CHAPTER 13
ACCOUNTING FOR LEGAL REORGANIZATIONS
AND LIQUIDATIONS
Chapter Outline
I. Because of a myriad of possible financial or business difficulties, a company may become
insolvent, unable to pay its debts as they come due.
A. To ensure the equitable treatment of all parties involved with an insolvent company
(stockholders as well as creditors), laws have been written to provide structure for the
bankruptcy process in the United States.
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, at least, 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 every creditor 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. All remaining unsecured creditors will receive assets from the debtor only after all of 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).
A. A trustee is appointed to oversee termination of business affairs, liquidation of noncash
properties, and distribution of cash resources.
B. The trustee prepares a periodic reporting of activities. Historically, that reporting has
been in the form of a Statement of Realization and Liquidation.
1. This statement indicates the book value and classification of remaining assets and
liabilities.
2. It also discloses the effects of all transactions that have occurred to date.
3. This statement is no longer appropriate for external reporting but can still be
produced internally to help monitor the activities.
C. At the point that liquidation becomes imminent, financial reporting must follow the
liquidation basis of accounting.
1. Liquidation is viewed as imminent when a plan has been approved by the court or by
individuals with that authority.
2. Under the liquidation basis, both a statement of net assets in liquidation and a
statement of changes in net assets in liquidation must be produced.
3. Assets are reported under the liquidation basis at the cash amount that is expected
which will often be lower than fair value. Liabilities are not adjusted until changed in
some legal fashion.
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 bankruptcy court.
B. Reorganization plans normally lay out 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 is important to allow parties to follow the progress
being made.
A. FASB’s Accounting Standards Codification, Topic 852, Reorganizations provides
guidance for preparing financial statements during the period that 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 on the balance sheet based on the
expected amount of the allowed claims.
VIII. Fresh start accounting is often 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 must be set at zero to indicate that a new entity has been formed.
Answers to Discussion Questions
What Do We Do Now?
Students are given a chance in this case to look at a non-accounting business decision: the
forcing of a valued client into bankruptcy. Thurber has already committed several unfortunate
mistakes in this case. For example, he has seen a dramatic slowdown in cash payments by
Many important figures can be gleaned from the company’s financial statements including the
amount of 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
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.
Students often address this type of case as either a black or white issue: give more credit or
force the debtor into bankruptcy. The case simply does not provide enough data to arrive at
How Much Is That Building Really Worth?
College textbooks frequently present fair value as if it were a known number that was easily
determined. Students may view an asset’s fair value as if getting that much money was virtually
assured. Thus, they 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 net realizable value might actually be no more than a
wild guess. Obviously, the value of most stocks and many bonds can be determined with
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
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
Is this the Real Purpose of the Bankruptcy Laws?
During the 1980s, as described in this case, the US saw a rash of bankruptcies that were filed to
resolve major financial problems. Previously, bankruptcy laws had been used almost exclusively
to settle insolvency problems. However, if a voluntary petition is filed and accepted by the
litigation.
As with many of the discussion questions in this book, this case is 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
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.
3. Bankruptcy cases have two overriding objectives:
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
5. The granting of an order for relief halts all actions against an insolvent company. The order
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
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,
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
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,
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.
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
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
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
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
15. A company must follow the liquidation basis of accounting once liquidation becomes
16. Liquidation is viewed as imminent (so that the liquidation basis of accounting is necessary) if
17. When a company is viewed as being in liquidation, then, at a minimum, a statement of net
assets in liquidation and a statement of changes in net assets in liquidation are required.
18. If the liquidation basis of accounting is applied, assets are reported at the amount of cash
19. If the liquidation basis of accounting is applied, liabilities continue to be reported based on
20. 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
21. 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
22. Numerous types of proposals are 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, closing stores, or terminating complete lines of business.
In addition, most reorganization plans identify sources that will be tapped in the future to
23. 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
24. A “cram down” is a legal provision whereby the court can confirm a reorganization proposal
25. 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
26. A company going through a Chapter 11 bankruptcy will report specified reorganization items
on its income statement separately from operating figures. However, these reorganization
27. Professional fees incurred during reorganization must be expensed as incurred.
Capitalization is not allowed.
28. “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
29. 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
30. 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.
31. 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
impairment.
Answers to Problems
1. B
2. D
11.A
12.A
24.C
25.C
26.(10 Minutes) (Distribution of cash in a business liquidation)
Free Assets:
Current Assets ……………………………………………….….. $ 35,000
Buildings and Equipment ……………….………………..… 110,000
Total ………..…………………………….…..…..…..…..….. $145,000
Liabilities with Priority:
Free Assets after Payment of Liabilities with Priority
($145,000 – $34,000) ………….…………………………..….. $111,000
Unsecured Liabilities
Notes Payable (in excess of value of security) ....... $ 30,000
Accounts Payable ………………………..…..…..…..…..….. 85,000
Percentage of Unsecured Liabilities to Be Paid: $111,000/$185,000 = 60 %
Payment on Notes Payable:
Value of Security (land) ………….…………………………… $ 90,000