Accounting for

Bankruptcy Reorganization

Ryan Ball
BUS 30117 – Winter 2011

Lecture 9

Ball – Winter 2011 Lecture 9

 Financial Distress: Uncertainty About the Future
A = LHighest Priority + LMid‐Priority + LLow Priority + OE1 +OE2

Cash flows per

unit of time

Possible
Future #1
Obligations per
unit of time

Possible
Future #2

Time
Past Present Future

Will there be agreement among claimholder over which future is most likely?

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 Dealing with Financial Distress
Financial Distress

O t off C
Out Courtt R
Resolution
l ti
Bankruptcy
• Creditor holdout problems

Voluntary
V l t Involuntary
I l t
(Debtor petition) (Creditors petition)

Chapter 7 Chapter 11
Liquidation Reorganization

Firm is converted to cash Plan of reorganization

and distributed to claimants approved

“Prepacks” or Firm emerges

Cramdowns from bankruptcy

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 Bankruptcy Costs
Th
There are significant
i ifi bankruptcy
b k costs that
h allll parties
i would
ld lik
like to avoid:
id

• Direct legal and accounting costs

• Chapter 7 specific costs

– Disposal costs (including the cost of flooding a particular market with assets)
– Lost synergies of business when assets sold piecemeal (try to avoid with Ch. 11)

• Chapter 11 specific costs

– Uncertainty regarding bankruptcy judge actions.
– Risk of throwing good money after bad (i.e.,
(i e is this just a step toward liquidation?).
liquidation?)
– Bris et al. (2006) find that about ½ of their Chapter 11 firms end up liquidating.
– Customer/supplier uncertainty: will they continue dealing with a bankrupt firm as a
counterparty
t t

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 Bankruptcy Costs

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 The Creditor Holdout Problem
• Creditors,
C di owners and
d managers might
i h try to “workout”
“ k ” the
h debt
d b problem.
bl

• Major deterrent to workout: the “holdout problem.”

• Prisoner’s dilemma type problem:

Bondholder #2

Restructure Holdout

Firm prospers Firm limps ahead

dholder #1

Restructure
(80, 80) (50, 100)
Bond

Firm limps ahead Firm Liquidates

Holdout
(100, 50) (60, 60)

• Prisoner’s dilemma problems can often be resolved with communication.

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 Chapter 7 – Liquidation
• Trustee
T
– Takes possession of the firm’s assets and converts them to cash.
– See that fraud is not committed byy management
g p
paying
y g claimholders out of order p
prior
to liquidation.

• Payment of Claims
– Absolute Priority Rule (APR) is observed.

• Accounting
– “Going
Going concern
concern” assumption is clearly violated so Assets recorded at liquidating values
values.
– Liabilities classified according to priority of claim.
– Accounting is simple: cash and prioritized claims.

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 The Absolute Priority Rule (APR)
• Secured
S d Claims
Cl i
– Claims secured by valid liens or encumbrances.

• Administrative and Priority Claims

– Employee
p y claims for wages/salaries
g / after filingg for bankruptcy.
p y
– Professional fees of lawyers, accountants, and investment advisors.
– Unpaid employee claims and Employee benefit plan claims subject to limits
– Tax claims
l i subject
bj to lilimits
i
– Creditors that extend credit after filing for bankruptcy

• Unsecured Claims

• Equity Claims

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 Chapter 11: The Reorganization Process
• Fil
File a petition,
ii kknown as the
h order
d off relief,
li f to reorganize
i with
i h the
h bankruptcy
b k
court, and an automatic stay is granted.

• If petition is approved, management becomes Debtor‐In‐Possession (DIP).

• Automatic Stay: upon petition, all pre‐petition debt payments are stopped due to
automatic stay,
y except
p for the following:g
– Criminal prosecution against the debtor.
– Payments to essential vendors through first‐day orders (e.g., paying fuel supplier for
airline carrier).
carrier)
– Most financial contracts.

• All other creditors must file a proof of claim to collect their debts.

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 Financial Reporting Under Chapter 11
• “G
“Going
i concern”” assumption
i isi not violated,
i l d so assets and
d liabilities
li bili i are recorded
d d
at GAAP values and not liquidation values.

• Duringg reorganization,
g , financial reporting
p g emphasizes
p distinction between ongoing
g g
operations and reorganization activities.

Balance Sheet Implications:

– The Asset section of the balance sheet separates out court‐restricted assets from all
other assets.
– Upon filing, a new classification for Liabilities Subject to Compromise is created,
consisting of all allowed pre‐petition unsecured or under‐secured claims that are
subject to revaluation or discharge as a result of the Chapter 11 bankruptcy
proceedings.
– Fully secured and post‐petition claims of the debtor are shown as Current and Non‐
current Liabilities.

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 Financial Reporting Under Chapter 11
I
Income SStatement Effects:
Eff
– A new classification, Reorganization Items, Net, is added to the Income Statement. This
is designed to capture all costs, benefits, gains, losses, and provisions for losses that
accrue directly
di tl as a resultlt off the
th reorganization
i ti process. EExamples l iinclude:
l d
 Fees for bankruptcy‐retained professionals.
 Interest earned on proceeds from the DIP financing/loans.
 Interest income on cash balances accumulated
acc m lated during
d ring Chapter 11.
11
 Write‐offs related to abandoned assets.

– Only Interest Expense on secured obligations and post‐petition debt continue to accrue
pending abandonment and/or confirmation of debt restructuring, while interest on
unsecured obligations is generally not recorded.

– Difference between contractual interest expense and accrued amount of interest

expense disclosed.

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 Emerging from Chapter 11: Financial Reporting
• Th
The centrall feature
f off the
h Reorganization
R i i Pl Plan is
i to d
determine
i and
d compute the
h
Reorganization Value (RV) of the firm.
– RV is the enterprise value of a firm (i.e., size of the economic ‘pie’).
– RV is the amount of assets available to satisfy all classes of allowed bankruptcy claims.

• RV is determined through an extensive, adversarial valuation process:

(1) A
Amountt to
t be
b received
i d as consideration
id ti for f assets
t that
th t will
ill nott b
be needed
d dbby th
the
reorganized business.

(2) Computation of the present value of cash flows that the reorganized business is
expected to generate for some time into the future.

(3) Computation of the terminal value of the reorganized business at the end of the
period for which cash flows are estimated
estimated.

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 Emerging from Chapter 11: Financial Reporting
• If the
h Reorganization
R i i PlanPl is
i accepted
d and
d approved
d by
b the
h court, then
h firm
fi
emerges from Chapter 11.

• Under specific circumstances, emerging firm will use Fresh Start Accounting.
– Fresh Start Accounting is very similar to accounting for business combinations.
– Treats emerging firm as an entirely new entity.

• To use Fresh Start Accounting, the following two criteria must be met:
(1) RV < Post‐Petition Liabilities + Allowed Pre‐Petition Liabilities
(2) Old equity holders receive < 50% of new equity in entity emerging from Chapter 11.

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 Fresh Start Accounting: An Illustration
l
Balance h
sheet off fi i to confirmation
firm prior fi i off Reorganization
i i Planl b
by court:

Book Fair
Value Value
Cash $ 200 $ 200
Other Assets 900 960
Goodwill 0
Total Assets $ 1,100

Post‐petition and Secured Debt $ 300 $ 300

Liabilities Subject to Compromise 1,100
Common Stock (Old Equity) 400
Retained Earnings (700)
Total Liabilities & Equity $ 1,100

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 Use Fresh Start Accounting? Criterion #1

(1) RV < Post‐Petition Liabilities + Allowed Pre‐Petition Liabilities?

• From the Reorganization Plan:

Excess Assets to be Distributed*: $ 150

+ Value of Assets to be Retained: 1,150
= Reorganization Value: $ 1,300

• RV = $1,300 < $300 + $1,100 so condition #1 of fresh start is satisfied.

* NOTE: Excess assets are those assets deemed unnecessary to successful future operations of the
reorganized company. These excess assets will be distributed to creditors as part of the plan of
reorganization.

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 Use Fresh Start Accounting? Criterion #2

(2) Old equity holders receive < 50% of new equity?

• New capital structure outlined in the Reorganization Plan:

Post‐petition Debt: $ 300

N D
New Debt:
bt 500
New Equity: 350
$ 1,150

– Given: pre‐petition creditors get 86% of new equity, $150 in cash and $500 new debt
– Old equity holders receive remaining 14% of new equity.

• Change in ownership is > 50%, so condition #2 of fresh start is met.

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 Fresh Start Accounting: Purchase Price
• FFresh
h SStart A
Accounting
i treats emergent company as if iti were acquired
i d ffor a
Purchase Price of Assets = Reorganization Value (RV).

– Tangible and separately identifiable intangible assets of emerging entity recorded at

their fair values (SFAS 141R).

– Any excess of RV over the fair value of identifiable assets is Goodwill.

– All post‐petition
post petition and secured liabilities of emerging entity recorded at the present value
of amounts to be paid.

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 Fresh Start Accounting: 3 Main Entries
E
Entry #1
#1: Adj
Adjust Assets
A to fair
f i value,
l and
d record
d any gains/(losses)
i /(l ) in
i the
h last
l
income statement of the Old Company.

Entry #2: Make entry to record debt discharge per the plan of reorganization and
record Gain on Debt Discharge as an extraordinary item in the last
income statement of the Old Company.

Entry #3: Record entry to cancel old equity of the Old Company.

GOAL: Create the opening balance sheet of the New Company by reflecting the
t
terms off th
the Plan
Pl off R
Reorganization
i ti and d Fresh
F h Start
St t Accounting.
A ti

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 Fresh Start Entries: Revalue Assets & Establish Goodwill
(1) Fresh
F h SStart: the
h Purchase
P h P
Price
i Allocation
All i

Reorganization Value (RV): $ 1,300 (given on Slide 19)

– Book Value of Identifiable Assets: (1,100) (from old balance sheet)

– Step‐up/(down) of Identifiable Assets: (60) (step‐up of Other Assets)

= Goodwill $ 140

• Corresponding journal entry:

Goodwill $ 140
Other Assets (step‐up) 60
Fresh Start Adjustment Gain (IS) $ 200

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 Fresh Start Entries: Debt Discharge & Cancel Old Equity
(2) Debt
D b Discharge:
Di h

Liabilities Subject to Compromise $ 1,100 (remove existing debt)

Cash
h $ 150 (paid to pre‐petition creditors)
New Debt 500 (add new debt)
New Equity (Common Stock/APIC) 301 = $350 × 0.86
Gain on Debt Discharge (IS) 149 (plug)

(3) Cancel Old Equity:

Common Stock $ 400 (remove existing equity)

New Equity (Common Stock/APIC) $ 49 = $350 × 0.14
Gain on Cancellation of Old Equity (IS) 351 (plug)

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 Fresh Start Balance Sheet

Predecessor Adjustments Successor

Cash $ 200 ($150) $ 50
Other Assets 900 60 960
Goodwill 0 140 140
Total
T t lAAssets
t $1
1,100
100 $ 50 $1
1,150
150

Post‐Petition Debt $ 300 – $ 300

Liab. Sub. to Compromise 1,100 ($1,100) –
New Debt – 500 500
Common Stock 400 (50) 350
Retained Earnings (700) 700 0
Total Liabilities & Equity $ 1,100 $ 50 $ 1,150

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 ‘Clean Slate’ Retained Earnings

g
Predecessor Retained Earnings: ($
($700))

+ (1) Fresh Start Adjustment Gain: 200

+ (2) Gain
G i on Debt
D bt Discharge:
Di h 149

+ (3) Gain on Cancellation of Old Equity 351

= Fresh Start Retained Earnings $0

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 Lecture 9 Key Points
• Chapter
Ch 7 bankruptcy
b k
– “Going concern” assumption is violated.
– Assets recorded at liquidation
q values.
– Liabilities are classified according to priority of claim (or absolute priority rule).

• Chapter 11 bankruptcy
– “Going concern” assumption is not violated.
– During Chapter 11 reorganization,
reorganization Assets and Liabilities recorded at historical cost (i
(i.e.,
e
GAAP basis)
– Generally, firms emerging from Chapter 11 will apply Fresh Start Accounting.

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 Lecture 9 Key Points
• Fresh
F h SStart A
Accounting
i
– Treats the emerging firm as if its Assets were acquired for a purchase price equal to the
Reorganization Value (RV).
– In other words, a purchase price allocation (same as M&A accounting) is performed
where all identifiable assets (including intangibles) are recognized.
– Any residual RV over the fair value of identifiable assets goes to Goodwill.
– Three entries made in Fresh Start accounting:
(1) Adjust Assets to fair value and record any gains/(losses) in the last income statement of the
“old”
old company.
(2) Record discharge of debt per the Plan of Reorganization and record gain as an extraordinary
item in the last income statement of the “old” company.
(3) Record the cancellation of previous equity balance in the “old”
old company.
company

– Purpose of Fresh Start accounting is to reset Retained Earnings equal to zero, which is
exactly what happens to the Target’s Retained Earnings in an M&A transaction.

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