Solution manual advanced accounting 9e by hoyle ch13

Fully secured creditors hold a collateral interest in assets of the insolvent company having a value in excess of the related liability.. Bankruptcy cases have two overriding objectives:

CHAPTER 13 ACCOUNTING FOR LEGAL REORGANIZATIONS

B At present, legal guidance is provided primarily by the Bankruptcy Reform Act of 1978

as amended

1 This law attempts to arrive at a fair distribution of a debtor's assets

2 It also seeks to discharge the obligations of an honest debtor

II Bankruptcy proceedings can be formally instigated by either the debtor or a group of creditors

A A voluntary petition is filed with the court by the insolvent company while an involuntary

petition must be filed by a minimum number of creditors with a minimum level of debt

B After a bankruptcy petition is received, normally the court will grant an order for relief to halt all actions against the debtor

III Within the bankruptcy process, determining the appropriate classification of all creditors is

an important step in achieving a fair settlement

A Fully secured creditors hold a collateral interest in assets of the insolvent company having a value in excess of the related liability

B Partially secured creditors also have a collateral interest but the expected net realizable value will not satisfy the entire obligation

C Some unsecured obligations (including administrative expenses, certain debts to employees, and government claims for unpaid taxes) have priority over other unsecured debts

D The remaining unsecured creditors receive assets from the debtor only after the above claims have been satisfied

IV A Statement of Financial Affairs is frequently produced by an insolvent company to disclose its current financial position

A Assets are reported at net realizable value along with the disclosure of any pledged amounts Liabilities are classified according to the security or priority of the creditor

B A Statement of Financial Affairs is especially useful if prepared at the beginning of the

bankruptcy process to assist all parties in evaluating the outcome of various actions

C Most of the asset balances reported in this statement are merely estimations, projections of future events

V Bankruptcy proceedings often conclude with the assets of the debtor being liquidated to satisfy creditor claims (a Chapter 7 bankruptcy)

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2 It also discloses the effects of all transactions that have occurred to date

Vl As an alternative to liquidation, a company may seek to stay in business and attempt to return to solvency (a Chapter 11 bankruptcy)

A A reorganization plan has to be devised that can win the approval of each class of creditors and each class of stockholders as well as the court

B Reorganization plans normally entail a specific course of action designed to save the company and can include proposed changes in operations, methods of generating additional working capital, and a settlement of the debts that were in existence on the day that the order for relief was entered

Vll Financial reporting during reorganization

A The AICPA Statement of Position 90-7 (SOP 90-7) provides guidance for preparing financial statements while a company goes through reorganization

1 Gains, losses, revenues, and expenses that result from reorganization must be reported separately on the income statement

2 Professional fees incurred in connection with the bankruptcy must be expensed immediately

3 Liabilities subject to compromise are reported based on the expected amount of the allowed claims

VIII Fresh start accounting may be required when a company emerges from reorganization

A Assets are restated to current value but only if the fair value of assets is less than the allowed claims and the original owners are left holding less than 50 percent of company

B The recognition of goodwill may also be required if the reorganization value of the emerging company is greater than the value of the identifiable assets (both tangible and intangible)

C Retained earnings is set at zero to indicate that a new entity has been formed

4 Describe the purpose of an order for relief

5 List and describe the categories used to classify creditors during bankruptcy proceedings

6 Give examples of the types of unsecured liabilities that have priority in a bankruptcy

7 Produce a Statement of Financial Affairs for an insolvent company

8 Identify the responsibilities of a trustee in a liquidation (a Chapter 7 bankruptcy)

9 Prepare a Statement of Realization and Liquidation for a business going through liquidation

10 Indicate possible proposals that might be included in a reorganization plan and the method

by which a plan becomes accepted and confirmed

11 Produce an income statement during reorganization with reorganization items identified and separately reported

12 Produce a balance sheet during reorganization with liabilities classified as "subject to compromise" and "not subject to compromise."

13 Identify companies that are required to apply fresh start accounting when they emerge from reorganization

14 Apply fresh start accounting to a company emerging from bankruptcy according to SOP

to take Many important figures can be gleaned from these statements including the amount of the company's working capital, the current ratio, the debt to equity ratio, the trend in sales, the trend in long-term debt, operating cash flows, the gross profit percentage, any expenses that have risen at a fast rate, the amount of property that has been mortgaged, and the like He should then ask for a meeting with the treasurer (or another officer) of Abraham and Sons In this meeting, Thurber should discuss the possibility of having the current debt secured in some manner as protection The development of a formal repayment schedule would also be wise

If Thurber is not satisfied by the financial statements and the discussion with the client, he should meet with the clothing manufacturer who has called as well as with a lawyer and/or accountant They should discuss possible actions and the outcomes that could result from each Inevitably, if loss of the receivable seems probable, filing an involuntary petition for

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bankruptcy may be the wisest course of action to take However, that procedure should only be undertaken after adequate study has been made In the long run, companies do not prosper by having their clients go into bankruptcy

Students often address this type of case as either a black or white issue: give more credit or force them into bankruptcy The case simply does not provide enough data to arrive at either choice Thus, the students should be directed to consider the types of information that could prove to be beneficial in making this decision Often, in decision-making, the gathering of information is the key step in arriving at the proper conclusion

How Much Is That Building Really Worth?

College textbooks often present fair value as if it were a known number that was dependable Students may view an asset’s fair value as if getting that much money was virtually assured Thus, students often believe that producing a statement of financial affairs requires little more than establishing and reporting what a buyer will pay for an asset

This case was written to emphasize that a net realizable value might actually be no more than a wild guess Obviously, the value of most stocks and bonds can be determined with accuracy However, many other assets such as the building in this case might eventually prove to have a liquidation value that can vary from zero (many deserted buildings are simply never sold because no one wants to buy that type of building in that particular location even if it is in great condition) up to a significant amount

The accountant faces the problem of preparing a statement of financial affairs that requires that

a single number be reported as the value of each asset Users of this statement can then make important financial decisions based on the number that is presented Subsequently, the actual amount received may be significantly higher or lower than the figure shown The users of the information may feel as if they have been mislead when, in fact, the accountant made the best possible estimation

Given the problems faced in determining fair value, the accountant will probably seek a very conservative number for reporting purposes In most cases, less potential damage will be created by reporting a relatively low figure However, use of a particularly low value may tempt the creditors to allow the company to reorganize because little would seem to be gained by forcing liquidation For this reason, a conservative approach can favor the company attempting

to avoid liquidation

Probably the most important lesson from this case is that decision makers should look with skepticism on many of the numbers reported as representing fair value In some cases, fair value is a figure that can only be estimated and may depend on a number of factors that cannot

be anticipated in advance by the accountant or by anyone else

Is this the Real Purpose of the Bankruptcy Laws?

During the 1980s, as described in this case, the country saw a rash of bankruptcies that were filed to resolve major financial problems Previously, the bankruptcy laws had been used almost exclusively to settle insolvency problems However, if a voluntary petition is filed and accepted

by the courts, companies such as Manville and A H Robins are provided with a method of settling issues before actual insolvency occurs Sometimes the final results are good for the companies but not always A H Robins, for example, had to agree to be bought as one of the conditions of its reorganization In effect, the company lost its independence in order to satisfy the lawsuits resulting from the Dalkon Shield

As with many of the discussion questions in this book, this case is simply intended to alert

students to a real-life issue and encourage them to consider the ramifications To function in society, accounting students must know more than just the mechanical aspects of a bankruptcy What are the objectives of the bankruptcy laws and do these particular cases fall outside of those objectives? Would either Manville or its claimants, for example, have been better served by having the company slowly pulled into insolvency over years or perhaps decades? Should a different set of bankruptcy laws be established for companies having these types of financial crises? Although these questions are not directly related to accounting, they are the types of questions that accountants (both as business people and as citizens) need to address

Answers to Questions

1 "Insolvent" refers to a state of financial position whereby a company (or individual) is unable

to pay debts as they come due

2 In the United States today, the primary piece of federal legislation that governs most bankruptcy proceedings is the Bankruptcy Reform Act of 1978 and its subsequent amendments

3 Bankruptcy cases have two overriding objectives:

— To achieve a fair distribution of assets to the various parties that are involved with an insolvent company (or individual) and

— To discharge the obligations of an honest debtor

4 A voluntary bankruptcy petition is one filed by an insolvent company to gain protection from its creditors Creditors may also seek to prevent or limit losses by filing their own (involuntary) petition Where a company has at least 12 unsecured creditors, a minimum of three (having total unsecured debts of over $13,475) must sign an involuntary petition If fewer than 12 unsecured creditors exist, only one is needed to file the petition but the minimum debt level remains at $13,475

5 The granting of an order for relief halts all actions against an insolvent company The order for relief provides the company as well as the creditors with time to decide on a future course of action It also brings the court into the process and provides a structure for what might otherwise be a chaotic event, the distribution of assets to the parties involved

6 A fully secured creditor has an obligation from an insolvent company but holds a collateral interest in assets that have a value in excess of the debt Thus, these parties can assume that they will suffer no loss regardless of the outcome of the bankruptcy proceedings A partially secured creditor also has a collateral interest but the liability is larger than the anticipated proceeds from the realization of the attached assets A portion of the liability is covered but a risk of loss still exists in connection with the remaining debt Unsecured creditors have no collateral interest and can only hope to collect after the various secured interests have been satisfied Obviously, this last group of creditors has the highest chance

of incurring a loss

7 A liability classified "with priority" is still unsecured However, because of provisions of the Bankruptcy Reform Act of 1978, these debts must be paid before any other unsecured obligations Thus, the chance of loss is reduced, sometimes significantly Unsecured liabilities having priority include the following:

— Claims for administrative expenses,

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— Deposits made with the company to acquire goods or services (up to a $2,425 limit),

— Government claims for unpaid taxes

8 Administrative expenses are classified as liabilities with priority to offer some protection to those individuals who serve the company during the period of insolvency Without a legitimate chance for monetary reward, few people would be willing to provide the various administrative services needed during the bankruptcy process Also, these debts were incurred after the order for relief

9 In a Chapter 7 bankruptcy, the assets of the insolvent company are liquidated to satisfy the claims of the creditors Business activities cease and noncash assets are sold Conversely,

in a Chapter 11 bankruptcy, the company attempts to survive its financial problems and return to solvency A reorganization plan is developed that will allow the company to continue operations and reach a settlement of its debts This reorganization plan must be accepted by each class of creditors, each class of stockholders, and the court

10 Unsecured creditors often face the possibility of absorbing substantial losses in a Chapter 7 liquidation because their claims rank below fully secured and partially secured liabilities Frequently, little or nothing is expected As a result of this risk, unsecured creditors may feel that they have a better chance of limiting their losses by agreeing to a reorganization plan to keep the company alive as a potential future customer

11 The statement of financial affairs helps the parties involved with a bankruptcy to anticipate their potential losses It reports all assets of the insolvent company at net realizable value whereas liabilities are classified as fully secured, partially secured, with priority, and unsecured Based on the potential cash inflows and outflows, an estimation can be made of the losses that will be incurred by each group of claimants A statement of financial affairs is considered especially useful at the beginning of the bankruptcy process since it can assist the parties in evaluating the outcome of various possible actions

12 In general, a trustee is assigned to prevent loss of the insolvent company's assets and oversee the liquidation and distribution process A number of rather procedural tasks are normally accomplished by the trustee shortly after appointment such as notifying the post office, changing locks, obtaining possession of corporate records, and opening a new bank account Thereafter, the trustee might have to operate the company for a period of time to complete any business still in process The trustee also has the power to void any transfer

made by the debtor within 90 days prior to the filing of the bankruptcy petition if the company

was insolvent at the time Subsequently, the trustee works to liquidate noncash assets and make appropriate disbursements to the various claimants During this entire process, the trustee needs to make periodic reportings to the court and other interested parties

13 A trustee can demand the return of any payment (or other asset transfer) made within 90 days prior to the filing of a bankruptcy petition if the company was already insolvent This legal procedure is known as the voiding of a preference transfer and is intended to prevent one party from gaining an unfair advantage over the remaining claimants In effect, the payment is viewed as a distribution of the insolvent company's assets, a process that is to

be controlled solely by the trustee and the court

14 A statement of realization and liquidation is designed to report (1) the account balances of the insolvent company at the date the order for relief is entered, (2) the liquidation of noncash assets, (3) the cash distributions made to the various claimants, (4) any other transactions incurred during this period, and (5) any remaining asset and liability balances

15 During the liquidation of an insolvent company, control is turned over to an outside trustee However, in a Chapter 11 bankruptcy (a reorganization), operations will usually be continued

so that an attempt can be made to arrive at a plan to save the company While the bankruptcy proceeds, control is normally retained by the ownership, a group legally referred

to as the debtor in possession

16 In a Chapter 11 bankruptcy, the debtor in possession (the present ownership of the company) is given the initial opportunity of filing a reorganization plan with the court If a formal proposal is not put forth by the debtor in possession within 120 days of the order for relief or is not accepted within 180 days, any interested party has the right to submit a plan Bankruptcy proceedings often drag on for lengthy periods because the time limitations can

be extended by the court However, because of recent changes in the bankruptcy laws, the debtor’s exclusivity to propose a plan cannot be extended beyond 18 months

17 Numerous types of proposals are to be found in reorganization plans For example, many will set forth specific ideas for changes to be made in the company's operations (to increase profitability) such as selling assets or terminating complete lines of business In addition, most reorganization plans identify sources that will be tapped in the future to generate additional funding Proposed changes in management may also be spelled out in an attempt

to persuade claimants that the company will have the ability to overcome its past economic problems Last, and probably most important, a reorganization plan must include some anticipated settlement of the claims against the company that were in existence at the time the order for relief was entered Before any reorganization plan is approved, the creditors (as well as the court) must be convinced that the financial rewards will outweigh the amounts that could be received from a liquidation

18 To become effective, a reorganization plan must be accepted by all interested parties For approval, each class of creditors (more than two-thirds in dollar amount and one-half in number) must vote for the proposal Each group of stockholders (two-thirds of the shares being voted) must also accept the plan The court will then confirm the reorganization plan but only if the court feels that all parties are being treated fairly The court also has the authority to confirm a proposal even if not accepted by the creditors or stockholders This procedure (known as a "cram down") is only used if the plan is judged to be fair and equitable

19 A "cram down" is a legal provision whereby the court can confirm a reorganization proposal for an insolvent company even though the plan has not been accepted by a particular class

of creditors or stockholders This step is not taken unless the court believes the plan being put forth is fair and equitable

20 During reorganization, some debts are in jeopardy of being settled at a significantly reduced amount whereas others will probably be paid at face value Unsecured and partially secured liabilities are likely to be settled at a lowered figure Conversely, fully secured liabilities and any debts incurred during the reorganization period are normally not at risk of being reduced Thus, if a balance sheet is produced while a company is in reorganization, all liabilities are reported as either being subject to compromise (reduction) or not being subject

to compromise The debts subject to compromise are reported at the expected amount of allowed claims rather than at an estimation of the settlement figure Such estimations are often difficult, if not impossible, to make

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21 A company going through a Chapter 11 bankruptcy will report specified reorganization items

on its income statement separately from operating figures However, these reorganization items are reported prior to income tax expense rather than in a manner similar to an extraordinary item These separately disclosed figures include gains and losses on the sale

of assets necessitated by the reorganization Professional fees incurred in connection with the reorganization are also reported in a similar manner as well as any interest revenue that would not have been earned except for the bankruptcy proceeding

22 Professional fees incurred during a reorganization must be expensed as incurred Capitalization is not allowed

23 “Fresh start accounting” refers to the adjustment of a company's assets to current value at the time the organization emerges from bankruptcy A company must use fresh start accounting if two criteria are met at the time the reorganization is finalized: (1) the fair value

of the assets is less than the total allowed claims as of the date of the order for relief plus the liabilities incurred during reorganization and (2) the original owners are left with less than

50 percent of the voting stock

In fresh start accounting, all assets are reported at current value while liabilities are reported based on the present value of the settlement amounts If the reorganization value of the company as a whole is greater than the total fair value of the individual assets, goodwill is reported for the excess

Initially, in fresh start accounting, retained earnings must be reported at a zero balance

24 Fresh start accounting is used by companies that are emerging from a bankruptcy reorganization if the value of the assets held at that time are less than the allowed claims associated with company’s liabilities (those present at the date of the order for relief and those incurred since that date) and the original owners are left with less than 50 percent of the voting stock of the reorganized company

25 In fresh start accounting, the tangible and intangible assets of the company are reported at their fair values Liabilities are reported at the present value of the future cash flows

26 When a company emerges from bankruptcy, the reorganization value of its assets as a whole must be determined The figure is normally computed by discounting anticipated future cash flows from the business This figure is then assigned to the various assets of the company based on individual fair values The total reorganization value may well be greater than the current value of the individual assets If so, the residual amount is recorded as the intangible account Goodwill Each year (or more often in some cases) it is reviewed for impairment

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Percentage of Unsecured Liabilities To Be Paid: $111,000/$185,000 = 60 %

Payment On Notes Payable:

Value of Security (land) $ 90,000

60% of Remaining $30,000 18,000

Total Collected by holders $108,000

23 (5 Minutes) (Distribution of assets in a liquidation)

Liabilities with Priority

Paid first—administrative expense $2,450

Paid second—wages up to a maximum of

$10,950 for Mr Key 16,950

All remaining money—government claims to unpaid taxes 5800

Total of free assets $25,200

No payments will be made in connection with the remainder of the salaries, the government claims and all of the unsecured accounts payable since no money is left

24 (8 Minutes) (Distribution of assets to partially secured creditors)

Liabilities with Priority $ 42,000

Free Assets after Payment of Liabilities with Priority

Percentage of Unsecured Liabilities To Be Paid: $84,000/$280,000 = 30%

Payment On Partially Secured Debt:

Value of Pledged Asset $ 50,000

30% of Remaining $80,000 24,000

Total to be Collected by holders $ 74,000

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Liabilities with Priority 20,000

26 (12 Minutes) (Liquidation of assets to satisfy debt)

The holder of Debt Two will receive $100,000 from the sale of the pledged asset Since the holder wants to receive $142,000 out of the total debt of

$170,000, the company must be able to generate enough cash to pay off 60 percent of the unsecured liabilities ($42,000/$70,000) after paying 100 percent

of the liabilities with priority ($110,000)

Cash Needed For These Liabilities $198,000

In order for the holder of Debt Two to receive exactly $142,000, the other free assets must be sold for $308,000 With that much money, the liabilities with priority ($110,000) can be paid with the remaining $198,000 going to the unsecured debts of $330,000 This 60 percent figure would insure that the holder of Debt Two would get $100,000 from the pledged asset and $42,000 ($70,000 x 60%) from the free assets

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27 (8 Minutes) (Payments to be made on unsecured and partially secured liabilities)

a The unpledged assets of $300,000 must be added to any excess to be received

get amount of free assets available of $350,000

Amount Available $350,000

Liabilities with Priority (160,000)

Available for Unsecured Creditors $190,000

Accounts Payable $390,000

Partially Secured Debt in Excess of Pledged

Assets ($490,000 – $380,000) 110,000

Unsecured Liabilities $500,000

Distribution to Unsecured Creditors: $190,000/$500,000 = 38%

An unsecured creditor to whom $3,000 is owed can expect to receive $1,140 ($3,000 x 38%)

b The bank will receive a total of $87,600 The secured interest will generate

$80,000 The remaining $20,000 liability is unsecured so that only an additional payment of $7,600 (38%) can be expected

28 (20 Minutes) (Distribution of assets in a liquidation)

Free Assets: (fair market value)

Cash $ 10,000

Inventory 60,000 Equipment 50,000

Note Payable C 60,000

Accounts Payable 120,000

Total $280,000

Percentage of Unsecured Liabilities To Be Paid: $70,000/$280,000 = 25%

Payment on Note Payable A:

Value of Security (land) $ 70,000

25% of Remaining $20,000 5,000

Total Collected $ 75,000

Payment on Note Payable B:

Value of Security (building) $ 40,000

25% of Remaining $80,000 20,000

Total Collected $ 60,000

Payment on Note Payable C (unsecured):

25% of $60,000 $ 15,000

Payment on Administrative Expenses:

As a liability with priority, the entire amount due is paid $ 20,000

Payment on Accounts Payable (unsecured):

25% of $120,000 $ 30,000

Payment on Income Taxes Payable:

As a liability with priority, the entire amount due is paid $ 30,000

Payment on Administrative Expenses Payable:

As a liability with priority, the entire amount due is paid $ 20,000

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29 (15 Minutes) (Liquidation of assets to satisfy debt)

Note payable B is unsecured The holders want at least $125,000 of the total balance of $250,000; thus, there must be at least enough money available to pay 50 percent of the unsecured debts All values are known except for the equipment

Less: Liabilities with Priority:

Estimated administrative expenses (12,000)

Taxes payable to government (20,000)

In order for unsecured creditors to receive 50 percent of their claims, $220,000

in free assets must be available (50 percent of $440,000) At present only

$96,000 is available Thus, $124,000 must be received from the liquidation of the equipment ($220,000 – $96,000)

30 (15 Minutes) (Payment of various liabilities in a liquidation)

Less: Liabilities with priority

Free assets available $84,000

Percentage of unsecured liabilities to be paid: $84,000/$210,000 = 40%

Amounts to be paid for:

Salary payable (liability with priority to be paid

Bonds payable (partially secured—will collect

$180,000 from building and 40 percent of the

remaining $120,000) $228,000

31 (2 Minutes) (Reporting of debts during liquidation)

Because of the uncertainty of the amount that will be paid on an unsecured debt, no attempt is made in financial reporting to anticipate the payment Liabilities are reported at the expected amount of the allowed claim In this case, the creditors apparently have a legitimate claim of $200,000

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to the $60,000 must be recognized

In addition, the retained earnings deficit must be eliminated and all other asset and liability accounts adjusted to the value on the day that the company exits from bankruptcy

Because common stock was transferred directly from the previous owners to the creditors, no entry is needed for the stock account However, because the reorganization value is $760,000 but liabilities are $300,000, stockholders’ equity must be $460,000 Since retained earnings will be zero and common stock will remain $330,000, additional paid-in capital should be adjusted to

Additional Paid-in Capital

33 (15 Minutes) (Prepare income statement for company going through a

bankruptcy reorganization)

ADDISON CORPORATION Income Statement

Revenues $ 467,000 Costs and expenses:

Cost of goods sold $ 211,000

Net loss $(22,400)

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The first criterion is that the fair value of the assets of the emerging company must be less than the allowed claims as of the date of the order for relief (plus liabilities incurred during reorganization)

The second criterion is that the original owners must be left with less than 50 percent of the voting stock of the emerging company

Whenever both of these criteria are met, the company's assets should be reported at current values

b Under fresh start accounting, the assets of the company are adjusted to current value on the date that it successfully emerges from bankruptcy reorganization A reorganization value for the entity’s assets as a whole is first determined by discounting the cash flows that are anticipated This balance is assigned to identifiable assets (both tangible and intangible) in the same manner as in a purchase combination Any amount of the reorganization value that exceeds the assigned total is recorded as goodwill

c The reorganization value in excess of the value of the identified assets and liabilities is reported as the intangible asset goodwill Goodwill is reviewed each year for impairment

35 (15 Minutes) (Prepare a balance sheet for a company in bankruptcy

reorganization)

JAEZ CORPORATION Balance Sheet December 31, 2008 Current assets:

Liabilities not subject to compromise

Current liabilities:

Accounts payable $ 60,000

Long-term liabilities:

Note payable (due 2010) $110,000

Liabilities subject to compromise

Accounts payable 123,000

Accrued expenses 30,000

Income taxes payable 22,000

Note payable (due 2013) 170,000 345,000 Total liabilities 615,000

Stockholders' equity

Common stock 200,000

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36 (40 Minutes) (Prepare journal entries for company emerging from bankruptcy using fresh start accounting)

Preliminary computations:

BOOK VALUES PRIOR TO EMERGING FROM REORGANIZATION

— Total assets at book value = $710,000 ($100,000 + $112,000 + $420,000 +

BOOK VALUES AFTER EMERGING FROM REORGANIZATION

— Total assets = $780,000 (reorganization value)

— Total liabilities = $340,000 ($5,000 + $4,000 + $100,000 + $50,000 + $71,000 +

$110,000)

— Total common stock = $240,000 (all 18,000 returned shares are reissued)

— Deficit = -0- (eliminated by the reorganization)

— Additional paid-in capital = $200,000 (figure needed to balance above accounts after reorganization)

— Because the company will have 30,000 shares outstanding after the reorganization, the additional paid-in capital equals $6.66 per share ($200,00/30,000)

— Because the company has a reorganization value of $780,000 but the assets have a market value of only $735,000, goodwill of $45,000 must be recognized

To adjust accounts to market value as part of fresh

start accounting

— Common stock 144,000

To record shares turned in to the company by the

owners as part of the reorganization plan, 18,000

36 (continued)

— Accounts payable 80,000

Note payable 5,000

Additional paid-in capital ($6.66 per share—see

To record settlement of accounts payable

— Accrued expenses 35,000

Note payable 4,000

To record settlement of accrued expenses

— Note payable 200,000

Note payable 50,000

Additional paid-in capital ($6.66 per share—see

To record settlement of note payable due in 2011

— Note payable 185,000

Note payable 71,000

Additional paid-in capital ($6.66 per share—see

To record settlement of note payable due in 2009

— Note payable 200,000

Note payable 110,000

To record settlement of note payable due in 2010

Gain on debt discharge 196,000

To adjust additional paid-in capital to

appropriate balance, close out gain, and

eliminate deficit balance as part of fresh start

accounting

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The original owners are left with less than 50 percent (40 percent actually)

of the voting stock

b Because the company has a reorganization value of $800,000 but only

$653,000 can be assigned to specific assets based on market value, the remaining $147,000 is reported as Goodwill

SMITH CORPORATION Balance Sheet December 31, 2008 ASSETS Current Assets:

Accounts receivable $ 18,000

Inventory 111,000 $129,000 Land, Buildings, and Equipment:

Land and buildings 278,000

Machinery 121,000 399,000 Intangible Assets:

Patents 125,000

Goodwill 147,000 272,000 Total Assets $800,000

LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities:

Accounts payable $ 97,000 Long-term Liabilities:

Note payable (due in 2 years) $ 35,000

Note payable (due in 5 years) 50,000

Note payable (due in 8 years) 100,000 185,000 Total Liabilities $282,000 Stockholders' Equity:

Common stock (par value) $500,000

Retained earnings -0- 518,000

38 (15 Minutes) (Distribution of assets in a liquidation)

Free assets: (liquidation value)

Other assets $ 81,000

Assets pledged with fully secured creditors in

excess of debt 45,000

Total free assets $126,000

Free assets after paying liabilities with priority

Total unsecured debts $360,000

Percentage of unsecured debts to be paid: $90,000/$360,000 = 25%

— Liabilities with priority collect the entire amount of $36,000

— Fully secured liabilities collect the entire amount of $200,000

— Partially secured liabilities collect $103,000 from the pledged assets and 25% of the remaining $77,000 ($19,250) for a total of $122,250

— Unsecured liabilities collect 25% of the $283,000 balance or $70,750