advance accounting ch10

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InsolvencyInsolvency—Liquidation and Liquidation and ReorganizationReorganization

Advanced Accounting, Fifth Edition

1010

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1. Distinguish between a Chapter 7 and a Chapter 11 bankruptcy.

2. Describe the five priority categories of unsecured claims and list the order in which they are settled.

3. Distinguish between a voluntary and involuntary bankruptcy petition.

4. Distinguish among fully secured, partially secured, and unsecured claims of creditors.

5. Describe contractual agreements that the debtor and its creditors may enter into outside of formal bankruptcy proceedings to resolve the debtor’s insolvent position.

6. Describe the ways debt may be restructured in a reorganization.

Learning ObjectivesLearning Objectives

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InsolvencyInsolvency

When a business becomes insolvent, it generally has three possible courses of action:

1. Debtor and its creditors may enter into a contractual agreement, outside bankruptcy;

2. Debtor or its creditors may file a bankruptcy petition, after which the debtor is liquidated under Chapter 7 of the Bankruptcy Reform Act; or

3. Debtor or its creditors may file a petition for reorganization under Chapter 11 of the Bankruptcy Reform Act.

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True/False: Insolvency means that a debtor has more current liabilities than current assets.

Review:Review:

FalseFalse

InsolvencyInsolvency

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Contractual AgreementsContractual Agreements

LO 5 Contractual agreements.LO 5 Contractual agreements.

A business that is unable to pay its obligations may reach an accommodation with its creditors. Possibilities generally include:

1. An extension of payment periods.2. Composition agreements.3. Formation of a creditors’ committee.4. Voluntary assignment of assets.

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Extension of Payment Periods

FASB ASC paragraph 470-50-40-6Provides that where a debt restructuring involves only a modification of terms of payment, the debtor should account for the restructuring prospectively and not change the carrying amount of the payable, unless the carrying amount exceeds the total future cash payments of principal and interest specified by the new terms. No gain is recognized when the restructuring involves an extension of the payment period only.

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Composition Agreements (Creditors Accept Less Than Full Amount)Creditors are often given some immediate cash payment, and the amount of the remaining debts and their interest rates are renegotiated.

Formation of a Creditors’ CommitteeCommittee is responsible for managing the debtor’s business affairs for the period during which plans are developed to rehabilitate, reorganize, or liquidate the business.

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Voluntary Assignment of AssetsA debtor may elect to place its property under the control of a trustee for the benefit of its creditors. Any proceeds remaining after payment of the creditors, are returned to the debtor.

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BankruptcyBankruptcy

Provisions of the Bankruptcy Reform Act apply to individuals, corporations, and partnerships, as well as to municipalities seeking voluntary relief from their creditors.A business unable to pay its obligations, may attempt to negotiate with its creditors. If an agreement cannot be reached, a legal petition for bankruptcy will be initiated by either the

debtor (a voluntary petition) or its creditors (an involuntary petition).

LO 3 Voluntary vs. involuntary LO 3 Voluntary vs. involuntary petitions.petitions.

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Voluntary PetitionsA debtor may file a voluntary petition with a bankruptcy court for;

liquidation under Chapter 7 or for reorganization under Chapter 11.

Filing a voluntary petition constitutes an order for relief. The bankruptcy petition (either voluntary or involuntary) is an official form that initiates bankruptcy proceedings and establishes an estate consisting of the debtor’s assets.

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Involuntary PetitionsCreditors initiate the action by filing a petition for liquidation or reorganization with the bankruptcy court.The bankruptcy court will generally enter an order for relief against the debtor only if evidence indicates that the debtor, in fact, has not been paying its debts as they become due.

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LO 4 Secured and unsecured creditors.LO 4 Secured and unsecured creditors.

Secured and Unsecured CreditorsSecured creditors are those whose claims are secured by liens or pledges of specific assets. If the proceeds from the sale of a pledged asset(s) exceed the secured claim, the excess proceeds are available for distribution to unsecured creditors.

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True/ False: Voluntary bankruptcy petitions may be filed under either Chapter 7 or Chapter 11 of the Reform Act.

Review:Review:

TrueTrue



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True/ False: Unsecured creditors with priority will receive full satisfaction before secured creditors are paid.

Review:Review:

FalseFalse



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Liquidation (Chapter 7)Liquidation (Chapter 7)

A voluntary or involuntary petition for liquidation may be filed under Chapter 7 of the Reform Act. Upon filing, the bankruptcy court must decide whether to accept or dismiss the petition.

Dismissals occur infrequently. Debtor may dispute an involuntary petition. If accepted,

an order for relief is entered and the bankruptcy court will appoint an interim

trustee until a permanent trustee is selected.

LO 7 Chapter 1 versus Chapter 7.LO 7 Chapter 1 versus Chapter 7.

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Reorganization Under Reform Act Reorganization Under Reform Act (Chapter 11)(Chapter 11)

Creditors of an insolvent debtor may believe their interests would be served by rehabilitating or reorganizing the debtor. In such a case:

Creditors and debtor may agree to a plan for reorganization. orDebtor or creditors may prefer to file with the bankruptcy court a petition for reorganization under Chapter 11 of the Reform Act.


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Fresh Start Accounting and Quasi ReorganizationWhen firms emerge from bankruptcy, FASB ASC paragraph 852-10-45-19 to 20 provides for fresh start accounting.

Assets and liabilities are reported at fair values. Beginning retained earnings is reported at zero.

Two conditions must exist: Fair value of assets must be less than the post

liabilities and allowed claims, and Original owners must own less than 50% of the

voting stock after reorganization.

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Fresh Start Accounting and Quasi ReorganizationQuasi reorganizationPer FASB ASC 852- 10-45-20 three steps are required:

1. Authorization from creditors and stockholders is required.

2. All assets are revalued to fair values with losses recorded in retained earnings.

3. The deficit in retained earnings is eliminated by charging to (reducing) paid-in capital.

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Reorganization Under Reform Act Reorganization Under Reform Act (Chapter 11)(Chapter 11)Accounting for Reorganization – Troubled DebtDebt may be restructured in any one (or a combination) of the following methods:

1. The debtor may transfer assets in full settlement of the payable.

2. The debtor may give an equity interest in its firm in full settlement of the payable.

3. The creditor may modify terms of the payable.


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Transfer of AssetsA debtor that transfers assets to a creditor in full settlement of a payable recognizes a gain.The gain is measured by the excess of the carrying value of the payable over the fair value of the assets transferred.The difference between the fair value and the carrying amount of the assets transferred is a gain or loss and is reported as a component of net income for the period of transfer.

Accounting for Reorganization – Troubled Debt

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Grant of an Equity InterestA debtor that issues an equity interest in its firm to a creditor in full settlement of a payable shall account for the equity interest at its fair value. Difference between the fair value of the equity interest issued and the carrying amount of the payable is reported as a gain on restructuring. Debtor determines its gain based on undiscounted cash flows.


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Modification of TermsA debtor, in a troubled debt restructuring involving only modification of terms of a payable, accounts for the effects of the restructuring prospectively from the time of restructuring.The carrying value of the payable is not changed at the time of restructuring unless the carrying value exceeds the total future cash payments specified by the new terms.


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True/False: In a reorganization involving a transfer of assets, the debtor will recognize a gain on restructuring measured by the excess of the carrying value of the payable settled over the book value of the assets transferred.

Review:Review:

FalseFalse



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E10-3: Bar Company, which is in financial difficulty and in the process of a voluntary reorganization, has agreed to transfer to a creditor a copyright it owns in full settlement of a $150,000 note payable and $15,000 in accrued interest. The copyright, which originally cost $100,000, has an accumulated amortization balance of $55,000 and a current fair value of $95,000.Required:a. Prepare the journal entries on Bar Company’s books to record the transfer of the copyright.

Reorganization – Transfer of AssetsReorganization – Transfer of Assets


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Copyright 50,000 Gain on Transfer of Assets 50,000

Revalue copyright to fair value. $95,000 – ($100,000 - $55,000)

Notes Payable 150,000Accrued Interest Payable 15,000Accumulated Amortization – Copyright 55,000 Copyright ($100,000 + $50,000) 150,000Gain on Debt Restructuring 70,000

E10-3 a. Prepare the journal entries on Bar Company’s books to record the transfer of the copyright.



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The gain on transfer of assets ($50,000) should be reported as a separate component (assuming material in amount) of operating income; the gain on restructuring ($70,000) should also be reported as a separate component of operating income.

E10-3 b. Explain the proper treatment of any gain or loss recognized in (a).



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Loss on Transfer of Assets 15,000 Copyright 15,000

Revalue copyright to fair value. $30,000 – ($100,000 - $55,000)

Notes Payable 150,000Accrued Interest Payable 15,000Accumulated Amortization – Copyright55,000

Copyright ($100,000 - $15,000) 85,000Gain on Debt Restructuring ($165,000 - $30,000)135,000

E10-3 c. Assuming the fair value of the copyright was $30,000, repeat the requirement in (a).



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E10-4: Lake Company, a major creditor of financially troubled Spain Company, has agreed to modify the terms of a debt owed to Lake Company. The debt consists of a $900,000, 12% note that is due currently along with accrued interest of $95,000. Lake Company agreed to extend the due date of the note and accrued interest for three years and to reduce the interest rate to 5% per annum (on both maturity value and accrued interest), with interest to be paid annually.Required:a. Should a gain on restructuring be recognized by Spain Company? Explain.

Reorganization – Modification of TermsReorganization – Modification of Terms


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No gain should be recognized because the total future cash payments specified by the new terms of $1,144,250 ($995,000 carrying value plus 3 years’ interest at $49,750 per year) exceed the current carrying value of the debt, $995,000.

E10-4 a. Should a gain on restructuring be recognized by Spain Company? Explain.



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Note Payable 900,000Accrued Interest Payable 95,000

Restructured Debt 995,000

E10-4 b. Prepare the entry that should be made on Spain Company’s books on the date of restructure.



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True/ False: Restructuring gains that arise from troubled debt restructurings are reported by the debtor as extraordinary gains.

Review:Review:

FalseFalse



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A plan for reorganization must show that creditors will receive as much as if the debtor were liquidated.

The Statement of Affairs is an accounting report that is designed to permit the user to determine:

the total expected amounts that could be realized on the disposition of the assets,

the priorities in the use of the realization proceeds in satisfying claims, and

the potential net deficiency that would result if the assets were realized and claims liquidated.

The “Accounting” Statement of Affairs

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E10-7: Ball Company is facing bankruptcy proceedings. A balance sheet and other information are presented below:Ball Company Balance Sheet - June 30, 2012Cash 20,400$ Accounts payable 350,000$ Accounts receivable 170,000 Accured wages 120,000 Inventory 180,000 Notes payable 200,000 Property and Equipment, net 430,000 Common stock 400,000

Retained earnings (deficit) (269,600) 800,400$ 800,400$

Estimated realizable values:Accounts receivable 95,000$ Inventory 110,000 Property and Equipment, net 320,000

Accounts receivable and inventory are each pledged as security on individual notes payable in the amount of $100,000 each.

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Book Realizable DeficiencyValue Assets Value Account

(Loss) / GainAssets Pledged with Fully Secured Creditors:

180,000$ Inventory 110,000$ (70,000)$ Note Payable 100,000 10,000

Assets Pledged with Partially Secured Creditors:170,000 Accounts Receivable 95,000 (75,000)

Note Payable 100,000

Free Assets20,400 Cash 20,400

430,000 Property and Equipment 320,000 (110,000) Total Net Realizable Value 350,400 Liabilities having Priority – Wages 120,000 Net Free Assets 230,400

Estimated Deficiency to Unsecured Creditors 124,600 800,400$ 355,000$ (255,000)$

E10-7: Statement of Affairs

Reorganization Under Reform Act (Chapter 11)Reorganization Under Reform Act (Chapter 11)

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Book Realizable DeficiencyValue Equities Value Account

Liabilities Having Priority: (Loss) / Gain120,000$ Accrued Wages 120,000$

Fully Secured Creditors:100,000 Note Payable 100,000

Partially Secured Creditors:100,000 Note Payable 100,000

` 95,000 5,000

Unsecured Creditors:350,000 Accounts Payable 350,000

Stockholders’ Equity400,000 Common Stock 400,000

(269,600) Retained Earnings (deficit) (269,600) 800,400$ 355,000$ 130,400$

Estimated deficiency * (124,600)$

E10-7: Statement of Affairs


* ($255,000) loss - $130,400 gain = $124,600 deficiency

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Accounts Receivable 75,000$ Common Stock 400,000$ Inventory 70,000 Retained Earnings (269,600) Property and Equipment 110,000 Estimated Deficiency to

Unsecured Creditors 124,600 255,000$ 255,000$

BALL COMPANYDeficiency Account

Estimated Losses Estimated Gains

E10-7: Deficiency Account


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True/ False: The statement of affairs is a report designed to estimate the amount expected to be earned by a debtor company during the time period needed to complete a reorganization.

Review:Review:

FalseFalse



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Trustee Accounting and ReportingTrustee Accounting and Reporting


Trustee (appointed to assume responsibility of managing the debtor’s business while the reorganization plan is developed or the business is liquidated) takes title to the debtor’s assets and is accountable to the court, the creditors, and other parties for the subsequent utilization or realization of the assets.If new books are opened (frequently used approach):

Trustee records the assets at their book values. No existing liabilities are recorded by the

trustee. Payment of preexisting debts reduces the

assets.

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E10-9: TRX Company has been forced into receivership. The trustee has decided to open a new set of books to distinguish between transactions occurring before and after the appointment. The following account balances were reported on September 1, 2012:Cash 26,700$ Allowance for uncollectibles 16,000$

Accounts receivable 130,400 Accumulated depreciation 211,500 Inventory 191,900 Accounts payable 308,400 Property and Equipment, net 590,400 Capital stock 800,000

Retained earnings (deficit) (396,500) 939,400$ 939,400$

Required: Prepare journal entries to record the following on the trustee set of books.

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Cash 26,700Accounts Receivable (old) 130,400Inventory 191,900Property and Equipment 590,400

Allowance for Uncollectibles (old) 16,000Accumulated Depreciation 211,500TRX Company – in Receivership * 711,900

* ($939,400 – $16,000 - $211,500)

E10-9: Record the receipt of TRX Company assets.



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Cash 31,500Accounts Receivable (new) 264,500

Sales 296,000

E10-9: 1. Sales were made in the amount of $296,000, of which $31,500 were cash sales.



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E10-9: 2. Receivables were collected in the following amounts:

Old receivables $ 76,800 New receivables 242,200



Cash 319,000Accounts Receivable (old) 76,800Accounts Receivable (new) 242,200

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E10-9: 3. Additional inventory was purchased on account in the amount of $127,500.



Purchases 127,500Accounts Payable (new) 127,500

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E10-9: 4. Cash payments were made as follows:On old accounts payable $206,500On new accounts payable 61,600For operating expenses 46,000For trustee fees 13,000



TRX Company – in Receivership 206,500Accounts Payable (new) 61,600Operating Expenses 46,000Trustee Expenses 13,000

Cash 327,100

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E10-9: 5. Journal entries were made to record:a. Bad debt expense of $21,600, of which $8,600

related to new accounts receivable.



Bad Debt Expense 21,600 Allowance for Uncollectibles (old) 13,000 Allowance for Uncollectibles (new) 8,600

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E10-9: 5. Journal entries were made to record:a. Bad debt expense of $21,600, of which $8,600

related to new accounts receivable.b. Depreciation expense of $32,400.c. Write-off of old accounts receivable of $21,000.



Depreciation expense 32,400Accumulated Depreciation 32,400

Allowance for Uncollectibles (old) 21,000Account Receivable (old) 21,000

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The court expects to receive periodic reports summarizing the realization and distribution activities of the fiduciary.The report, realization and liquidation account, has three main sections—assets, liabilities, and revenues and expenses.The asset section consists of four parts, illustrated as follows:

Realization and Liquidation AccountRealization and Liquidation Account


Assets to be realized Assets realizedAssets acquired Assets not realized

Assets

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The court expects to receive periodic reports summarizing the realization and distribution activities of the fiduciary.The report, realization and liquidation account, has three main sections—assets, liabilities, and revenues and expenses.The liabilities section consists of four parts, illustrated as follows:

Realization and Liquidation AccountRealization and Liquidation Account


Liabilities liquidated Liabilities to be liquidatedLiabilities not liquidated Liabilities incurred

Liabilities

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FASB issued exposure draft (Oct., 2008) on ‘Going Concern.’

Board decided to carry forward the going concern guidance from AU Sec. 341, subject to modifications to align with IFRSs.

One modification is to change the time horizon for the going concern assessment. AU Section 341 states that there is a “responsibility to

evaluate whether there is a substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited.”

Realization and Liquidation Realization and Liquidation AccountAccount


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FASB issued exposure draft (Oct., 2008) on ‘Going Concern.’

IAS 1 requires that an entity consider “all available information about the future, which is at least, but is not limited to, twelve months from the end of the reporting period” when assessing whether the going concern assumption is appropriate.

The other modification includes using the wording in IAS 1 with respect to the type of information that should be considered in making the going concern assessment (all available information about the future).

Realization and Liquidation Realization and Liquidation AccountAccount


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