solution manual advanced financial accounting 8th edition baker chap020

Q20-2 The major difference between a Chapter 7 action and a Chapter 11 action is that the debtor continues as a business after a Chapter 11 reorganization whereas the business does not

Chapter 20 - Corporations in Finanacial Difficulty

CHAPTER 20 CORPORATIONS IN FINANCIAL DIFFICULTY

ANSWERS TO QUESTIONS

Q20-1 The nonjudicial actions available to a financially distressed company are debt

restructuring arrangements and creditor's committee management The judicial actions available are corporate liquidation (Chapter 7) and corporate reorganization (Chapter 11)

Q20-2 The major difference between a Chapter 7 action and a Chapter 11 action is that

the debtor continues as a business after a Chapter 11 reorganization whereas the business does not survive a Chapter 7 liquidation

Q20-3 Under two circumstances an involuntary petition for relief may be filed The first

circumstance is that the debtor is generally not paying debts as they become due The second circumstance is that within the last 120 days a custodian has been appointed by other creditors, by the debtor, or by some other agency to take possession of the debtor's assets If more than 12 creditors exist, then three or more creditors must combine to file the petition These three or more creditors must have aggregate unsecured claims of at least $5,000

Q20-4 The following items are usually included in the Plan of Reorganization filed as

part of a Chapter 11 reorganization:

All major actions to be taken during the reorganization:

(1) Discontinuances of unprofitable operations

(2) Restructuring of debt with specific creditors

(3) Revaluation of assets and liabilities

(4) Changes in the par value of outstanding stock, or realignment of

stockholders' equity with newly issued shares of voting common stock

Q20-5 The account Reorganization Value in Excess of the Amount Assigned to

Identifiable Assets is established during a Chapter 11 fresh start accounting to record the excess of the reorganization value that is not assigned to specific assets The

account is an intangible asset and is accounted for in accordance with FASB 142

Q20-6 A company in Chapter 11 reorganization qualifies for fresh start accounting if

both of the following occur:

1 The reorganization value of the entity's assets of the emerging entity immediately before the date of confirmation is less than the total of all post-petition liabilities and allowed claims; and

2 Holders of existing voting shares immediately before confirmation receive less than 50% of the voting shares of the emerging entity

Companies using fresh start accounting revalue their assets to fair values, using the

procedures in FASB 141 An account called Reorganization Value in Excess of the

Amount Assigned to Identifiable Assets is used to record any excess in reorganization

Q20-7 The financial statements that must be filed by a company during a Chapter 11 reorganization include a complete set of audited financial statements SOP 90-7

established specific guidelines for these statements, noting that amounts associated with reorganization should be reported separately

Q20-8 The rights of creditors with priority in a Chapter 7 liquidation are to receive any

assets available to unsecured creditors after the secured creditors have been satisfied

Q20-9 The statement of affairs is the basic accounting report made at the beginning of

the liquidation process to present the expected realizable amounts from disposal of the assets, the order of creditors' claims, and the expected amount unsecured creditors will receive as a result of the liquidation In addition, the statement of affairs presents the book values of the debtor company's balance sheet accounts and the estimated deficiency to the general unsecured creditors As a final point, the statement of affairs is not a going concern report

Q20-10* A trustee who takes title to the debtor's assets in a liquidation must make a

periodic financial report to the bankruptcy court reporting on the progress of the liquidation and on the fiduciary relationship held When the trustee accepts the assets, a new set of books is opened for the debtor and a new account is created to recognize the debtor's interest in the net assets accepted by the trustee A statement of realization and liquidation is prepared on a monthly basis for the bankruptcy court showing the results of the trustee's fiduciary actions’ beginning at the point the trustee accepts the debtor's assets

Q20-11* Sales of assets are reported in the statement of realization and liquidation as

assets realized in the assets section of the statement

Chapter 20 - Corporations in Finanacial Difficulty

SOLUTIONS TO CASES

C20-1 Creditors' Alternatives

The options to the creditors are (1) form a creditors' committee, (2) a Chapter 11 reorganization, and (3) a Chapter 7 liquidation The eventual decision must rest upon the creditors' assessment of the viability of the rehabilitation of the debtor versus the liquidation values of the debtor's assets

Most creditors do not want to see the liquidation of a debtor because, as creditors, they are in the business of loaning monies, not trying to manage a business or attempting to obtain as much of a liquidation dividend as possible in a liquidation Most creditors will work with the debtor's management as long as possible Secured creditors have greater protection of their receivables than do unsecured creditors However, even most secured creditors prefer to see a debtor company be rehabilitated after a time of financial difficulty rather than see the debtor liquidated The timing of the cash flows is somewhat dependent on the amount of reduction in debt the creditors are willing to absorb If the creditors are willing to work with the debtor, the creditors may eventually realize a greater percentage of their debt, but it usually takes a longer time to receive the payments from the debtor

The creditors' committee is a nonjudicial action that provides for flexibility to both the creditors and the debtor The creditors' committee typically works with the debtor company to enact a plan of settlement of the debtor's indebtedness In some cases, the creditors may assume management control of the company, but most creditors are reluctant to do this because of the added risk of legal action if the company does enter bankruptcy Creditors may eventually receive a substantial part, or possibly all, of their receivables as the debtor is able to "work down" its debt over time

Chapter 11 reorganization offers the creditors a chance to continue having a customer once the customer solves its immediate financial problems A reorganization is an acceptable option if the creditors feel the company would have the basic operating and financial foundations after the reorganization to become a going concern Creditors often accept reduced amounts as settlements of their receivables, or will modify the terms of existing debt as part of the reorganization agreement

Chapter 7 liquidations are the final step The creditors must go through the judicial process that may take a long time to complete Liquidation should be used only if no other alternative is viable Creditors often receive a smaller portion of their receivables because of the forced liquidation of the assets and the extensive legal and administrative costs involved in a liquidation

C20-2 Research Related to Bankruptcy

The website for the U.S Bankruptcy Courts is: www.uscourts.gov/bankruptcycourts.html

a The Frequently Asked Questions (FAQs) for the U.S Bankruptcy Courts state that a U.S bankruptcy judge is a district court judicial officer who is appointed by the majority of judges of the U.S appeals court to have jurisdiction over bankruptcy matters As bankruptcy cases come before a district court, a bankruptcy judge is assigned to the case Some courts assign judges based on random assignment while other courts have

a chief judge who seeks to select a judge to assign based on a judge’s experience or special expertise relevant to the case Each court will have a written plan or system for assigning cases

b The U.S Bankruptcy Court’s Website has a link to Official Bankruptcy Forms to be used

in filings before the courts The forms and instructions for a Voluntary Petition are available in Part I of the Bankruptcy Forms Manual page The official form is FORM B1 for a voluntary petition

A voluntary petition is initiated by the debtor and therefore the information required is principally related to the debtor, such as name, address, and location of the principal assets of the debtor The debtor must declare such items as the number of creditors, the estimated assets, the estimated debts, the type of petition (i.e., Chapter 7, Chapter 11, etc.), if sufficient funds will be available to satisfy the unsecured creditors The debtor may also be required to file additional exhibits (Exhibit A for publicly traded companies, Exhibit B is used in personal filings and Exhibit C to describe any property that might pose a threat of identifiable harm to public health or safety)

c The United States Bankruptcy Courts Website presents a link to Bankruptcy Statistics that are presented in pdf format Statistics are presented for various time periods such

as quarters, fiscal years and calendar years Note that Case 20-3 asks for the most recent calendar year ending on December 31

(1) Total business filings are presented at the top of the form for business and nonbusiness filings for the twelve month period ended for the most recent year Statistics for prior years are also available Business filings are typically about 34,000 but do fluctuate slightly based on economic conditions Approximately sixty percent of these filings are under Chapter 7, about twenty-eight percent under Chapter 11, and the remainder under various other chapters of the Bankruptcy Code

(2) Students should find the Federal judicial district in which their educational institution

is located The larger states typically have several districts and students may have

to make an assumption for which district they are located It is instructive to see that the numbers of filings vary widely by district The number of filings may differ due to different economic factors for specific parts of the United States, the nature

of the industrial base in a specific district, the size of a district, and other factors reflecting business factors across court districts Students might reflect on why the number of filings in their Federal court district are different from those in other districts in other circuits

Chapter 20 - Corporations in Finanacial Difficulty

C20-3* Selection of Bankruptcy Trustee and Trustee’s Responsibilities

Title 11 of the United States Code may be obtained from several sources through using

a web browser and the search term, “Title 11 of the U.S Code.” The case asks about trustees for a Chapter 7 bankruptcy filing

a Subchapter 1 of Chapter 7 of Title 11 of the U.S Code specifies the administration of

a Chapter 7 bankruptcy filing Section 701 states that the United States Trustee shall appoint an interim trustee who is a member of the panel of private trustees established under federal law Private trustees are persons who have prior financial expertise and experience and have been approved by a formal review process After the appointment of an interim trustee, Section 702 describes how creditors may elect

a trustee under the circumstances in which creditors holding at least twenty percent

of the unsecured claims request that an elected trustee administer the Chapter 7 bankruptcy A candidate must receive the votes of creditors holding a majority of the claims of the unsecured creditors

b Section 704 of Subchapter 1 of Chapter 7 of Title 11 of the U.S Code defines the duties of the trustee The trustee is responsible for administering the business, is accountable for all property received, and must evaluate the claims of the creditors to make sure the claims are valid prior to settlement The trustee also prepares periodic reports and summaries of the operations of the business which it provides to the United States Trustee or Bankruptcy Court Upon completion of the operations, the trustee must file a final report on the administration of the estate with the court and with the United States Trustee

C20-4 The Bankruptcy of WorldCom

Overall, the 2002 bankruptcy of WorldCom resulted in a cumulative net reduction to their shareholders’ equity of $70.8 billion as of December 31, 2001, and a reduction in previously reported net income of $17.1 billion and $53.1 billion for the years ended December 31, 2001, and 2000 respectively Goodwill of $44.9 billion was reduced to zero at December 31, 2001 The WorldCom bankruptcy and resultant adjustments made during the reorganization process are certainly one of the most significant bankruptcies in U.S business history

The following information is taken from WorldCom Inc.’s 10-K for the fiscal year 2002 that was filed with the SEC on March 12, 2004

a (Source: Item 3, Legal Proceedings) WorldCom filed a voluntary petition for bankruptcy on July 21, 2002, under Chapter 11, Reorganization

b (Source: Item 3, Legal Proceedings and the MD&A) The primary reason seems to

be that management and the Board of Directors had been informed of very significant accounting irregularities and needed time to investigate the possible irregularities, and to protect the company from lawsuits from creditors and others For example, on June 26, 2002, the SEC filed a civil suit against the company for its past financial reports On April 29, 2002, Bernard Ebbers resigned as President and Chief Executive Officer The company undoubtedly felt it needed the protection of bankruptcy to give it time to study the breadth of its financial and accounting problems and to reorganize to recover from those problems without additional legal pressure from its creditors

c (Source: Item 3, Legal Proceedings) On June 25, 2002, the company publicly announced that an internal audit found a number of transfers from line cost expenses (referred to as access cost expenses) to capital accounts, thus decreasing expenses and increasing assets For the year 2001 and the first quarter of 2002, this amount

of transfer was $3.9 billion In addition to this item, the company was improperly accounting for impairment tests on its long-lived assets, its acquisitions, its revenue contracts and several other irregularities However, it was the accounting for the access costs as assets when they were clearly expenses that were the primary accounting irregularity that initiated the internal review

d (Source: Item 7, Management’s Discussion and Analysis) Item 7 of the company’s

2002 10-K presents a section titled “Restatements and Reclassifications of Previously Issued Consolidated Financial Statements” A table is presented that summarizes the restatement items on revenue and pre-tax income or loss for the years ended December 31, 2001 and 2000 The major categories of income statement restatement adjustments are presented below (in $millions), with a brief explanation of each category following the table: (Parentheses used for decreases in reported amounts)

Chapter 20 - Corporations in Finanacial Difficulty

C20-4 (continued)

Year Ended December 31, 2001

Year Ended December 31, 2000

Pre-tax income (loss) Revenue

Pre-tax income (loss)

Because most of the accounting personnel, including the Chief Financial Officer and the controller, were terminated shortly after the large scope of the accounting irregularities were discovered, the company determined that it could not objectively restate periods prior to the 2000 fiscal year However, a minor adjustment decrease

of $.7 billion was made to the ending shareholders’ equity as of December 31, 1999

A brief explanation of each of the 10 adjustment categories above is summarized from the disclosures in Item 6 of WorldCom’s 2002 10-K

1 Impairment: The company discovered that impairment tests had not been

performed for goodwill and long-lived assets even though FASB 121 triggers had

occurred The application of these impairment tests resulted in very significant writedowns for both 2000 and 2001

2 Improper reduction of access costs: The primary adjustments for this item were due to the improper capitalization of access costs that should have been expensed as incurred in accordance with GAAP

3 Purchase accounting: The company made numerous acquisitions, including the MCI acquisition, between 1993 and 2001 and a review of these acquisitions concluded that a number of errors were found in the application of purchase accounting valuations and procedures that overstated the amounts capitalized for the acquisitions

C20-4 (continued)

4 Long lived asset accounting: This item includes adjustments to depreciation and amortization, changes in the estimated useful lives of long-lived assets, including those acquired in the MCI combination, and other costs that had been inappropriately capitalized as long-lived assets that should have been expensed

5 International: Adjustments were made for correcting the U.S GAAP-based statements from the foreign accounting principles In addition, a review of the functional currency rules resulted in changing the functional currencies for many

of the international subsidiaries from the local currency to the U.S dollar

6 Revenue related adjustments: A number of adjustments were made because of lack of documentation to support the company’s deferral of income under SAB

101 In addition, the company had incorrectly accounted for some contracts as sales when in fact the company had acted as an agent and should have recorded just the net of the amounts as income rather than record gross sales and gross costs

7 Adjustments to accrued liabilities: Adjustments were made to eliminate improper accruals of liabilities for items such as legal reserves, employee benefits and tax liabilities

8 Embratel and Avantel acquisitions: A review of the Embratel acquisition showed

an incorrect interpretation with regard to not having control over Embratel and that Embratel should have been consolidated rather than reported net as an investment A review of the Avantel relationship to WorldCom resulted in changing the accounting from an equity investment to a full consolidation

9 Unclassified income/ (expense): A review of several accrued liability accounts showed that there was inadequate documentation to support the accruals Also, there were other accrued assets and some liabilities recorded on the historical balance sheet for which there was either no, or inadequate, documentation to support that the company owned the assets or owed the liabilities

10 Other: The company made a number of reclassifications, revaluations of derivatives, intercompany balances, and certain capitalized costs such as interest, labor and overhead for capital projects

These adjustments were also carried through the restated balance sheet and statement of cash flows for 2001 and 2000

e (Source: Item 7 of WorldCom’s 2002 10-K) From the date the bankruptcy petition was filed, July 21, 2002, through the entire reorganization period, the company used the provisions of SOP 90-7 for accounting and financial reporting purposes The

“Debtors-In-Possession” heading informs readers of the financial statements that the company is in bankruptcy reorganization but management still controls the company under the administration of a bankruptcy trustee The balance sheet reports pre-petition liabilities separately from others and liabilities not subject to compromise are reported separately in both the current and noncurrent sections of the balance sheet The income statement separately reports the reorganization gain or loss realized during the reorganization period

f (Source: Item 7 of WorldCom’s 2002 K) Towards the beginning of Item 7, the

10-K reports that the company will adopt fresh-start accounting under the provisions of SOP 90-7 as of the fresh-start reporting date The company will revalue its assets and liabilities, allocate the reorganization value to the assets and liabilities, eliminate the accumulated deficit in shareholders’ equity, and the company’s new debt and equity will be recorded

Chapter 20 - Corporations in Finanacial Difficulty

E20-2 Recovery Analysis for a Chapter 11 Reorganization

a Recovery analysis for plan of reorganization:

Taylor Companies, Inc

Plan of Reorganization Recovery Analysis December 31, 20X1

Recovery

of Debt Surviving of Taylor's Common Stock Total Recovery

Chapter 20 - Corporations in Finanacial Difficulty

Record discharge of debt

E20-4 Chapter 7 Liquidation

a Schedule to calculate amount available for general unsecured creditors:

Claims of secured creditors:

Notes payable and interest

Bonds payable and interest

$125,000 Claims of creditors with priority:

Less: Secured by receivables and inventory (115,000) 80,000