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Insolvency-Liquidation and Reorganization (Online) : Learning Objectives Chapter Contents
Insolvency-Liquidation and Reorganization (Online) : Learning Objectives Chapter Contents
INSOLVENCY—LIQUIDATION AND
REORGANIZATION (ONLINE)
1
FASB ASC paragraph 470–60–35–5 (Statement of Financial Accounting Standards No.15, “Accounting
by Debtors and Creditors for Troubled Debt Restructurings” (Norwalk, CT.: FASB, 1997), par. 16).
in the full discharge of the debtor’s obligations to them. If there are proceeds remaining
after payment of the creditors, they are returned to the debtor.
During 2008, the number of failed banks totaled 25 equaling then cumulative number of
IN bank failures since 2001. However, in 2009 and 2010, this number skyrocketed to 157 and
THE 140 banks failing respectively. The number of failed banks declined in the subsequent years
NEWS to a recent low of 24 failed banks in 2013. By 2016 and 2017, the number of bank failures
dropped to 5 and 8.3
10.2 BANKRUPTCY
Article I, Section 8 of the U.S. Constitution gives the Congress authority to enact
uniform bankruptcy laws. Congress passed the first bankruptcy law in 1800 and
has repealed and enacted new laws on several occasions since that time. The most
significant revision is the Bankruptcy Reform Act of 1978 (hereafter referred to
as the Reform Act), which became effective in October 1979. The Bankruptcy
Act was amended in 1984, 1988, 1990, and 1994. The Reform Act consists of
eight chapters:
Chapter 1 General Provisions
Chapter 3 Case Administration
Chapter 5 Creditors, the Debtor, and the Estate
Chapter 7 Liquidation
Chapter 9 Adjustment of Debts of a Municipality
Chapter 11 Reorganization
Chapter 12 Adjustment of Debts of Family Farmers with Regular Income
Chapter 13 Adjustment of Debts of an Individual with Regular Income4
2
www.retaildive.com, “The Walking Company files second bankruptcy in 10 years,” 3/8/2018.
3
Federal Deposit Insurance Corporation, www.fdic.gov, failed bank list.
4
Several revisions to the bankruptcy statute over time have resulted in the elimination of some chapters by
their consolidation with others. For example, Chapters VIII, X, XI, and XII (before the Reform Act, Roman
numerals were used) were consolidated into Chapter 11 of the Reform Act.
voluntary relief, and Chapter 13, which applies to bankruptcy petitions by individuals,
will not be discussed here. We will concentrate on petitions by business entities under
Chapter 7 (Liquidation) and Chapter 11 (Reorganization).
Provisions of the Reform Act apply to individuals, corporations, and partnerships,
all of which are referred to as persons, as well as to municipalities seeking voluntary
relief from their creditors (municipalities cannot be forced into bankruptcy proceed-
ings). Insurance companies and most financial institutions are excluded because they
are covered by other specific statutes.
As mentioned earlier, when a business is unable to pay its obligations as they
mature, it may attempt to negotiate some type of contractual agreement with its cred-
itors without initiating a bankruptcy proceeding. If a satisfactory 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). The Reform Act uses
the single term debtor to refer to the subject of a bankruptcy proceeding.
Since January 1, 2017, retailers have announced plans to close more than 6,700 stores in the
IN United States by October of 2017, more than any other year. By year end, 8,600 stores are
THE expected to close. Early in 2018, Toys R Us is preparing for liquidation and is expected to close all
NEWS its stores. Shares of Mattel have dropped 8% as analysts predict that some toy sales will be
lost forever.5
In April 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act
of 2005 was signed; it became effective in October 2005. The aim of this law is to
protect creditors from abuses related to Chapter 7 bankruptcies. Most debts have been
discharged completely under Chapter 7 in past years; while attractive to struggling
debtors, creditors view this leniency as an invitation to abuse. The alternatives under
Chapters 11 and 13 focus instead on helping the debtor to work out realistic payment
plans and become financially stable rather than discharging their debts with ease.
However, the major changes under the 2005 act relate to individual debtors rather than
to businesses.
Voluntary Petitions
A debtor may file a voluntary petition with a bankruptcy court for liquidation under
LO 3 Voluntary vs. involuntary Chapter 7 or for reorganization under Chapter 11. Filing of a voluntary or involuntary
petitions. petition constitutes an order for relief, which prohibits the start or continuation of
legal action against the debtor by its creditors. The bankruptcy judge, however, may
refuse a voluntary petition if refusal is considered to be in the best interest of the
creditors.
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. The debtor must file a form listing all its property (at current market values)
and its debts. This form, called a Statement of Assets and Liabilities, consists of the
following separate schedules:
5
“http://www.money.cnn.com” www.money.cnn.com, 2017 just set the all-time record for store clos-
ing, Oct. 25, 2017. And “http://www.cnbc.com”, “Toys R Us prepares plan to liquidate its business”,
March 13, 2018.
Involuntary Petitions
In an involuntary proceeding, creditors initiate the action by filing a petition for liqui-
dation or reorganization with the bankruptcy court. If there are 12 or more creditors,
the petition must be signed by 3 or more such creditors whose claims aggregate at least
$13,475 more than the value of any liens on the property of the debtor.7 If there are
fewer than 12 creditors, the petition may be filed by one or more such creditors whose
claims aggregate at least $10,000 more than the value of any liens on the debtor’s prop-
erty. Involuntary petitions may be filed under either Chapter 7 or Chapter 11 of the
Reform Act. 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.
6
“http://www.usatoday.com”, “21st Century Oncology files for Chapter 11 bankruptcy protection,
May 26, 2017.
7
Section 104 provides for an adjustment every three years.
claims are those with liens against assets whose realizable value is equal to or in excess
of the claim. Partially secured claims are those with liens against assets whose realizable
value is less than the amount of the claim.
LO 2
The Reform Act assigns priorities to certain claims, and each rank must be satisfied
Five priority categories for
unsecured claims.
in full before the next-lower rank is paid. The following order of priority for unsecured
creditors is specified as follows:
After all these priorities have been satisfied, any remaining unsecured credi-
tors participate pro rata in any remaining realization proceeds. The distribution to
unsecured creditors is termed a dividend and is generally expressed in terms of the
percentage of the total unsecured claims that will be paid. For example, if $100,000 of
proceeds remains after all secured claims and claims having priority have been paid,
and total unsecured claims amount to $400,000, each unsecured creditor will receive
a 25% dividend.
In Illustration 10‑1, the number of business bankruptcies filed between 2009 and
2013 have been declining to levels approaching the pre-financial industry crisis.
ILLUSTRATION 10-1
45,000
40,000
35,000
30,000
Chapter 7
25,000
Chapter 11
20,000
Chapter 13
15,000
10,000
5,000
–
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
8
www.money.cnn.com 4/17/2014.
7. Pay creditors as promptly as possible, giving due regard to secured claims and
priorities.
8. File a final report on the administration of the estate, including a statement of
receipts and disbursements.
In addition, the trustee has the authority to hire attorneys, accountants, appraisers, and
other professionals to assist in carrying out his or her duties.
The court may permit the debtor to maintain possession of its assets and conduct the
affairs of the business, or it may appoint a trustee. If a trustee is appointed, his or her pri-
mary duties in reorganization are:
9
A trustee must be appointed if the debtor’s debts (other than debts for goods, services, or taxes) exceed
$5,000,000.
The reorganization plan may propose the alteration of legal, contractual, and
equity interests of any class of creditors or equity security holders. Unsecured cred-
itors will generally accept payment of a portion of their claims and cancellation of
the remainder of their claims. The plan must be equitable to all parties by providing
for the same treatment for each claim or interest of a particular class. The plan must
also contain adequate means for its own execution; that is, it must contain specific
provisions for such things as (1) the retention of any property by the debtor, (2) the
transfer of property to other entities, (3) the merger or consolidation of the debtor
with another company, (4) the sale of property or the distribution of property to
parties of interest, and (5) the issuance of securities of the debtor for cash, property,
or existing securities of the debtor. After the plan is filed with the court, it must be
accepted by two-thirds in amount and one-half in number of the allowed claims of
each class of creditors, and by two-thirds in amount of the allowed interests of each
class of stockholders. In addition, the court must approve of the overall fairness of the
plan before it will be accepted.
When a firm files for bankruptcy, one of the first things that it will do is to ask the bankruptcy-
IN court judge to approve a loan in the form of senior secured debtor-in-possession financing. This
THE type of debt provides the banks a ‘superiority’ status, which means that they will be paid for new
NEWS loans before anyone else.10
Chapter 11 Proceedings
IN “Accounting Standards Codification (ASC) 852, ‘Reorganizations’, is applicable to entities operating
THE under Chapter 11 of the Bankruptcy Code. ASC 852 generally does not affect the application of
NEWS U.S. GAAP used to prepare prior consolidated financial statements. It does require increased dis-
closures for transactions and events that were directly related to the Chapter 11 proceedings.11
10
WSJ, “WorldCom Plans Bankruptcy Filing,” by Shawn Young, Carrick Mollenkamp, Jared Sandberg,
and Henny Sender, 7/22/02, p. A3.
11
GM 10-K, 12/31/10, p. 154.
NOTE: Solutions to Test Your Knowledge questions are found at the end True or False
of each chapter before the end-of-chapter questions.
2. __________ Insolvency means that a debtor has more
Multiple Choice current liabilities than current assets.
1. The highest priority for payment of unsecured claims 3. __________ If an insolvent debtor has more than 12
in a bankruptcy proceeding is creditors, an involuntary petition must be signed by
a. Wages up to $4,650 earned within three months at least 3 of those creditors.
before the petition 4. __________ Unsecured creditors with priority will receive
b. Unpaid federal income taxes full satisfaction before secured creditors are paid.
c. Administrative expenses of the bankruptcy 5. __________ Either a debtor or its creditors may file a
d. Wages owed to an insolvent employee petition for reorganization under Chapter 11 of the
Reform Act.
If paid-in capital is not sufficient to eliminate retained earnings, the capital stock account
is reduced, thus causing a reduction in the par value of the stock. No retained earnings can
be created in a quasi reorganization, and retained earnings must be “dated” for 10 years.
This means that the firms disclose on the balance sheet that the balance in retained earn-
ings has only been accumulated since the date of the quasi reorganization.
1. The reorganization value of the assets of the emerging entity immediately before
the date of confirmation is less than the total of all postpetition liabilities and
allowed claims.
If the firm qualifies, the company’s reorganized value is assigned to the entity’s
assets and liabilities in accordance with FASB ASC subtopic 805-20 (Business Com-
binations—Identifiable Assets, Liabilities, and any Noncontrolling Interest).
Additionally, 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 shall be reflected in the predecessor entity’s final state-
ment of operations. Forgiveness of debt, if any, shall be reported as an extinguish-
ment of debt and classified in accordance with FASB ASC subtopic 225-20 (Income
Statement—Extraordinary and Unusual Items).
Adopting fresh start reporting results in a new reporting entity with no beginning
retained earnings or deficit. When fresh start reporting is adopted, the notes to the initial
fresh start financial statements shall disclose the following additional information
(FASB ASC paragraph 852-10-50-7):
As a result of fresh start accounting, GM reduced its liabilities by $93.4 billion and
increased its assets by $34.6 billion. One interesting (and rather ironic) aspect of GM’s
fresh start was the creation of additional recorded goodwill of $30.2 billion. This asset
results from the application of several accounting rules. For instance, in valuing liabil-
ities, the firm’s creditworthiness must be considered. Since GM’s creditworthiness was
considered somewhat problematic, higher discount rates are used to value liabilities,
resulting in lower valuations for liabilities and higher goodwill amounts. Similarly, lower
tax asset carrying values (which are lower than market) also contributed to higher good-
will amounts.
Bankruptcy creates a market for claims traders November 10, 2017 marked the 10th year of
IN Chapter 11 for Circuit City Stores, Inc. Early in the process, creditors were expecting to receive 8 to
THE 32 cents on the dollar. Now, it is likely that creditors might receive more than 51 percent. The
NEWS longevity of the case has created a market of investors known as claims traders. So if the original
estimate as 16 cents on the dollar, the claims traders would offer a discount betting that the final
outcome would be higher. It is estimated that the three largest holders with $450 million in claims
are claims traders.*
* “Circuit City bankruptcy: 9 years and counting”, Richmond BizSense, November 21, 2017.
LO 6 Debt restructuring. Transfer of Assets A debtor that transfers assets to a creditor in full settlement
of a payable recognizes a gain on the restructuring. The gain is measured by the excess
of the carrying value of the payable over the fair value of the assets transferred. The
carrying value of the payable is the face amount increased or decreased by applicable
accrued interest and applicable unamortized premium, discount, finance charges, or issue
costs. The fair value of the assets transferred is the amount that the debtor could reason-
ably expect to receive in a current sale between a willing buyer and a willing seller, that
is, other than in a forced sale. The difference between the fair value and the carrying
amount of the assets transferred is a gain or loss on the transfer of assets and is reported
as a component of net income for the period of transfer. The gain on restructuring is
included in net income in the period of restructuring. Assume, for example, that a debtor
transferred land with a cost of $20,000 and a fair value of $15,000 to a creditor in full
settlement of a $25,000 payable. Ignoring income tax effects, the debtor would report a
$5,000 loss $20, 000 $15, 000 from the transfer of assets and a $10,000 ordinary gain
$25, 000 $15, 000 from debt restructuring.
Grant of an Equity Interest A 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. The difference between the fair value of the equity interest issued and the carry-
ing amount of the payable is reported as a gain on restructuring. The debtor determines
its gain based on undiscounted cash flows.
If, however, in an nonbankruptcy case, the total future cash payments specified by
the new terms, including both payments designated as interest and those designated as
face amount, are less than the carrying value of the payable, the debtor should reduce
For cash- the carrying value to an amount equal to the total future cash payments specified by
IN strapped the new terms and recognize a gain on restructuring. Thereafter, all cash payments
THE companies in under the terms of the payable should be accounted for as reductions of the carrying
NEWS bankruptcy value of the payable, and no interest expense should be recognized on the payable for
proceedings any period between the restructuring and maturity.
caught in the A restructuring may involve a combination of asset transfer, grant of an equity
balance between staying open interest, and modification of terms. In those cases, assets transferred or the equity
and shutting down, debtor-in-
interest given are treated first and measured as described earlier. The carrying value of
possession loan agreements
have become the lifeline that
the payable is reduced by the total fair value of the assets transferred or equity interest
keeps employees paid, vendors given, and a gain or loss on the transfer of assets is recognized for the difference bet-
delivering, and the doors open. ween the fair value and carrying value of the assets transferred. A gain on restructuring
Such loans, known as DIP is then recognized only if the remaining carrying value of the payable exceeds the total
financing, have gained more future cash payments specified by the terms of the debt remaining unsettled.12
attention as household names A creditor in a modification of the terms computes the loss by discounting all the
in Chapter 11, such as retailer future cash flows (face value and interest) using the original effective interest rate. If
Kmart Corp., with $2 billion this amount is less than the carrying value of the existing debt (plus accrued interest),
in DIP financing, and cable the difference is charged to bad debt expense with a credit to a valuation allowance
company Adelphia Communi- account (less accrued interest). Then, as interest payments are received, the valuation
cations Corp., with a $1.5 billion
allowance account is amortized and the cash interest receipts are recorded as interest
DIP loan, have secured this type
of lending to stay afloat.13
revenue over the remaining life of the debt.
Restructuring Illustration
To illustrate the accounting process, assume that Box Company filed a petition for reor-
ganization with the bankruptcy court. The reorganization plan has been approved by the
parties of interest and the court. Box Company’s balance sheet on April 30, 2020 prior to
reorganization, is shown in Illustration 10‑2.
Provisions of the reorganization plan and the appropriate journal entries to account
for the restructuring follow:
Notice that a loss on transfer of assets is recognized for the difference between the
book value of the receivables ($107,000) and their fair value ($100,000). A gain
12
FASB ASC paragraph 470–60–35–8 (Statement of Financial Accounting Standards No. 15, Par. 19).
13
The Wall Street Journal, “Debtor Loans Help Cash-Poor Firms,” by Marc Hopkins, 7/24/02, p. B3G.
ILLUSTRATION 10-2
on restructuring is then recognized for the difference between the carrying value
of the payable ($134,000) and the fair value of the receivables ($100,000).
3. A creditor holding a $120,000 note from Box Company agrees to accept the land
held as an investment in full settlement of the note plus accrued interest of $8,000.
The land has a fair value of $95,000.
The land is increased to its fair value and a gain on transfer of assets is recognized
in the amount of $15,000. The land and payable are then written off and a gain
on restructuring is recognized for the difference between the carrying value of the
payable ($128,000) and the fair value of the land ($95,000).
4. A creditor holding a 14%, $80,000 note from Box Company (on which $4,000
interest has accrued) agrees to extend the maturity date of the note for two years
(until April 30, 2022) and reduce the interest rate to 8%.
Since the total future cash payments of $92,800 (principal of $80,000 and
interest of $12,800) exceed the carrying value of the debt ($84,000), no gain on
restructuring is recognized. Interest expense is recorded in the future by com-
puting the effective interest rate that, when applied to the carrying amount of
the payable at the beginning of the period, will amortize the debt over the period
to maturity.
Since the carrying value of the bonds payable exceeds the fair value of the equity
interest given, a gain on restructuring is recognized.
ILLUSTRATION 10-3
The net gain on transfer of assets ($15, 000 − $7, 000 ) will be reported as a part
of operations on the income statement, and the gain on restructuring of debt of
$329, 500 ($34, 000 + $33, 000 + $262, 500 ) is reported in net income. If the conditions
are met, the gain on restructuring may be reported as an extraordinary item. After
giving effect to the reorganization entries, Box Company’s balance sheet will be as
shown in Illustration 10‑3.
Notice that, although the stockholders’ deficiency has been eliminated, there is
still a retained earnings deficit. If desired by the parties of interest, the reorganization
plan could have included a provision to decrease the par value of the common stock
and eliminate the accumulated deficit.
NOTE: Solutions to Test Your Knowledge questions are found at the end Short Answer
of each chapter before the end-of-chapter questions.
Assume that a debtor owes a creditor a $10,000 note
payable with $2,000 accrued interest. Determine the
amount of the gain or loss included in ordinary income and/
or the amount of the gain or loss from restructuring.
Assume that land with a book value of $8,000 and a fair
value of $9,000 is given in full payment of the amount owed.
14
This statement is an accounting report and should not be confused with the Statement of Affairs the
Bankruptcy Reform Act requires from the debtor company, which is simply a series of questions concerning
the debtor company’s financial position.
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.
In that respect, stockholders’ or owners’ equity balances have no significance.
1. The notes receivable are expected to be fully realized, and they have been pledged
as collateral on a bank note in the principal amount of $20,000 plus accrued
interest of $600.
2. Accounts receivable have an estimated collectible value of $28,000.
3. Inventories have a realizable value of $102,280.
Preston Company Balance Sheet April 30, 2020
Assets
Cash $ 8,200
Notes Receivable 24,000
Accounts Receivable (net) 47,000
Inventories 119,000
Prepaid Expenses 1,200
Investment in Beta Company Stock, 1,000 Shares at Market Value 26,500
Land 42,000
Buildings (net) 198,000
Machinery and Equipment (net) 93,000
Total Assets $558,900
The Statement of Affairs for Preston Company, along with a deficiency account
summarizing estimated gains and losses on the realization of assets, is presented in
Illustration 10‑4.
ILLUSTRATION 10-4
Book Unsecured
Value Equities Liabilities
Liabilities Having Priority
$ 13,500 Accrued Salaries and Wages $ 13,500
Fully Secured Creditors
32,000 Notes Payable 32,000
1,100 Accrued Interest 1,100
Partially Secured Creditors
200,000 Mortgage Note Payable 200,000
8,500 Accrued Interest 8,500
Total 208,500
Land and Buildings 140,000 $ 68,500
Unsecured Creditors
195,000 Accounts Payable 195,000
Stockholders’ Equity
250,000 Capital Stock 250,000
(141,200) Retained Earnings (deficit) ( 141,200)
$558,900 $263,500 $108,800
Estimated deficiency $ (82,520)
Preston Company
Deficiency Account April 30, 2020
Estimated Losses
Estimated Gains
Accounts Receivable $ 19,000 Capital Stock $250,000
Inventory 16,720 Retained Earnings (141,200)
Prepaid Expenses 600 Estimated Deficiency to
Land and Buildings 100,000 Unsecured Creditors 82,520
Machinery and Equipment 55,000
Total $191,320 Total $191,320
Starbucks and Amazon-owned Whole Foods are the latest victims of retail landlords pushing back
IN against companies closing stores and trying to bypass contractual agreements. Recently, the largest U.S.
THE mall owner, Simon Property Group, claimed a high-profile victory in court over Starbucks, which was
NEWS planning to close 77 of its Teavana stores across Simon’s properties. Starbucks previously announced
this summer it was planning to shutter all Teavana locations by the spring of 2018, as they were
dragging down Starbucks’ overall financial performance. However, an Indiana judge has ruled in Simon’s
favor, preventing the coffee giant from closing 77 doors or facilitating any “going out of business” or similar sales, court
documents reviewed by CNBC showed. The lease agreements Starbucks originally signed with Simon for the Teavana
brand require the tenant to be “open and operating during normal business hours.” Some of those 77 leases still extend
for up to another decade.16
15
The Wall Street Journal, “Debtor Loans Help Cash-Poor Firms,” by Marc Hopkins, 7/24/02, p. B3G.
16
www.cnbc.com, “Retail landlords flex muscle as stores close, and Starbucks, Whole Foods emerge as
losers.” December 9, 2017.
During the period from October 1, 2020, through December 31, 2020, the following
transactions occurred:
(3) Sales for the period were: on account, $52,000; cash, $7,000.
(4) Cash was collected by the trustee on
Accounts receivable (old) $18,000
Accounts receivable (new) 46,000
(5) Payments were made by the trustee for
Accounts payable (old) $43,000
Accounts payable (new) 14,000
Operating expenses 10,500
Trustee’s expenses 2,000
(6) Adjusting entries recorded by the trustee on December 31, 2020 were:
Estimated uncollectibles on
Accounts receivable (old) $ 3,500
Accounts receivable (new) 400
Accounts receivable written off 4,500
on accounts receivable (old)
Depreciation expense 7,600
(7) The merchandise inventory balance on December 31 was $42,000.
Entries to record the effect of these transactions on the trustee’s and the debtor’s books
are presented in Illustration 10‑5. In order to prepare financial statements for Axon
Company on December 31, 2020, the trustee’s accounts must be combined with Axon
Company’s accounts. A combining workpaper for this purpose is presented in Illus-
tration 10‑6.
The assets to be realized part identifies the individual assets to which the trustee
has taken title from the debtor. Cash is not included in the report because it is already
realized. Although cash is excluded, the court is given a copy of the cash account of
the trustee, which shows the beginning amount received from the debtor, as well as all
the individual receipts and disbursements for the period covered. The assets acquired
part itemizes the assets either discovered or received from operating activities during
the period. The assets realized part identifies proceeds received from the conversion
of specific assets. The assets not realized part identifies the assets remaining with the
trustee at the end of the reporting period.
17
A fiduciary is a person to whom property is entrusted to hold, control, or manage for another.
ILLUSTRATION 10-5
Journal Entries
Trustee’s Books Axon Company’s Books
(1) Cash 6,400 Gary Trent, Trustee 160,000
Receivables (old) 32,000 Allowance for Uncollectibles 2,900
Inventory 48,600 Accumulated Depreciation 44,100
Property and Equipment 120,000 Cash 6,400
Allowance for Uncollectibles 2,900 Receivables 32,000
Accumulated Depreciation 44,100 Inventory 48,600
Axon Company—in Receivership 160,000 Property and Equipment 120,000
(2) Purchases 26,000 No entry
Accounts Payable (new) 26,000
(3) Cash 7,000 No entry
Accounts Receivable (new) 52,000
Sales 59,000
(4) Cash 64,000 No entry
Accounts Receivable (old) 18,000
Accounts Receivable (new) 46,000
(5) Axon Company—in Receivership 43,000 Accounts Payable 43,000
Accounts Payable (new) 14,000 Gary Trent, Trustee 43,000
Operating Expenses 10,500
Trustee’s Expenses 2,000
Cash 69,500
(6) Bad Debts Expense 3,900 No entry
Depreciation Expense 7,600
Allowance for Uncollectibles (old) 3,500
Allowance for Uncollectibles (new) 400
Accumulated Depreciation 7,600
Allowance for Uncollectibles (old) 4,500 No entry
Accounts Receivable (old) 4,500
(7) Sales 59,000 Gary Trent, Trustee 2,400
Inventory 6,600 Income Summary 2,400
Purchases 26,000 Income Summary 2,400
Operating Expenses 10,500 Retained Earnings 2,400
Trustee’s Expenses 2,000
Bad Debts Expense 3,900
Depreciation Expense 7,600
Income Summary 2,400
Income Summary 2,400
Axon Company in Receivership 2,400
In a similar manner, the liabilities section consists of four parts, as indicated below:
Liabilities
Liabilities liquidated Liabilities to be liquidated
Liabilities not liquidated Liabilities incurred
The liabilities to be liquidated part identifies the liabilities that the trustee took
responsibility for at the date of appointment. Liabilities incurred reflect the liabilities
ILLUSTRATION 10.6
Credits
Allowance for Uncollectibles (old) 1,900 1,900
Allowance for Uncollectibles (new) 400 400
Accumulated Depreciation 51,700 51,700
Accounts Payable (old) 32,000 32,000
Accounts Payable (new) 12,000 12,000
Capital Stock 180,000 180,000
Retained Earnings (deficit) (95,000) (95,000)
Sales 59,000 59,000
Axon Company, in Receivership 117,000 (2) 117,000
Total 242,000 117,000 149,600 149,600 59,000
Net Income 2,400 2,400
Total 56,600 185,400
incurred by the trustee for operating activities during the period. Liabilities liquidated
identify specific liabilities paid by the trustee, and liabilities not liquidated reflect
those that remain to be paid by the trustee.
The revenues and expenses section of the report lists the supplementary expenses
incurred and revenues received by the trustee during the period, as follows:
Revenues and Expenses
Supplementary charges Supplementary credits
The realization and liquidation account is prepared in the typical account form
with debits on the left side and credits on the right side of the account. Any figure
needed to balance the account reflects a gain or loss for the reported period.
Note that the balancing figure (labeled “net gain”) in the realization and liquida-
tion account is the same as the $2,400 net income reported for the period October 1 to
December 31, 2015, in Illustration 10‑6. This is as it should be, since no assets were
realized during the period except through normal operating activities. If assets had
been realized by other than normal operating activities (for example, the sale of land),
any gain or loss would increase or decrease the net gain reported in the Realization
and Liquidation account. The transaction could be treated in one of two ways. Assets
realized could be reported at the amount received from the sale of the asset (the tra-
ditional approach), or they might be reported at the book value of the asset sold and
any gain or loss on the sale reported as a supplemental credit or supplemental charge.
For example, assume that the property and equipment account of Axon Company
included a parcel of land that cost $25,000 and that the parcel was sold by the trustee
for $35,000. The traditional approach would report assets realized at $35,000 with a
decrease in assets not realized of $25,000. The $10,000 difference between the two
would be reflected as part of a net gain of $12,400, rather than the $2,400 in Illustra-
tion 10‑7. The items that would be different in Illustration 10‑7 are:
Assets Realized
Property and Equipment $35,000
The basic weakness in this approach is that the components of the “net gain” or “net loss”
are not disclosed.
An alternative is to report the sale of the land as assets realized at book value,
$25,000, a decrease in assets not realized of $25,000, and a supplementary credit “Gain
on sale of land” of $10,000. Although the net gain needed to balance the account is still
$12,400, the reader of the report is able to identify the components of the net gain. The
items that would be different in Illustration 10‑7 under this approach are:
Assets Realized
Property and Equipment $25,000
ILLUSTRATION 10-7
Axon Company, Gary Trent, Trustee, Realization and Liquidation Account, October 1, 2012,
to December 31, 2020
Assets to Be Realized Assets Realized
Receivables (old) $ 32,000 Accounts Receivable (old) $ 18,000
Less: Allowance for 2,900 $ 29,100 Accounts Receivable (new) 46,000
Uncollectibles
Inventory 48,600
Property and Equipment 120,000 Assets Not Realized
Less: Accumulated Depreciation 44,100 75,900 Accounts Receivable (old) $ 9,500
Less: Allowance for Uncollectibles 1,900 7,600
Assets Acquired Accounts Receivable (new) 6,000
Accounts Receivable (new) 52,000 Less: Allowance for Uncollectibles 400 5,600
Inventory 42,000
Supplementary Charges Property and Equipment 120,000
Purchases 26,000 Less: Accumulated Depreciation 51,700 68,300
Operation Expenses 10,500
Trustee’s Expenses 2,000 Supplementary Credits
Sales 59,000
Liabilities Liquidated
Accounts Payable (old) 43,000 Liabilities to Be Liquidated
Accounts Payable (new) 14,000 Accounts Payable (old) 75,000
Liabilities Not Liquidated Liabilities Incurred
Accounts Payable (old) 32,000 Accounts Payable (new) 26,000
Accounts Payable (new) 12,000
Net Gain 2,400
Total $347,500 Total $347,500
Supplementary Credits
Gain on Sale of Land 10,000
Net Gain 12,400
The auditor is not responsible for predicting future conditions or events. The fact that
the entity may cease to exist as a going concern subsequent to receiving a report
from the auditor that does not refer to substantial doubt, even within one year following
the date of the financial statements, does not in itself indicate inadequate performance
by the auditor. Accordingly, the absence of reference to substantial doubt in an audi-
tor’s report should not be viewed as providing assurance as to an entity’s ability to
continue as a going concern.
where:
x1 (current assets less current liabilities) / total assets
x2 retained earnings / total assets
x3 earnings before interest and taxes / total assets
x4 market value of equity / total liabilities
x5 sales / total assets
If the calculated z-score is below 1.8, the firm is classified as a distressed firm. Firms
with z-scores between 1.1 and 2.675 are considered in the “gray zone,” and z-scores
above 2.99 are considered safe.
In Illustration 10‑8, General Motors’ z-score is computed for the years 2000
through 2008. The z-score has been decreasing over time (with the exception of 2006)
and is in the “bankrupt” zone in virtually every year. GM’s market cap in 2008 fell
to around $4 billion down from a high of $52 billion in 2000. While there were some
modest increases in revenues over this period, the firm earned a net loss every year
after 2004.
ILLUSTRATION 10-8
3 Safety line
2.5
2
Bankrupt line
1.5
1
0.5
0
2000 2001 2002 2003 2004 2005 2006 2007 2008
−0.5
GM’s Z-Score
−1
−1.5
−2
Because the z-score reported above relies on the market value of equity, the for-
mula can’t be applied to private firms. A revised Z score for private firms is:
Z = 0.717x1 + 0.847x2 + 3.107x3 + 0.42x4 + 0.998x5
where the definition of X4 used before is replaced with the book value of equity
divided by total liabilities. If the calculated private firm z-score is below 1.23, the firm
is classified as a distressed firm. Firms with z-scores between 1.23 and 2.9 are consid-
ered in the “gray zone,” and z-scores above 2.9 are considered safe.
The auditor has a responsibility to evaluate whether there is substantial doubt
about the entity’s ability to continue as a going concern for a reasonable period of
time. Reasonable period of time is defined as a period not to exceed one year beyond
the date of the financial statements being audited. Currently, AU Section 341, The
Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, of the
AICPA Codification of Statements on Auditing Standards contains the guidance about
the going concern assessment. The Public Company Accounting Oversight Board
(PCAOB) adopted AU Section 341 on an initial transitional basis.
Conditions and events that may raise a substantial doubt about an entity’s ability
to continue as a going concern include negative financial trends such as recurring
operating losses, working capital deficiencies, negative cash flows from operations,
and/or adverse key financial ratios. Other indications of possible financial difficulties
might include such events as defaulting on loans, having not paid dividends, seeking
new sources of financing, selling assets, or restructuring debt.
FASB issued accounting standards update No. 2014-15 Presentation of Financial
Statements – Going Concern on August 27, 2014. The update outlines management’s
responsibilities in evaluating the entity’s going concern uncertainties. FASB believes
that an entity would continue as a going concern until the entity’s liquidation becomes
imminent. If and when, and entity’s liquidation becomes imminent, financial statements
are prepared under the liquidation basis of accounting in accordance with topic ASC 205-
30 Liquidation Basis of Accounting. Otherwise, the entity would be required to evaluate
going concern uncertainties at each annual and interim reporting period. First, if it is
probable that the entity will not be able to meet its obligations as they become due within
one year after the date that the financial statements are issued, management shall evaluate
whether its plans that are intended to mitigate those conditions and events will alleviate
substantial doubt about the entity’s ability to continue as a going concern. If information
available on the date the financial statements are issued, indicate both a) it is probably that
management’s plan will be effective within one year after the date the financial statements
are issued and b) it is probable that management’s plans, when implemented, will mitigate
the conditions that raise substantial doubt about the entity’s ability to continue as a going
concern within one year of the financial statements being issued.
If, after considering management’s plans, substantial doubt about an entity’s
ability to continue as a going concern is not alleviated, the entity shall include a state-
ment in the footnotes indicating that there is substantial doubt about the entity’s ability
to continue as a going concern within one year after the date the financial statements
are issued. In addition, regardless of whether substantial doubt is alleviated by man-
agement’s plan, the firm is required to disclose the following three items if substantial
doubt is raised:
1. the principal conditions and events that give rise to the entity’s potential inability
to meet its obligations,
2. management’s evaluation of the significance of those conditions and events,
3. management’s plans that are intended to address the entity’s potential inability to
meet its obligations.
SUMMARY
1 Distinguish between a Chapter 7 and a Chapter 11 bank- 4 Distinguish among fully secured, partially secured, and unse-
ruptcy. In a Chapter 7 bankruptcy, the company ceases cured claims of creditors. Fully secured claims are those
operations and the assets are generally sold by a trustee. In a with liens against assets whose realizable value is equal to
Chapter 11 bankruptcy, the business is reorganized and the or in excess of the claim. Partially secured claims are those
creditors agree on a plan for payment of their claims. with liens against assets whose realizable value is less than
2 Describe the five priority categories of unsecured claims and the amount of the claim. Unsecured creditors, including those
list the order in which they are settled. The five categories having priority, are paid from whatever proceeds remain from
listed in order of priority are: (a) administration expenses, the realization process.
fees, and charges incurred in administering the bankrupt’s 5 Describe contractual agreements that the debtor and its cred-
estate; (b) unsecured claims for wages, salaries, or commis- itors may enter into outside of formal bankruptcy proceedings
sions earned by an employee within 90 days before the date to resolve the debtor’s insolvent position. These agreements
of filing of the petition; (c) unsecured claims for contributions generally include (a) an extension of payment periods;
to employee benefit plans from services rendered within 180 (b) composition agreements where the creditors agree to
days before the date of the filing of the petition; (d) unsecured accept less than the full amount to their claims; (c) formation
claims of individuals arising from the deposit of money in of a creditors’ committee where the parties agree to the
connection with the purchase, lease, or rental of property or formation of a creditors’ committee that is responsible for
services that were not delivered or performed; and (e) unse- managing the debtor’s business affairs for the period during
cured claims of governmental units for unpaid taxes. which plans are developed to rehabilitate, reorganize, or liq-
3 Distinguish between a voluntary and involuntary bankruptcy uidate the business; or (d) a voluntary assignment of assets
petition. A debtor may file a voluntary petition with a where the debtor may elect to place its property under the
bankruptcy court for liquidation under Chapter 7 or for reor- control of a trustee for the benefit of its creditors.
ganization under Chapter 11. In an involuntary proceeding, 6 Describe the ways debt may be restructured in a reorganiza-
creditors initiate the action by filing a petition for liquida- tion. In reorganization, debt might be restructured using
tion or reorganization with the bankruptcy court. Filing of one of the following: (a) the debtor may transfer assets in full
a voluntary or involuntary petition constitutes an order for settlement of the payable; (b) the debtor may give an equity
relief, which prohibits the start or continuation of legal action interest in its firm in full settlement of the payable; or (c) the
against the debtor by its creditors. creditor may modify terms of the payable.
10.2 Ordinary gain on revaluation of land is $1,000 and the restructuring gain is $3,000.
QUESTIONS
LO 5 1. List the primary types of contractual agreements between 10. What is the purpose of a combining workpaper prepared LO 1
a debtor company and its creditors and briefly explain by a trustee?
what is involved in each of them. 11. What is the purpose of a realization and liquidation account? LO 1
LO 3 2. Distinguish between a voluntary and involuntary bank-
ruptcy petition. Business Ethics
LO 4 3. Distinguish among fully secured, partially secured, and From an ethical perspective, some believe that it is never justifi-
unsecured claims of creditors. able for an individual or business to declare bankruptcy. Others
LO 2 4. Five priority categories of unsecured claims must be believe that some actions are appropriate only in extreme circum-
paid before general unsecured creditors are paid. Briefly stances. Without question, as stated in the Journal of Accountancy,
describe what makes up each category. November 2005, page 51, “the ease with which debtors have been
LO 4 5. What are “dividends” in a bankruptcy proceeding? able to walk away from debt has frustrated creditors for years.”
6. For each of the following debt restructurings, indicate 1. Describe the differences between Chapter 7 (liquidations)
LO 6
whether a gain is recognized and, if so, how the gain is and Chapter 11 (reorganizations) from an ethical standpoint.
measured and reported. Who is most likely to be hurt by a Chapter 7 bankruptcy?
(a) Transfer of assets by the debtor to the creditor. 2. Discuss the Bankruptcy Abuse Prevention and Consumer
Protection Act of 2005. Do you believe the changes
(b) Grant of an equity interest by the debtor to the creditor.
wrought by this act will serve to protect creditors?
(c) Modification of the terms of the payable.
3. The Protection Act of 2005 requires individuals, but not
LO 1 7. What is the purpose of a Statement of Affairs? businesses, to undergo a “means” test before they can
LO 4 8. One of the officers of a corporation that had just received seek Chapter 7 relief. Do you believe this change should
a discharge in bankruptcy said, “Good, now we don’t owe be applied to businesses as well? Why or why not?
anyone.” Is he correct? 4. Do you think that you would ever resort to filing for bank-
LO 1 9. What are the duties of a trustee in a liquidation proceeding? ruptcy relief yourself? Why or why not?
Income Statement
Total Revenues 1,557,020 1,513,177 1,494,251 1,402,860 1,311,316 1,442,718
Cost of goods sold 755,996 753,631 767,459 734,067 682,828 62%
Gross margin 801,024 759,546 726,792 668,793 628,488 38%
Operating income 236,168 171,772 11,460 (14,561) (63,718) 5%
Net income 1,282 (65,307) (211,978) (236,435) 53,899 3%
Required:
1. Evaluate the performance of Claire’s Stores over time. Is there a year, where you first
become concerned about the likelihood of bankruptcy?
2. Because Claire’s is a private company, the market value of equity is unknown. Compute the
Z-score for private firms. Make an assessment of the likelihood of bankruptcy during 2018.
AFS10-2 Toys R Us
The following information is available for Claire’s Stores from January 2013 through
January 2017.
In the last column, the median industry values are reported for Retail-Hobby, Toy,
and Game Shops. Assets and revenues are in millions of dollars, balance sheet percent-
ages are a percentage of total assets, income statement percentages are a percentage of
total revenues, and the statements of cash flow percentages are a percentage of total assets.
Toys R Us Median
(dollars in thousands) Jan. 2013 Jan. 2014 Jan. 2015 Jan. 2016 Jan. 2017 Industry 2016
Balance Sheet
Assets 8,921,000 7,549,000 7,115,000 6,910,000 6,908,000 2,147,640
Total Liabilities 8,436,000 8,205,000 8,210,000 8,175,000 8,200,000 117%
Stockholders’ equity 485,000 (656,000) (1,095,000) (1,265,000) (1,292,000) −19%
Required:
3. Evaluate the performance of Toys R Us over time. Is there a year, where you first become
concerned about the likelihood of bankruptcy?
4. Because Toys R Us is a private company, the market value of equity is unknown. Com-
pute the Z-score for private firms. Make an assessment of the likelihood of bankruptcy
during 2018.
EXERCISES
Required:
Compute the amount that will be paid to each class of creditor.
Crane Company has had operating difficulties, accumulating a deficit over several years before
2020. During 2020, however, Crane reported a significantly lower operating loss, and pros-
pects for the future are relatively bright. Although management and stockholders are optimistic
about the future, it is almost certain that the company will lack the necessary working capital to
handle existing obligations and expected future growth. In light of these facts, Crane has filed
for reorganization under Chapter 11. The reorganization plan, the provisions of which are set
out below, has received the approval of stockholders, creditors, and the court. Provisions of the
reorganization plan are as follows:
1. Accounts receivable are to be written down to $40,000 to reflect their current expected real-
izable value.
2. Inventory is fairly valued, but goodwill is to be written off, and property and equipment is to
be written down to its fair value of $118,000.
3. The $20 par value common stock is to be replaced with $4 par value common stock on a
share-for-share basis in order to create some reorganization capital, which will be used to
eliminate the deficit.
4. The bondholders agree to exchange their bonds for new 8% bonds in the same maturity
amount, but with a due date of June 30, 2022, and 6,000 shares of $4 par value common
stock. The stock will be divided ratably among the bondholders. The fair value of the
common stock is equal to its par value.
5. Accounts payable are expected to be paid in full, although creditors have agreed to extend
due dates by as much as six months.
6. Any accumulated deficit is to be eliminated.
Required:
A. Prepare journal entries to record the effects of the reorganization plan.
B. Prepare a balance sheet as it would appear immediately after the reorganization.
In the four months immediately after your appointment, the following transaction occurred:
1. Sales were made in the amount of $296,000, of which $31,500 were cash sales.
2. Receivables were collected in the following amounts:
The inventory balance at the end of your first four months as trustee (the end of the fiscal year for
TRX Company) was $149,700.
Required:
Prepare journal entries to record the foregoing on your set of books. Include appropriate clos-
ing entries.
ASC Exercises: For all ASC exercises indicate as part of your answer: the Codification topic, subtopic, section, and
paragraph upon which your answer is based (unless otherwise specified). All ASC questions require
access to the FASB Codification.
ASC10-1 Presentation A sometimes-confusing aspect of the definition of current assets is the inclusion of
prepaid items. Prepaid expenses are not usually converted into cash in the current period. How does
GAAP rationalize this classification issue?
ASC10-2 Disclosure Must a firm separately disclose the cash flow pertaining to extraordinary items or discon-
tinued items in operating activities?
ASC10-3 Scope Must a defined pension plan that presents financial information in accordance with the provi-
sions of topic 960 provide a statement of cash flows?
ASC10-4 General List all the topics found in topic 400—Liabilities.
(Hint: There are nine topics.) ASC 405-10 provides the overall guidance for liabilites. What is the
overall objective of this section?
ASC10-5 Glossary What is a troubled debt restructuring?
ASC10-6 Presentation Describe fresh start accounting and the conditions under which it is acceptable under
current GAAP.
PROBLEMS
Current Liabilities
Accounts Payable—Unsecured $142,700
12% Notes Payable—Unsecured 57,000
Accrued Wages—with Priority 11,900
Accrued Interest Payable 38,400
Total Current Liabilities 250,000
10% Note Payable—Unsecured 54,400
9% Mortgage Note Payable—Secured by Equipment 80,000
Stockholders’ Equity
Common Stock, $.50 par value, 2,500,000
Shares Authorized, 480,000 shares issued and Outstanding 240,000
Retained Earnings (deficit) (156,800)
Total Equities $467,600
Required:
A. Prepare journal entries to give effect to the reorganization.
B. Prepare a post-reorganization balance sheet dated January 2, 2020.
C. Prepare journal entries to accrue interest on December 31, 2020, and to record the payment
of interest on January 2, 2021.
The following information concerning the period from June 30, 2020, to December 31, 2020, is
also available:
1. All Bran Company’s assets were transferred to the trustee.
2. Sales for the period were $130,000, of which $30,000 were cash sales.
3. Receivables collected by the trustee in cash were:
Old receivables $38,000
New receivables 85,000
4. Merchandise inventory was purchased on account by the trustee in the amount of $35,000.
5. Cash payments were made by the trustee for:
(a) Accounts payable (old), $110,000
(b) Accounts payable (new), $30,000
(c) Operating expenses, $47,000
(d) Trustee expense, $2,000
6. Adjusting entries recorded by the trustee on December 31, 2020, were:
(a) Estimated uncollectibles
Accounts receivable (old) $ 1,000
Accounts receivable (new) 2,000
Required:
Prepare a realization and liquidation account, including a copy of the cash account, for the period
June 30, 2020, to December 31, 2020. Use the alternate approach for reporting the components of
the net gain or loss on the sale of land and equipment.
The trustee, P. Smith, who was appointed to manage the debtor’s business during the period of
liquidation, opened a new set of books and took title to Plum Company’s assets on June 1, 2020.
The activities of the trustee during the five-month period ended October 31, 2020, are as follows:
1. The trustee sold all Plum Company’s inventory for $153,000, of which $75,000 represented
credit sales.
2. Cash was collected on old receivables, $11,250, and on new receivables, $64,500.
3. Expenses paid during the period were
Operating expenses $11,850
Trustee expenses 3,000
Required:
A. Prepare journal entries to record the effects of these transactions on the books of both the
trustee and Plum Company.
B. Prepare a combining workpaper at the end of the five-month period, October 31, 2020.
Debit Credit
Cash $ 6,000
Accounts Receivable 63,000
Allowance for Bad Debts $ 2,000
Notes Receivable 50,000
Accrued Interest on Notes Receivable 1,200
Inventory 60,000
Buildings 182,000
Accumulated Depreciation—Buildings 63,000
Equipment 14,600
Accumulated Depreciation—Equipment 1,400
Prepaid Insurance 1,100
Goodwill 8,500
Accrued Wages—with Priority 6,000
Taxes Payable—with Priority 2,400
Accounts Payable 170,000
Notes Payable 80,000
Accrued Interest Payable 1,600
Common Stock 110,000
Retained Earnings (deficit) 50,000
$436,400 $436,400
The assets are expected to bring cash on conversion in the following amounts:
Accounts receivable $50,000
Notes receivable including $1,000 accrued interest 40,800
Inventory 30,000
Building 75,000
Equipment 4,200
Prepaid insurance 400
The notes receivable are pledged as security on a note payable of $40,000. A note payable of
$20,000 is secured by a lien on the building, and the equipment is pledged as security on a note
payable of $10,000. One-half of the interest payable relates to the $40,000 note payable; the other
half of the interest payable relates to the $20,000 note payable. There is no accrued interest on the
other notes payable.
Required:
Prepare a statement of affairs as of May 31, 2020. Include a deficiency account, and determine the
estimated dividend rate to the general unsecured creditors.
Additional Information:
1. The cash account includes a $500 travel advance that has been spent.
2. Of the total accounts receivable, $75,000 is believed to be collectible. The remaining
accounts are doubtful, but it is believed that about one-third of these will be realized eventu-
ally. The accounts receivable are pledged as security on a $10,000 note payable.
3. Notes receivable of $50,000 have been pledged as security on a note payable of $45,000.
This portion of the notes receivable has an estimated realizable value of $35,000. The
remaining notes receivable, including the accrued interest, are expected to be fully collected.
The $45,000 note payable has accrued interest due of $1,000.
4. The finished-goods inventory is expected to sell at 20% above its cost, with expenses involved
in its disposition approximating 10% of selling price. The work in process inventory can
be completed at an additional cost of $55,000, of which $40,000 represents materials used
from the present raw materials inventory. The completed work in process should then sell
for $145,000; the remaining raw materials should sell for one-half their cost. Supplies are
expected to realize $1,300.
5. The investment in stock consists of 2,000 shares of Monelli Vineyards. The stock has a
current market value of $50 per share and is pledged as security on a note payable of $41,000.
Interest accrued on the note payable amounts to $1,750.
6. The land and buildings have been appraised at $165,000 and $260,000, respectively. They
are pledged as collateral on the mortgage note payable.
7. The equipment is expected to realize $100,000.
8. Prepaid expenses are nonrealizable.
Required:
A. Prepare a statement of affairs.
B. Prepare a deficiency account detailing estimated gains and losses.
C. Calculate the dividend rate per dollar of unsecured liabilities.