount available for free assets in a statement of affairs for a business enterprise undergoing bankruptcy liquidation is equal to the assets : a. Carrying amounts less current fair values. b. Carrying amounts plus gain or less loss on realization. c. Carrying amounts plus loss or less gain on realization. d. Current fair values less carrying amounts. 16. A retained earnings deficit of a business enterprise undergoing bankruptcy reorganization typically is eliminated by its: a. Offset against gain from discharge of indebtedness in bankruptcy. b. Inclusion with costs of bankruptcy proceedings. c. Offset against legal capital. d. Offset against additional paid-in capital. 17. On April 30, 2006, Carson Welles, trustee in bankruptcy liquidation for Lyle Company, paid $12,140 in full settlement of Lyle s liability under product warranty, which had been carried in Welles s accounting records at $10,000. The appropriate journal entry for Welles (explanation omitted) is: a. Liability under Product Warranty 12,140 Cash 12,140 b. Liability under Product Warranty 10,000 Estate Deficit 2,140 Cash 12,140 c. Liability under Product Warranty 10,000 Product Warranty Expense 2,140 Cash 12,140

Chapter 14 Bankruptcy: Liquidation 625 (Exercise 14.2) d. Liability under Product Warranty 10,000 Retained Earnings (Prior Period Adjustment) 2,140 Cash 12,140 The December 18, 2006, statement of affairs of Downside Company, which is in bankruptcy liquidation, included the following: CHECK FIGURE To partially secured liabilities, $48,000. Assets pledged for fully secured liabilities $100,000 Assets pledged for partially secured liabilities 40,000 Free assets 120,000 Fully secured liabilities 80,000 Partially secured liabilities 50,000 Unsecured liabilities with priority 60,000 Unsecured liabilities without priority 90,000 (Exercise 14.3) Prepare a working paper to show the estimated amount of assets expected to be received by each of the four classes of creditors of Downside Company in its bankruptcy liquidation. Amounts related to the statement of affairs of Foldup Company, in bankruptcy liquidation on April 30, 2006, were as follows: CHECK FIGURE Estimated deficiency, $100,000. Assets pledged for fully secured liabilities $ 80,000 Assets pledged for partially secured liabilities 50,000 Free assets 280,000 Fully secured liabilities 60,000 Partially secured liabilities 80,000 Unsecured liabilities with priority 40,000 Unsecured liabilities without priority 330,000 (Exercise 14.4) Prepare a working paper to compute the total estimated deficiency to unsecured, nonpriority creditors, and the cents per dollar that such creditors may expect to receive from Foldup Company. Data from the April 30, 2006, statement of affairs of Windup Company, which was undergoing bankruptcy liquidation, included the following: CHECK FIGURE To partially secured liabilities, $35,000. Assets pledged for fully secured liabilities $70,000 Assets pledged for partially secured liabilities 30,000 Free assets 50,000 Fully secured liabilities 60,000 Partially secured liabilities 40,000 Unsecured liabilities with priority 30,000 Unsecured liabilities without priority 50,000 Prepare a working paper to show how Windup Company s assets on April 30, 2006, are expected to be apportioned to Windup s creditors claims on that date.

626 Part Four Accounting for (Exercise 14.5) Components of the December 17, 2006, statement of affairs of Liquo Company, which was undergoing liquidation under Chapter 7 of the Bankruptcy Code, included the following: CHECK FIGURE To partially secured liabilities, $114,400. Assets pledged for fully secured liabilities, at current fair value $150,000 Assets pledged for partially secured liabilities, at current fair value 104,000 Free assets, at current fair value 80,000 Fully secured liabilities 60,000 Partially secured liabilities 120,000 Unsecured liabilities with priority 14,000 Unsecured liabilities without priority 224,000 (Exercise 14.6) Prepare a working paper dated December 17, 2006, to compute the amount expected to be paid to each class of creditors of Liquo Company. The following column headings are suggested: Class of Creditor, Total Claims, Computation, Estimated Amount. The total of the Estimated Amount column should equal total assets, $334,000. Scott Company filed a debtor s bankruptcy petition on June 25, 2006, and its statement of affairs included the following amounts: CHECK FIGURE Cash received by partially secured creditors, $84,000. Carrying Current Amounts Fair Values Assets Assets pledged for fully secured liabilities $160,000 $190,000 Assets pledged for partially secured liabilities 90,000 60,000 Free assets 200,000 140,000 Totals $450,000 $390,000 Liabilities Unsecured liabilities with priority $ 20,000 Fully secured liabilities 130,000 Partially secured liabilities 100,000 Unsecured liabilities without priority 260,000 Total $510,000 (Exercise 14.7) CHECK FIGURE Amount to Stark Company, $22,897. Assuming that Scott Company s assets realized cash at the current fair values and the business was liquidated by the bankruptcy trustee, prepare a working paper to compute the amount of cash that the partially secured creditors should receive. The statement of affairs for Wick Corporation shows that approximately 78 cents on the dollar probably will be paid to unsecured creditors without priority. Wick owes Stark Company $23,000 on a promissory note, plus accrued interest of $940. Inventories with a current fair value of $19,200 collateralize the note payable. Prepare a working paper to compute the amount that Stark Company should receive from the trustee of Wick Corporation, assuming that actual payments to unsecured creditors without priority amount to 78 cents on the dollar. Round all amounts to the nearest dollar.