advanced accounting 6e by jeter chaney chapter 10

• When a business becomes insolvent, it generally has three possible courses of action: – Debtor and its creditors may enter into a contractual agreement, outside bankruptcy; – Debtor o

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Learning Objectives

• Distinguish between a Chapter 7 and a Chapter 11 bankruptcy

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

• Distinguish between a voluntary and involuntary bankruptcy petition

• Distinguish among fully secured, partially secured, and unsecured claims of creditors

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

• Describe the ways debt may be restructured in a reorganization

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• Insolvency refers to the inability of a debtor to pay its obligations as they become due

– Although the Bankruptcy Reform Act provides for relief of all types of insolvent debtors,

including individuals, our discussion will concentrate on the provisions of the act dealing

with insolvent business entities.

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

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

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

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

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– Formation of a creditors’ committee.

– Voluntary assignment of assets

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LO 5 Contractual agreements.

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Contractual Agreements

Extension of Payment Periods

• FASB ASC paragraph 470-50-40-6:

– Where a debt restructuring involves only a modification of terms of payment,

• the debtor should account for the restructuring, prospectively from the time of

restructuring and

• should 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

A composition agreement is an agreement between the debtor and its creditors under which the

creditors agree to accept less than the full amount of their claims

• Creditors are often given some immediate cash payment, and the amount of the remaining debts and their interest rates are renegotiated

• The benefit to the creditors is that they receive an immediate cash payment and expect to

eventually receive more than they would if the debtor were forced to liquidate

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Formation of a Creditors’ Committee

• Responsible for managing the debtor’s business affairs for the period during which plans are

developed to rehabilitate, reorganize, or liquidate the business

• Often, an extension of payment periods for debtor obligations is agreed to while the committee

deliberates the ultimate disposition of the business

– If the decision is to rehabilitate the business, the agreement may include the cancellation or restructuring of existing debts and possible infusion of new capital by the creditors

– If the decision is to liquidate the business, the debtor’s property may be turned over to a

trustee

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Voluntary Assignment of Assets

• A debtor may elect to place its property under the control of a trustee for the benefit of its

creditors

• Purpose of the assignment

– Permit the trustee to sell the property and distribute the proceeds among the creditors

– Any proceeds remaining after payment of the creditors, are returned to the debtor

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• Provisions of the Bankruptcy Reform Act of 1978 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)

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LO 3 Voluntary vs involuntary petitions.

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Voluntary Petitions

proceedings and establishes an estate consisting of the debtor’s assets.

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LO 3 Voluntary vs involuntary petitions.

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Secured and Unsecured Creditors

• Secured 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

– Secured creditors are paid first with the proceeds from the sale of specific assets upon

which they have liens

– Thereafter, unsecured creditors, including those having priority, are paid from whatever

proceeds remain from the realization process

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LO 4 Secured and unsecured creditors.

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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 the petition is accepted

• An order for relief is entered and the bankruptcy court will appoint an interim trustee until a permanent trustee is selected

• The court must call a meeting of the debtor’s creditors

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LO 1 Chapter 7 versus Chapter 11.

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Reorganization Under Reform Act (Chapter 11)

• Creditors of an insolvent debtor may believe their long-range interests would be served by

rehabilitating or reorganizing the debtor

• In such a case:

– Creditors and debtor may agree to a plan for reorganization or

– Debtor 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 Reorganization

• When firms emerge from bankruptcy, FASB ASC paragraphs 852-10-45-19 to 20 provide for

fresh start accounting (implication is that a new firm exists)

– 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 Reorganization

Quasi reorganization

• 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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Accounting for Reorganizations – Troubled Debt Restructurings

• Debt may be restructured in any one (or a combination) of the following methods:

– The debtor may transfer assets in full settlement of the payable

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

– The creditor may modify terms of the payable

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• 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

• The gain on restructuring is included in net income in the period of the restructuring

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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

• 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 Terms

• A 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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Review:

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

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Reorganization – Transfer of Assets

• 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

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Copyright 50,000

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

Notes Payable 150,000

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

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

Notes Payable 150,000

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

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Reorganization – Modification of Terms

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

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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 900,000

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

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Review:

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

debtor as extraordinary gains

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The “Accounting” Statement of Affairs

• 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

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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, 2015

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

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E10-7: Statement of Affairs

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E10-7: Statement of Affairs

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

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E10-7: Deficiency Account

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Review:

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

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Trustee 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, but liabilities occurred later are recorded

– Payment of preexisting debts reduces the assets for which the trustee is accountable

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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, 2015:

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

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Cash 26,700

* ($939,400 – $16,000 - $211,500)

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

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Cash 31,500

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:

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

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E10-9: 4 Cash payments were made as follows:

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