20 Corporations in Financial Difficulty McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, Inc All rights reserved Overview • • • A company in financial difficulty has a large number of alternatives, of which bankruptcy is only a final course A company may petition the courts for bankruptcy for other reasons, such as to protect itself from an onslaught of legal suits Several companies have also attempted to void union contracts by petitioning for bankruptcy 20-2 Courses of Action • • Bankruptcy is the final step for a financially distressed business Nonjudicial Actions – Formal agreements between the company and its creditors are legally binding but are not administered by a court 20-3 Nonjudicial Actions • Debt Restructuring Arrangements – The debtor may solicit an extension of due dates of its debt, ask for a decrease of the interest rate on the debt, or ask for a modification of other terms of the debt contract – Composition agreement: Creditors agree to accept less than the face amount of their claims 20-4 Nonjudicial Actions • Creditors’ committee management – The creditors may agree to assist the debtor in managing the most efficient payment of creditors’ claims – Most creditors’ committees are advisory and counsel closely with the debtor because the creditors not want to assume additional liabilities and problems of actual operation of the debtor – Usually initiated with a plan of settlement proposed by the debtor 20-5 Nonjudicial Actions • Transfer of assets – Debtors may transfer assets, such as receivables or other financial instruments, in an effort to obtain quick cash – Assets may be sold “with recourse” or “without recourse” – A transfer of financial assets is considered a sale only if the transferor has surrendered control over the transferred assets 20-6 Judicial Actions • Bankruptcy is a judicial action administered by bankruptcy courts and bankruptcy judges using the guidance provided in Title 11 of the United States Bankruptcy Code 20-7 Judicial Actions • Either the debtor or its creditors may decide that a judicial action is best – The debtor may file a voluntary petition seeking judicial protection in the form of an order of relief against the initiation or continuation of legal claims by the creditors – Creditors may file an involuntary petition against the debtor • Certain conditions must exist before creditors may file a petition 20-8 Chapter 11 Reorganizations • Chapter 11 of the Bankruptcy Code – Allows for legal protection from creditors’ actions during a time needed to reorganize the debtor company and return its operations to a profitable level – The bankruptcy court administers reorganizations and often appoints trustees to direct the reorganization – The company petitions the bankruptcy court – If granted protection, the company receives an order of relief to suspend making any payments on its prepetition debt 20-9 Chapter 11 Reorganizations – The company continues to operate while it prepares a plan of reorganization – A disclosure statement is transmitted to all creditors and other parties eligible to vote on the plan of reorganization – The bankruptcy court then evaluates the responses to the plan from creditors and other parties and either confirms the plan of reorganization or rejects it 20-10 Chapter 11 Reorganizations • Fresh start accounting – A reorganization value in excess of amounts assignable to identifiable assets is reported as an intangible asset – The emerging company’s liabilities are recorded at the present values of the amounts to be paid – Any retained earnings or deficits are eliminated – A set of final operating statements is prepared just prior to emerging from reorganization – In essence, the company is a new reporting entity after reorganization 20-14 Chapter 11 Reorganizations • Companies not qualifying for fresh start accounting – Companies should determine whether their assets are impaired in value – They should report liabilities at the present values of the amounts to be paid, with any gain or loss on the revaluation of the liabilities recorded in accordance with APB 30 as to extraordinary or ordinary events 20-15 Chapter 11 Reorganizations • Companies not qualifying for fresh start accounting – They should recognize a liability for a cost associated with an exit or disposal activity when the liability is incurred, not at the earlier time the company makes a commitment to an exit plan – Long-lived assets are divided between (1) those to be held and used and (2) those to be disposed of by sale 20-16 Chapter 11 Reorganizations • Plan of reorganization – Components: Disposing of unprofitable operations Restructuring of debt with specific creditors Revaluation of assets and liabilities Reductions or eliminations of claims of original stockholders and issuances of new shares to creditors or others 20-17 Chapter Liquidations • • Liquidations are administered by the bankruptcy courts in the interests of the corporation’s creditors and shareholders The intent in liquidation is to maximize the net dollar amount recovered from disposal of the debtor’s assets 20-18 Chapter Liquidations • Classes of creditors – Secured creditors • • Have liens, or security interests, on specific assets, often called “collateral” A creditor with such a legal interest in a specific asset has the highest priority claim on that asset – Creditors with priority • Unsecured creditors having no collateral claim against specific assets, who have priority over other unsecured creditors 20-19 Chapter Liquidations • Classes of creditors – Unsecured creditors • • • The lowest priority is given to these claims They are paid only after secured creditors and unsecured creditors with priority are satisfied to the extent of any legal limits Often they receive less than the full amount of their claim 20-20 Chapter Liquidations • Statement of affairs – The basic accounting report made at the beginning of the process to present the expected realizable amounts from disposal of the assets, the order of creditors’ claims, and the expected amount that unsecured creditors will receive as a result of the liquidation – A different report, also entitled the “statement of affairs,” is a list of questions the debtor must answer as part of the bankruptcy petition 20-21 Chapter Liquidations • Statement of affairs – It is an important planning report for the anticipated liquidation of a company – It presents the book values of the debtor company’s balance sheet accounts, the estimated fair market values of the assets, the order of the claims, and the estimated deficiency to the general unsecured creditors 20-22 Additional Considerations • Trustee accounting and reporting – Bankruptcy courts appoint trustees to manage a company under Chapter 11 reorganization in cases of management fraud, dishonesty, incompetence, or gross mismanagement – The trustee then attempts to rehabilitate the business 20-23 Additional Considerations • Trustee accounting and reporting – In Chapter liquidations, the trustee normally has the responsibility to expeditiously liquidate the bankrupt company and pay creditors in conformity with the legal status of their secured or unsecured interests – In some cases under Chapter 7, the court appoints a trustee to operate the company for a short time in an effort to obtain a better price for the company in entirety rather than selling it piecemeal 20-24 Additional Considerations • Trustee accounting and reporting – Trustees examine the proofs of all creditors’ claims against the debtor’s bankruptcy estate, that is, the debtor’s net assets – Sometimes the trustee receives title to all assets as a receivership, becomes responsible for the actual management of the debtor, and must direct a plan of reorganization or liquidation 20-25 Additional Considerations • Trustee accounting and reporting – The general form of the trustee’s opening entry, accepting the assets of the debtor company, is as follows: 20-26 Additional Considerations • Trustee accounting and reporting – Statement of realization and liquidation is a monthly report prepared for the bankruptcy court • • It shows the results of the trustee’s fiduciary actions beginning at the point the trustee accepts the debtor’s assets The statement has three major sections: assets, supplementary items, and liabilities 20-27 Additional Considerations • Sections of the statement of realization and liquidation 20-28 ... claims by the creditors – Creditors may file an involuntary petition against the debtor • Certain conditions must exist before creditors may file a petition 20- 8 Chapter 11 Reorganizations • Chapter. .. reorganization or rejects it 20- 10 Chapter 11 Reorganizations • Statement of Position No 90-7 provides guidance for financial reporting for companies in reorganization – The financial statements should... limits Often they receive less than the full amount of their claim 20- 20 Chapter Liquidations • Statement of affairs – The basic accounting report made at the beginning of the process to present