Advanced Accounting MCGRAW-HILL_chapter 13_SOLMAN

CHAPTER 13 ACCOUNTING FOR LEGAL REORGANIZATIONS AND LIQUIDATIONS 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 proceedings. Thurber has already committed several unfortunate mistakes in this case. For example, he has seen a dramatic slowdown in cash payments by Abraham and Sons without seeking any further information about the prospects of the client. Furthermore, he has let the treasurer pressure him into providing additional credit without any valid justification. He is now being pushed by another company into filing a bankruptcy petition without adequate assurance that Abraham and Sons has a real problem. Because Thurber has not acted earlier, he should now request audited financial statements from Abraham and Sons so that he can make a reasonable decision as to the course of action 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 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 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. McGraw-Hill/Irwin Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e

© The McGraw-Hill Companies, Inc., 2009 13-1

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. 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 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 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 whereby a company (or individual) is unable to pay debts as they come due. 2.

In the United 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.

McGraw-Hill/Irwin 13-2

© The McGraw-Hill Companies, Inc., 2009 Solutions Manual

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. 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 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, 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 Claims for administrative expenses, — Obligations Obligations arising between the date that a bankruptcy petition is filed and the appointment of a trustee or the issuance of an order for relief. — Employee Employee claims for wages earned during the 180 days preceding the filing of a bankruptcy petition (limited to $10,950 per person), — Employee Employee claims for contributions to a benefit plan earned during the 180 days preceding the filing of a bankruptcy petition (within certain restrictions), — Deposits Deposits made with the company to acquire goods or services (up to a $2,425 limit), — Government Government claims for unpaid taxes. 8. Administrative expenses are classified as liabilities with 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 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 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.

McGraw-Hill/Irwin Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e


11. The statement of financial affairs helps the parties involved with 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 p revent 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. 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.



Answers to Problems 1. B 2. D 3. B 4. C 5. A 6. D 7. C 8. B 9. C 10. B 11. A 12. A 13. A 14. B 15. C 16. A 17. C 18. A 19. D 20. C 21. C



22. (10 Minutes) (Distribution of cash in a liquidation) Free Assets: Current Assets .......................................................... Buildings and Equipment ........................................ Total ....................................................................

$ 35,000 110,000 $145,000

Liabilities with Priority: Administrative Expenses ......................................... Salaries Payable (only $3,000 per employee).......... Income Taxes ............................................................ Total ....................................................................

$ 20,000 6,000 8,000 $ 34,000

Free Assets After Payment of Liabilities with Priority ($145,000 – $34,000) ................................................

$111,000

Unsecured Liabilities Notes Payable (in excess of value of security) ...... Accounts Payable ..................................................... Bonds Payable .......................................................... Total ....................................................................

$ 30,000 85,000 70,000 $185,000

Percentage of Unsecured Liabilities To Be Paid: $111,000/$185,000 = 60 % Payment On Notes Payable: Value of Security (land) ............................................ 60% of Remaining $30,000 ....................................... Total Collected by holders .......................................


$ 90,000 18,000 $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) Free Assets: Other Assets ............................................................. Excess from Assets Pledged with Fully Secured Creditors ($116,000 – $70,000) ........................... Total ....................................................................

46,000 $126,000

Liabilities with Priority ...................................................

$ 42,000

Free Assets after Payment of Liabilities with Priority ($126,000 – $42,000) .................................................

$ 84,000

$ 80,000

Unsecured Liabilities: Excess of Partially Secured Liabilities Over Pledged Assets ($130,000 – $50,000) ............................... $ 80,000 Unsecured Creditors ................................................ 200,000 Total .................................................................... $280,000 Percentage of Unsecured Liabilities To Be Paid: $84,000/$280,000 = 30% Payment On Partially Secured Debt: Value of Pledged Asset ............................................ 30% of Remaining $80,000 ....................................... Total to be Collected by holders ........................


$ 50,000 24,000 $ 74,000


25. (8 Minutes) (Distribution of assets to partially secured creditors) Free Assets: Cash .......................................................................... Excess from Assets Pledged with Fully Secured Creditors ($90,000 – $80,000) .............................. Total ......................................................................

$50,000 10,000 $60,000

Liabilities with Priority....................................................

20,000

Free Assets after Payment of Liabilities with Priority .

$40,000

Unsecured liabilities: Excess of Partially Secured Liabilities Over Pledged Assets ($150,000 – $130,000) ............... Accounts Payable ...................................................... Total ....................................................................

$ 20,000 180,000 $200,000

Percentage of Unsecured Liabilities to be Paid: $40,000/$200,000 = 20% Payment on Bond: Value of Pledged Asset ............................................. 20% of Remaining $20,000 ........................................ Total to be Received by holders .........................


$130,000 4,000 $134,000


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). Unsecured Liabilities: Unsecured Creditors ..................................................... $230,000 Excess Liability of Debt One in Excess of Pledged Asset ($210,000 – $180,000) ............................................... 30,000 Excess Liability of Debt Two in Excess of Pledged Asset ($170,000 – $100,000) ............................................... 70,000 Total Unsecured Liabilities ................................. $330,000 Necessary Percentage ................................................... 60% 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.



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 from assets pledged on fully secured debts ($200,000 – $150,000 = $50,000) to get amount of free assets available of $350,000. Amount Available ........................................................... Liabilities with Priority ................................................... Available for Unsecured Creditors ..........................

$350,000 (160,000) $190,000

Accounts Payable .......................................................... Partially Secured Debt in Excess of Pledged Assets ($490,000 – $380,000) ....................................... Unsecured Liabilities ......................................................

$390,000 110,000 $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 .......................................................................... Inventory .................................................................... Equipment .................................................................. Total ....................................................................

$ 10,000 60,000 50,000 $120,000

Liabilities with Priority: Administrative Expenses ......................................... Income Taxes ............................................................ Total .....................................................................

$ 20,000 30,000 $ 50,000

Free Assets After Payment of Liabilities With Priority ($120,000 – $50,000) .................................................

$ 70,000

Unsecured Liabilities Note Payable A (in excess of value of security) ..... Note Payable B (in excess of value of security) .... Note Payable C ......................................................... Accounts Payable ..................................................... Total ....................................................................

$ 20,000 80,000 60,000 120,000 $280,000

Percentage of Unsecured Liabilities To Be Paid: $70,000/$280,000 = 25% Payment on Note Payable A: Value of Security (land) ................................................. 25% of Remaining $20,000 ............................................ Total Collected ..........................................................

$ 70,000 5,000 $ 75,000

Payment on Note Payable B: Value of Security (building) ........................................... 25% of Remaining $80,000 ............................................ Total Collected ..........................................................

$ 40,000 20,000 $ 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



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. Unsecured Liabilities: Accounts payable ...................................................... Note payable A—unsecured portion ........................ Note payable B .......................................................... Total .................................................................... Free Assets (except for equipment): Cash .......................................................................... Accounts receivable .................................................. Inventory .................................................................... Land (value does not cover related debt) ................ Buildings ($320,000 less $300,000 in bonds) ............................................................... Total .................................................................... Less: Liabilities with Priority: Estimated administrative expenses ......................... Taxes payable to government .................................. Total free assets except for equipment..............

$180,000 10,000 250,000 $440,000

$24,000 28,000 56,000 -020,000 $128,000

(12,000) (20,000) $96,000

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) Free Assets: Cash .................................................................... Receivables (30 percent collectible) ........................ Inventory .................................................................... Land (value in excess of secured note: $120,000 – $110,000) ............................................ Total .................................................................... Less: Liabilities with priority Salary payable (below maximum) ....................... Free assets available ........................................... Unsecured Liabilities: Accounts payable ...................................................... Bonds payable (less secured interest in building: $300,000 – $180,000) ............................ Unsecured liabilities ............................................

$30,000 15,000 39,000 10,000 $94,000

(10,000) $84,000

$90,000 120,000 $210,000

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 in full) .................................................................... Accounts payable (unsecured—will collect 40% of debts of $90,000) .............................................. Note payable (fully secured by land—will collect entire balance) ..................................................... Bonds payable (partially secured—will collect $180,000 from building and 40 percent of the remaining $120,000) .............................................

$10,000 $36,000 $110,000

$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.



32. (9 Minutes) (Adjusting a company coming out of reorganization to fresh start accounting) The individual assets of this company have a total fair value of $700,000 but a reorganization value of $760,000. Thus, an intangible asset (Goodwill) equal 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 $130,000. Receivables ($90,000 - $80,000) .................................... Inventory ($210,000 - $200,000) ..................................... Buildings ($400,000 - $300,000) ..................................... Goodwill .......................................................................... Retained Earnings (eliminate deficit) ................. Additional Paid-in Capital ($130,000 – $20,000) .......................................


10,000 10,000 100,000 60,000 70,000 110,000


33. (15 Minutes) (Prepare income statement for company going through a bankruptcy reorganization) ADDISON CORPORATION Income Statement Revenues ....................................................................... Costs and expenses: Cost of goods sold ................................................... Rent expense ............................................................ Salary expense ......................................................... Depreciation expense .............................................. Advertising expense ................................................. Interest expense ....................................................... Earnings before reorganization items and tax effects Reorganization items: Loss on closing of branch ...................................... Professional fees ..................................................... Interest revenue ........................................................ Loss before income tax benefit ................................... Income tax benefit (20 percent) ................................... Net loss ....................................................................


$ 467,000 $ 211,000 16,000 70,000 22,000 24,000 4,000

(109,000) (71,000) 32,000

(347,000) 120,000

(148,000) (28,000) 5,600 $(22,400)


34. (15 Minutes) (Description of balance sheet for a company emerging from bankruptcy reorganization) a. SOP 90-7 holds that a company should be considered a new entity (so that current values would be applicable for reporting purposes) if two criteria are met. Otherwise, the company is simply considered to be a continuation of the old concern, a company that should continue to report its historical cost figures. 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: Cash .......................................................................... Inventory ................................................................... Land, buildings, and equipment: Land .......................................................................... Buildings ................................................................... Equipment .................................................................. Total assets ......................................................... Liabilities not subject to compromise Current liabilities: Accounts payable ................................................ Long-term liabilities: Note payable (due 2010) ................ $110,000 Note payable (due 2011) ................ 100,000 Liabilities subject to compromise Accounts payable ..................................................... Accrued expenses .................................................... Income taxes payable .............................................. Note payable (due 2013) .......................................... Total liabilities ...................................................... Stockholders' equity Common stock .......................................................... Retained earnings (deficit) ...................................... Total liabilities and shareholders' (deficit) ........


$ 23,000 45,000

140,000 220,000 154,000

$ 68,000

514,000 $582,000

$ 60,000

210,000

123,000 30,000 22,000 170,000

$ 270,000

345,000 615,000

200,000 (233,000) $ 582,000


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 + $78,000) — Total liabilities at book value = $800,000 ($80,000 + $35,000 + $100,000 + $200,000 + $185,000 + $200,000) — Total common stock = $240,000 (given) — Deficit = $330,000 (given) — Since the above accounts balance, no additional paid-in capital must exist at this time. 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 JOURNAL ENTRIES — Land and buildings ................................................... Goodwill .................................................................... Accounts receivable ........................................... Inventory .............................................................. Equipment ............................................................ Additional paid-in capital (to balance) ............... To adjust accounts to market value as part of fresh start accounting. — Common stock .......................................................... Additional paid-in capital .................................... To record shares turned in to the company by the owners as part of the reorganization plan, 18,000 shares at an $8 per share par value.


80,000 45,000 20,000 22,000 13,000 70,000

144,000 144,000


36. (continued) — Accounts payable ..................................................... Note payable ........................................................ Common stock ($8 per share par value) ........... Additional paid-in capital ($6.66 per share—see above, or 1/30 of company total) .................. Gain on debt discharge ...................................... To record settlement of accounts payable.

80,000

— Accrued expenses ................................................... Note payable ........................................................ Gain on debt discharge ...................................... To record settlement of accrued expenses.

35,000

5,000 8,000 6,666 60,334

4,000 31,000

— Note payable ............................................................ Note payable ........................................................ Common stock ($8 per share par value) ........... Additional paid-in capital ($6.66 per share—see above, or 1/3 of company total) .................... Gain on debt discharge ...................................... To record settlement of note payable due in 2011.

200,000

— Note payable ............................................................. Note payable ........................................................ Common stock ($8 per share par value) ........... Additional paid-in capital ($6.66 per share—see above, or 7/30 of company total) .................. Gain on debt discharge ...................................... To record settlement of note payable due in 2009.

185,000

— Note payable ............................................................ Note payable ........................................................ Gain on debt discharge ...................................... To record settlement of note payable due in 2010.

200,000

— Additional paid-in capital ($334,000 – $200,000) .... Gain on debt discharge ........................................... Retained earnings (deficit) ................................. To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.

134,000 196,000


50,000 80,000 66,667 3,333

71,000 56,000 46,667 11,333

110,000 90,000

330,000


37. (25 Minutes) (Prepare a balance sheet for a company emerging from bankruptcy reorganization) a. Smith Corporation must apply fresh start accounting because it meets both requirements established by SOP 90-7: The reorganization value of $800,000 of the company is less than the allowed claims of $730,000 ($180,000 + $200,000 + $350,000) plus the liabilities incurred following the order for relief of $97,000. 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 ................................................. Inventory ................................................................... Land, Buildings, and Equipment: Land and buildings ................................................... Machinery .................................................................. Intangible Assets: Patents ....................................................................... Goodwill .................................................................... Total Assets .........................................................

$ 18,000 111,000

$129,000

278,000 121,000

399,000

125,000 147,000

LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable ..................................................... 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 Total Liabilities .................................................... Stockholders' Equity: Common stock (par value) ....................................... $500,000 Additional paid-in capital (balancing figure) .......... 18,000 Retained earnings .................................................... -0Total Liabilities and Stockholders' Equity ........


272,000 $800,000

$ 97,000

185,000 $282,000

518,000 $800,000


38. (15 Minutes) (Distribution of assets in a liquidation) Free assets: (liquidation value) Other assets .............................................................. Assets pledged with fully secured creditors in excess of debt ..................................................... Total free assets ..................................................

45,000 $126,000

Free assets after paying liabilities with priority ($126,000 – $36,000) ......................................................

$ 90,000

$ 81,000

Unsecured debts: Accounts payable ...................................................... $283,000 Partially secured liabilities in excess of pledged assets ($180,000 – $103,000) .......................................... 77,000 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.



39. (35 Minutes) (Prepare a statement of financial affairs) LIMESTONE COMPANY Statement of Financial Affairs June 3, 2008

Book Values

$400,000

180,000

3,000 65,000 88,000

$736,000


Assets Pledged with Fully Secured Creditors: Land and buildings $310,000 Less: Notes payable-long-term (190,000) Pledged with Partially Secured Creditors: Equipment $130,000 Notes payable—current (250,000) Free Assets: Cash ................................................................ Accounts receivable ...................................... Inventory ......................................................... Total amount available to pay liabilities with priority and unsecured creditors ..... Less: Liabilities with priority (listed below) .............................................. Available for unsecured creditors ................ Estimated deficiency ......................................

Available for Unsecured Creditors

$120,000

-0-

3,000 26,000 80,000 $229,000 (42,000) $187,000 21,000 $208,000


39. (continued ) Book Values

Liabilities and Stockholders' Equity

Unsecured— Nonpriority Liabilities

$ 10,000

Liabilities with Priority: Administrative expenses ................ $ 18,000 Salaries payable ............................... 10,000 Taxes payable ................................... 14,000 Total .................................................. $ 42,000

190,000

Fully Secured Creditors: Notes payable - long-term .............. $190,000 Less: Land and buildings ................ (310,000)

-0-

Partially Secured Creditors: Notes payable current .................... $250,000 Less: Equipment ............................... (130,000)

$120,000

250,000

88,000 198,000 $736,000

Unsecured Creators: Accounts payable (other than salaries) Stockholders' equity .......................................


88,000 -0$208,000


40. (25 Minutes) (Distribution of assets in a liquidation) Free Assets: Cash ................................................................................................ Accounts Receivable ..................................................................... Inventory ........................................................................................ Investments ..................................................................................... Land Value In Excess of Related Debt ($72,000 – $65,000) ....... Total ..........................................................................................

$ 6,000 18,000 31,000 8,000 7,000 $ 70,000

Liabilities With Priority: Administrative Expenses (estimated) ........................................... Salaries Payable ............................................................................. Taxes Payable ................................................................................. Total ..........................................................................................

$ 22,000 6,000 10,000 $ 38,000

Free Assets After Payment of Liabilities With Priority ($70,000 – $38,000) .......................................................................

$ 32,000

Unsecured Liabilities: Notes Payable (in excess of value of buildings) . ......................... Bonds Payable (in excess of value of equipment) ...................... Accounts Payable ........................................................................... Total ..........................................................................................

$ 10,000 80,000 70,000 $160,000

Percentage of Unsecured Liabilities To Be Paid: $32,000/$160,000 = 20% Payment on the $65,000 of notes payable secured by land will be made in total since the value of the land is greater than the debt. Payment on Notes Payable (secured by buildings): Value of Security (building) ................................................................. 20% of Remaining $10,000 .................................................................. Total Collected by holders .............................................................

$ 68,000 2,000 $ 70,000

Payment on Bonds Payable: Value of Security (equipment) ............................................................ 20% of Remaining $80,000 .................................................................. Total Collected by holders .............................................................

$ 35,000 16,000 $ 51,000

Payment on Accounts Payable (unsecured): 20% of $70,000 .....................................................................................

$ 14,000

Payment of Salaries Payable: As a liability with priority, the entire amount due is paid.

$ 6,000

Payment of Taxes Payable: As a liability with priority, the entire amount due is paid.

$ 10,000

Payment of Administrative Expenses: As a liability with priority, the entire amount due is paid.

$ 22,000



41. (20 Minutes) (Reporting of a reorganization and a liquidation) a. Since the land's net realizable value is less than the amount of the note payable, the debt will be reported on a statement of financial affairs as a liability owed to "partially secured creditors." The $80,000 obligation is disclosed in this manner and then reduced by the $48,000 anticipated cash proceeds. The remaining $32,000 balance will be shown by Anteium as an unsecured nonpriority liability. The land is still reported as an asset, one pledged with partially secured creditors. The $31,000 cost is revealed within the statement of financial affairs although this information is not considered relevant in a liquidation. The $48,000 net realizable value is reported but is offset by the $80,000 liability; thus, no cash will be available to unsecured creditors unless a greater amount is generated by the sale. b. Fresh start accounting must be used because the reorganization value is less than the debts and the original owners are left with less than 50 percent of the voting stock. After the reorganization, the assets will be reported at $82,000 with one $5,000 debt. Since the common stock has a total par value of $40,000, additional paid-in capital must be $37,000. — Land .......................................................................... Investments ............................................................... Goodwill ..................................................................... Additional paid-in capital .................................... To adjust asset values to fair market value (a total of $73,000) with a Goodwill asset established to bring the total up to $82,000 reorganization value.

17,000 5,000 9,000

— Note payable ............................................................. Additional paid-in capital (60% of company total) Gain on discharge of debt .................................. To record issuance of stock to bank in settlement of debt.

80,000

31,000

— Accounts payable ..................................................... 20,000 Note payable ........................................................ Gain on discharge of debt .................................. To record settlement of accounts payable for 3-year note.


22,200 57,800

5,000 15,000


41. (continued ) — Gain on discharge of debt ....................................... Additional paid-in capital ......................................... Retained earnings (deficit) ................................. To reduce additional paid-in capital balance to correct figure, to close out gain account, and to eliminate deficit as a step in establishing fresh start accounting.

72,800 16,200 89,000

c. The bank will collect a total of $59,000. Obviously, the $50,000 proceeds generated by the land sale must go to the bank with the remaining $30,000 obligation then being ranked as an unsecured-nonpriority liability. Anteium (the insolvent company) will have $15,000 of the $26,000 cash left after paying the $11,000 administrative expenses. Unsecured debts total $50,000 ($30,000 from the note and $20,000 of accounts payable). Thus, 30% of these debts will be paid ($15,000/$50,000). The bank collects an additional $9,000 ($30,000 x 30%); the accounts payable collect $6,000 ($20,000 x 30%).



42. (25 Minutes) (Prepare a statement of realization and liquidation) a.

Balances, 8/8/08 Investments sold Inventory sold Payment is made on note from proceeds of auction Remaining debt is reclassified Administrative expenses incurred Land and buildings all sold Payment is made on note from proceeds of sale Reclassify liabilities with priority Equipment sold Receivables collected Administrative expenses paid Final balances remaining for unsecured creditors

LITZ CORPORATION Statement of Realization and Liquidation

Cash

Noncash Assets

$ 16,000 39,000 48,000

$763,000 (32,000) (69,000)

Liabilities with Priority

-0-

Fully Secured Creditors

Partially Secured Creditors

$259,000

$132,000

(48,000)

(48,000) (84,000)

StockUnsecured holders' Nonpriority Equity Liabilities (Deficits)

$150,000 $238,000 7,000 (21,000)

84,000

$15,000 315,000

(15,000) (55,000)

(370,000)

(259,000)

(259,000) 34,000

84,000 34,000 (15,000) $214,000

(34,000)

(210,000) (82,000)

(126,000) (48,000) (15,000)

-0-

$34,000

-0-

b. Total amount available to pay liabilities with priority and unsecured creditors (see part a) $214,000 Less: liabilities with priority (34,000) Available for unsecured creditors $180,000 Percentage of claim to be received by each unsecured creditor ($180,000/$200,000) 90%



-0-

$200,000 $(20,000)

43. (40 Minutes) (Prepare journal entries for company emerging from bankruptcy using fresh start accounting) Company must use fresh start accounting because the reorganization value of $650,000 is less than the company's allowed debts and the original owners hold less than 50 percent of the voting stock after the reorganization. BOOK VALUES AFTER EMERGING FROM REORGANIZATION — Total assets = $637,000 (reorganization value of $650,000 plus proceeds from sale of stock of $77,000 less $90,000 value of land and investments used to settle two debts) — Total liabilities = $350,000 ($130,000 + $40,000 + $180,000) — Total common stock = $160,000 (10,000 additional shares are issued with a $10 per share par value so that total outstanding shares = 16,000) — Deficit = -0- (eliminated by the reorganization) — Additional paid-in capital = $127,000 (figure needed to balance above accounts after reorganization) — Because the company has a reorganization value of $650,000 but the assets have a market value of only $623,000, Goodwill must be established for $27,000. JOURNAL ENTRIES —Investments ................................................................ Land ............................................................................ Buildings .................................................................... Goodwill ...................................................................... Accounts receivable ............................................. Inventory ............................................................... Equipment ............................................................. Additional paid-in capital (to balance) ................. To adjust accounts to market value as part of fresh start accounting.

14,000 23,000 52,000 27,000 20,000 16,000 31,000 49,000

—Cash .......................................................................... Common stock ($10 par value) .......................... Additional paid-in capital .................................... To record shares sold to new investor.

77,000

—Cash ............................................................................ Investments ......................................................... Investments sold.

40,000


70,000 7,000

40,000


43. (continued) —Notes payable—current ............................................. Cash ........................................................................ Notes payable (due in 2012) .................................. Gain on discharge of debt ..................................... To record settlement of current notes.

220,000

—Accounts payable ....................................................... Notes payable (due in 2009) .................................. Gain on discharge of debt ..................................... To record settlement of accounts payable.

129,000

—Notes payable (due in 2011) ...................................... Land ........................................................................ Notes payable (due in 2015) .................................. Common stock ($10 par value) ............................. Additional paid-in capital (3/16 of total computed above) .......................... Gain on discharge of debt ..................................... To record settlement of long-term debt.

325,000

—Gain on debt discharge ............................................. Additional paid-in capital ($127,000 – $79,813) ... Retained earnings (deficit) .................................... To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.

180,187


40,000 130,000 50,000

40,000 89,000

50,000 180,000 30,000 23,813 41,187

47,187 133,000


44. (40 Minutes) (Prepare statement of financial affairs, determine amounts to be paid in liquidation) a. OREGON CORPORATION Statement of Financial Affairs Available for Book Unsecured Values Assets Creditors Pledged with Fully Secured Creditors: $33,000 Land (Plots A and D) $43,000 Less: Notes payable (30,000) $13,000 28,000

6,000 25,000

Pledged with Partially Secured Creditors: Land (Plots B and C) $25,000 Less: Notes payable (30,000) Free Assets: Cash Accounts receivable Total available to pay liabilities with priority and unsecured creditors Less: Liabilities with priority (listed below) Available for unsecured creditors Estimated deficiency

-06,000 12,000 $31,000

$92,000

28,000 $ 3,000 47,000 $50,000

Book Values


Liabilities and Stockholders' Equity Liabilities with Priority: -0Administrative expenses (estimated) $12,000 Salaries payable Total (above) Fully Secured Creditors: 30,000 Notes payable Land (Plots A and D) Partially Secured Creditors: 30,000 Notes payable Land (Plots B and C) Unsecured Creditors: 25,000 Notes payable 20,000 Accounts payable (less salaries shown above) (25,000)* Stockholders' equity $92,000

$16,000 12,000 $28,000 $30,000 (43,000)

-0-

$30,000 (25,000)

$ 5,000 25,000 20,000 $50,000

*Derived as a balancing figure.



44. (continued) b. According to the statement of financial affairs prepared above, $3,000 cash should be available for unsecured nonpriority creditors. Unfortunately, $50,000 in unsecured nonpriority liabilities exist. Thus, only 6% of these claims will be covered ($3,000/$50,000). Cash of $11,240 will be paid on the note payable that is secured by plot B. The land is to be sold for $11,000 leaving a $4,000 unsecured debt. Since 6% of this amount is expected to be paid, the holder will only receive an additional $240. c. As indicated in part b, only 6% of the unsecured nonpriority claims can be satisfied. Thus, just $1,500 will be paid on the unsecured $25,000 note payable. d. Selling plot D for $30,000 rather than $27,000 generates an additional $3,000 in available cash. The statement of financial affairs produced above would then report $6,000 as the amount available for unsecured nonpriority claims or 12% of the total ($6,000/$50,000). After plot B is sold for $11,000, the remaining $4,000 of this note is classified as an unsecured nonpriority liability. Since 12% of this amount is to be paid, an additional $480 is transferred to the holder of the note for a total of $11,480.



45. (40 Minutes) (Prepare a statement of financial affairs) LYNCH, INC. Statement of Financial Affairs March 14, 2008

Book Values

$40,000

14,000

1,000 25,000 100,000 15,000

Assets Pledged with Fully Secured Creditors: Land and building Less: Notes payable

Available for Unsecured Creditors

$75,000 (70,000)

$5,000

Pledged with Partially Secured Creditors: Equipment $19,000 Less: Notes payable (150,000)

-0-

Free Assets: Cash Accounts receivable Inventory Investments Total available to pay liabilities with priority and unsecured creditors Less: Liabilities with priority (listed below) Available for unsecured creditors Estimated deficiency

1,000 15,000 33,000 21,000 $75,000

$195,000

(22,000) $53,000 115,000 $168,000



45. (continued)

Book Values


Liabilities and Stockholders' Equity

-0$5,000 1,000

Liabilities with Priority: Administrative expenses (estimated) Salaries payable Payroll taxes payable Total (above)

$16,000 5,000 1,000 $22,000

70,000

Fully Secured Creditors: Notes payable Land and building

$70,000 (75,000)

-0-

$150,000 (19,000)

$ 131,000

150,000

33,000 4,000 (68,000) $195,000

Partially Secured Creditors: Notes payable Equipment Unsecured Creditors: Accounts payable Advertising payable Stockholders' equity


33,000 4,000 $168,000


46. (30 Minutes) (Prepare a statement of realization and liquidation) a. LYNCH, INC. Statement of Realization and Liquidation March 14, 2008 to July 23, 2008

Book balances, 3/14/08 Answer from Problem 45 Accounts receivable collected —remaining balance assumed to be uncollectible Inventory sold Accounts payable discovered Land and buildings all sold Fully secured note paid Equipment sold Payment made on partially secured debt Investments sold Administrative expenses accrued Remaining partially secured claims reclassified as unsecured liabilities Final balances remaining for unsecured creditors

Cash

Noncash Assets

$ 1,000

$194,000

18,000 40,000

(25,000) (100,000)

71,000 (70,000) 11,000

(40,000)

Liabilities with Priority

$6,000

Fully Secured Creditors

Partially Secured Creditors

StockUnsecured holders' Nonpriority Equity Liabilities (Deficits

$70,000

$150,000

$ 37,000 $(68,000)

10,000

(11,000) 21,000

(70,000) (14,000)

(3,000) (11,000)

(15,000)

6,000 (20,000)

20,000 _______ $81,000

(7,000) (60,000) (10,000) 31,000

-0-

$26,000

(139,000) -0-

-0-

139,000 $186,000$(131,000)

b. The statement of realization and liquidation prepared in (a) indicates that $81,000 in cash remains. However, $26,000 of this amount must be distributed to the liabilities with priority leaving only $55,000 for the unsecured nonpriority creditors. Since these unsecured liabilities amount to $186,000, only 30% (rounded) ($55,000/$186,000) of each debt will be paid. Thus, a creditor holding a $1,000 claim will receive approximately $300. McGraw-Hill/Irwin 13-36


47. (30 Minutes) (Prepare Journal entries for company emerging from bankruptcy using fresh start accounting) The Holmes Corporation must use fresh start accounting because the reorganization value of $225,000 is less than the company's allowed debts and the original owners hold less than 50 percent of the voting stock after the reorganization. BOOK VALUES AFTER EMERGING FROM REORGANIZATION — Total assets = $248,200 ($225,000 reorganization value plus proceeds from sale of stock of $36,000 less $12,800 payment made to settle unsecured liabilities [20 percent of $64,000]) — Total liabilities = $118,000 ($18,000 + $70,000 + $30,000) — Total common stock = $105,000 (11,000 additional shares are issued with a $5 per share par value – total outstanding shares = 21,000) — Deficit = -0- (eliminated by the reorganization) — Additional paid-in capital = $25,200 (figure needed to balance above accounts after reorganization) JOURNAL ENTRIES — Goodwill .................................................................... Additional paid-in capital .................................... To adjust to total reorganization value as part of fresh start accounting ($225,000 – $210,000).

15,000 15,000

— Salary payable .......................................................... Note payable—1 year .......................................... To record note issued for accrued salaries.

18,000

— Notes payable ........................................................... Note payable—6 years ........................................ Common stock ($5 par value) ............................ Additional paid-in capital (5/21 of total computed above) ....................... Gain on discharge of debt .................................. To record settlement of partially secured debt.

140,000

— Cash ........................................................................... Common stock ($5 par value) ............................ Additional paid-in capital .................................... To record shares sold to new investor.

36,000


18,000

30,000 25,000 6,000 79,000

30,000 6,000


— Notes payable ........................................................... 50,000 Accounts payable ..................................................... 10,000 Accrued expenses .................................................... 4,000 Cash ..................................................................... Gain on discharge of debt .................................. To record payment of unsecured debts—20% payment made. — Gain on debt discharge ............................................ Additional paid-in capital ($27,000 – $25,200) ........ Retained earnings (deficit) ................................. To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.


12,800 51,200

130,200 1,800 132,000


Develop Your Skills Research Case 1 This case allows the student to review the official information provided by the Securities and Exchange Commission in connection with bankrupt organizations. Therefore, the student has the opportunity to make use of the SEC website as well as gain information about reporting requirements for organizations in bankruptcies. In addition, this assignment allows the student to see how the SEC attempts to educate the public on matters pertaining to financial investing. This site includes a significant amount of general information including the following:            

The differences between a Chapter 7 and a Chapter 11 bankruptcy. The risks incurred by the various parties. A description of a prepackaged bankruptcy plan. The advantages of filing under Chapter 11. The appointment of creditor committees. The development of a reorganization plan. Steps in a Chapter 11 reorganization, especially those that involve the SEC. Conveyance of information about a bankruptcy. Voting on a reorganization plan. The effect on stockholders and bondholders. The steps of a Chapter 7 liquidation. Sources of additional information for a specific bankruptcy case.

Research Case 2 This assignment provides the student with the chance to work with actual data from a real company. Thus, the student can get the feel for the process of retrieving information of interest about a company that has previously gone through bankruptcy. In addition, this assignment can help the student appreciate the frustration that sometimes comes about when analyzing financial statements. Textbooks often have information laid out for the student so that analysis may resemble a “connect the dots” assignment. In reality, pages and pages of data are often available that require slow and meticulous study. Here is the actual note supplied by the Hawaiian Airlines which can serve as the basis for considerable class discussion. On March 21, 2003 (the Petition Date), Hawaiian filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code (the Bankruptcy Code) in the U.S. Bankruptcy Court for the District of Hawaii (the Bankruptcy Court). The Company did not file for relief under Chapter 11 of the Bankruptcy McGraw-Hill/Irwin Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e


Code. On May 30, 2003, a bankruptcy trustee was selected to serve in connection with the Chapter 11 case and operate Hawaiian, which thereafter operated its business under the jurisdiction of the Bankruptcy Court and in accordance with the applicable provisions of the Bankruptcy Code and orders of the Bankruptcy Court until June 2, 2005, the effective date of Hawaiian’s joint plan of reorganization and its emergence from bankruptcy (the Effective Date). On March 11, 2005, the Company, together with the bankruptcy trustee, the Official Committee of Unsecured Creditors of Hawaiian, a wholly-owned subsidiary of the Company formerly known as HHIC, Inc. (HHIC), a Delaware corporation, and RC Aviation, LLC (RC Aviation), which is currently the Company’s largest shareholder, sponsored the Third Amended Joint Plan of Reorganization (the Joint Plan) to provide for Hawaiian to emerge from bankruptcy. The Joint Plan provided for payment in full of all allowed claims, including unsecured claims. The Joint Plan also provided for the merger of Hawaiian with and into HHIC, with HHIC being the surviving entity and renamed Hawaiian Airlines, Inc., a Delaware corporation. As used hereinafter in this report, the term “Hawaiian” refers to the predecessor company for all periods prior to the merger with HHIC, and the successor company for all periods subsequent to the merger with HHIC. The Company retained its 100% equity interest in Hawaiian; however, in connection with the Joint Plan, the Company issued shares of its common stock to creditors of Hawaiian to help fund the Joint Plan, resulting in a dilution of the ownership interest of its common shareholders. The following table summarizes the classification and treatment of claims under the Joint Plan (in millions): Class

Classification

Treatment under the Joint Plan

Unclassified

Unsecured Priority Tax Claims

In cash, paid in 24 equal quarterly installments

Cash $ 1.2

Long-Term Obligations

Common Stock

$ 29.5

---

Class 1 Secured Priority (Unimpaired) Tax Claims

In cash, paid in accordance with the legal, equitable and contractual rights of the holder of the claim

0.9

---

---

Class 2 Other Secured (Unimpaired) Claims

Generally, at the election of Hawaiian, (i) cash, (ii) surrender of the collateral securing the claim, (iii) cure and reinstatement, or (iv) retention by the holder of its legal, equitable and contractual rights

1.3

1.2

---

Class 3 Other Priority (Unimpaired) Claims

Cash

0.1

---


---


Class 4 (Impaired)

Unsecured Claims Cash equal to 100% of not included in a the allowed claim Category below

31.7

---

Class 5 (Impaired)

Lease Related Claims

A combination of cash, common stock of the company based on a stock value of $6.16 per share. and subordinated convertible notes of the Company

27.0

60.0

$87.0

Class 6 (Impaired)

Convenience Claims

Cash

0.8

---

---

____ $ 63.0

____ $ 90.7

____ $ 87.0

Class 7 Equity (Impaired/ Interests Unimpaired)

---

Holders of equity interests in Hawaiian retained their interests in the reorganized Hawaiian, without modification or alteration by the Joint Plan. However, the Company was required to issue new common stock to creditors of Hawaiian, which resulted in a dilution of the ownership interest of the Company’s common shareholders. Total

The Joint Plan was financed through the issuance of approximately 14.1 million shares of the Company’s common stock to the holders of aircraft lease related claims, a $50.0 million senior secured credit facility of Hawaiian, a $25.0 million junior secured term loan of Hawaiian and a private placement by the Company of $60.0 million in subordinated convertible notes (collectively, the Exit Financing Transactions), as discussed further in Note 6. Analysis Case 1 Students may look up any one of a number of companies that have emerged recently from bankruptcy reorganization. The type of results that will be found will be based on the specific company. One company, for example, that has emerged from reorganization is AMF Bowling. Here is a press release obtained at www.amf.com: Richmond, Virginia, March 8, 2002 - AMF Bowling Worldwide, Inc. today announced that it has emerged from Chapter 11 after completing its exit financing arrangements with Deutsche Banc Alex Brown and its affiliate McGraw-Hill/Irwin Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e


Bankers Trust Company. AMF Bowling Worldwide, Inc. and its U.S. subsidiaries filed voluntary petitions for reorganization under Chapter 11 on July 2, 2001. "We are emerging from this Chapter 11 process as a healthy company, and we are grateful to all parties for helping us to conclude the proceeding," said Roland Smith, the Company's President and Chief Executive Officer. "We will now be able to focus our resources on the business of bowling. We are determined to build value for the Company's stakeholders, including our employees, whose hard work and dedication were key factors in the Company's successful reorganization." The Company today closed on its $350 million exit financing. The agreement consists of a $290 million term loan, as well as a $60 million revolving credit facility. In addition, the Company issued $150 million in subordinated notes. In accordance with the previously approved plan of reorganization, the Company will provide its pre-petition senior secured lenders with recovery of their approximately $620 million in claims through a combination of equity (equal to 92 percent of the common stock of the reorganized company), $150 million in subordinated notes, and cash. In addition, unsecured creditors will share proportionately in 7 percent of the common stock, as well as warrants for the right to purchase additional shares. The unsecured creditors' common stock and warrants will be issued later this year. The Company's former parent, AMF Bowling, Inc., which conducts no operations, filed a separate Chapter 11 case and will likely have no assets to distribute to its common stockholders, and little, if any, assets to distribute to its creditors. AMF Bowling Worldwide, Inc. is no longer affiliated with AMF Bowling, Inc. The shares of AMF Bowling Worldwide's common stock that were issued under its plan of reorganization are separate and distinct from the shares of its former parent. The Company is the largest owner and operator of bowling centers in the world and is a leader in the manufacturing and marketing of bowling products. In addition, the company manufactures and sells the PlayMaster, Highland and Renaissance brands of billiards tables. Additional information about AMF is available on the Internet at www.amf.com. A second source of information is the Securities and Exchange Commission. According to the SEC website, using an EDGAR search, AMF filed a Form 8-K on the same date as the above press release that made public the following: On March 8, 2002, AMF Bowling Worldwide, Inc. issued a Press Release announcing that it has emerged from Chapter 11 under the United States



Bankruptcy Code. A copy of the Press Release is filed herewith as Exhibit 99.1. In connection with its emergence and pursuant to the previously approved Second Amended Second Modified Plan of Reorganization, among other things, AMF Bowling Worldwide, Inc. filed an Amended and Restated Certificate of Incorporation with the Secretary of State of the State of Delaware; adopted Amended and Restated Bylaws; entered into a new Senior Secured Credit Agreement providing for a term loan of $290,000,000 and a revolving credit facility of $60,000,000 secured by substantially all of its domestic assets and guaranteed by its subsidiaries; issued $150,000,000 of 13.00% Senior Subordinated Notes due 2008 pursuant to an Indenture with Wilmington Trust Company, as Trustee, guaranteed by its domestic subsidiaries; entered into a Registration Rights Agreement with certain holders of common stock; entered into a Series A Warrant Agreement and a Series B Warrant Agreement with Mellon Investor Services LLC, as Warrant Agent, providing for the issuance of warrants to purchase an aggregate of up to 3,488,844 shares of common stock; and adopted a 2002 Stock Option Plan providing for the issuance of options to purchase up to 1,839,388 shares of common stock to certain directors, officers, advisors, employees and independent consultants. Copies of these documents are filed herewith as exhibits. Following this information in the Form 8-K, over 70 pages of additional documents were presented including the certificate of incorporation. Finally, a search of The Wall Street Journal finds a number of articles discussing the bankruptcy reorganization of AMF including: “AMF Bowling Worldwide Inc.: Chapter 11 Protection Ends Via $350 Million Financing,” March 11, 2002, p. B-2. “AMF Bowling Property Said Court Approved Its Reorganization Plan,” February 5, 2002, p. A-4. “AMF Bowling Inc.: Unit Changes the Payments In Its Reorganization Plan,” January 11, 2002, p. B-8. So, there are obviously many ways available to investors who are trying to get information about a bankruptcy reorganization plan.

Analysis Case 2 While a company is going through a bankruptcy reorganization, creditors, investors, employees, and other interested parties all want to know the current McGraw-Hill/Irwin Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e


status of the process. This assignment was designed simply to help students determine what information can be readily gained from a company’s website about a reorganization that is in process. Different companies will undoubtedly provide widely differing amounts of information. Following is a portion of a December 30, 2004 press release made by Aloha Airlines that was posted on its website: In a continuing effort to restore the company’s long-term financial health, Aloha Airgroup, Inc. and its principal operating subsidiary, Aloha Airlines, Inc., announced today they have filed voluntary petitions for reorganization under Chapter 11 of the U.S. Bankruptcy Code. “It will be business as usual as we move forward to complete the restructuring of our Company,” said David A. Banmiller, Aloha’s president and chief executive officer. Banmiller went on to say Aloha hopes to emerge from Chapter 11 as expeditiously as possible. “Meanwhile, it is important for the traveling public to know that reservations for future travel will continue to be taken, tickets will be honored, and flights will continue to operate as scheduled.” Banmiller said: “Despite actions already taken to cut unprofitable routes and reduce senior management by 36 percent, Aloha must continue to pursue cost-reduction initiatives necessary to offset higher fuel and operating expenses in what has become a fiercely competitive market environment. If Aloha is to effectively compete, we must align our aircraft lease rates to market levels and match our expenses to those of competitors who have already benefited from bankruptcy protection. “The decision to file Chapter 11 was not easy for Aloha - a company with a proud history etched by a conscientious desire to be a good corporate citizen and deeply rooted in the communities we serve.” Banmiller emphasized: “With our valued customers and loyal employees in mind, Aloha is focused on successfully emerging to become a bigger, stronger and more competitive player in the industry, so that we can continue to optimize our route network and provide our high-quality service at affordable fares to travelers in the cities we serve in Hawaii and North America.” Chapter 11 of the U.S. Bankruptcy Code enables companies to reorganize under court supervision while they continue to operate and meet their customers’ needs. Aloha’s restructuring efforts will be led by Banmiller, a veteran airline executive with an accomplished background specializing in airline financings and turnaround ventures for “financially-challenged” companies. Banmiller has a proven record of successfully taking other airline companies such as Sun Country Airlines and Pan Am through Chapter 11 reorganization.



In addition, Banmiller has retained Giuliani Capital Advisors to assist Aloha in exploring all strategic alternatives to maximize value through the Chapter 11 process. This is the first time in Aloha’s 58-year history that the privately held Honolulu-based company has sought bankruptcy protection. Another Hawaiibased carrier, publicly held Hawaiian Airlines, came under Chapter 11 in 1993 and again in March 2003. Since the attacks of September 11, 2001, the nation’s airlines have faced what has been described as “the perfect storm” of financial hardships. A general economic slowdown and a skittish world travel market stiffened competition, which brought air fares down and reduced revenue at a time when the price of fuel, insurance and other fixed costs were skyrocketing. In Hawaii, the prolonged slump in visitor arrivals from Asia and the increase in Mainland flights going direct to the Neighbor Islands had a compounding economic impact on Aloha, the state’s largest provider of inter-island air services. In 2002, when a merger attempt was called off between Aloha and Hawaiian airlines, and private capital was unavailable, Aloha Airlines sought and received a loan guarantee from the federal Air Transportation Stabilization Board in 2002. The federally backed $45 million loan program enabled Aloha to upgrade systems and pursue expansion plans. To date, Aloha has repaid approximately half of the loan. Rapidly mounting fuel and other operational costs sapped the company’s financial strength in 2004. In spite of an 8 percent increase in enplanements in the airline’s transpacific service, Aloha was unable to post a profit in the third quarter of 2004 due to higher fuel cost and lower ticket prices. Through November 2004, Aloha has paid $24 million more in fuel than over the same period in 2003 representing a 48% increase in fuel expenses year-over-year. In announcing the airline’s restructuring, Banmiller emphasized that: • Aloha’s top priority will be to provide travelers with safe and consistently reliable and high-quality service. • Aloha’s inter-island and transpacific flights will continue to operate according to schedule. • All Aloha tickets and coupons will be honored. Reservations, ticketing and refunds will continue as normal. • AlohaPass members will still be able to earn and redeem mileage and Aloha will continue to offer frequent flyers the option of earning United Mileage Plus miles on Aloha flights. • Transactions made with the Aloha AirAwards Card will continue to earn bonus miles. • Vendors will be paid in the ordinary course for goods and services provided after the filing date. • Aloha will continue to operate its air-cargo freight service. • Aloha will continue to provide contracted services to those airlines with signed agreements. • Code-sharing agreements with partner airlines will not be affected by the filing. McGraw-Hill/Irwin Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e


Founded in 1946, the privately held, Honolulu-based Aloha is a leading provider of aviation services in the State of Hawaii. Aloha offers approximately 620 interisland flights per week between Honolulu, Kahului, Kona, Hilo and Lihue. In February 2000, Aloha inaugurated transpacific service from Hawaii to Oakland, California. Today the airline operates 140 transpacific flights a week between Hawaii and Oakland, Burbank, Orange County, San Diego and Sacramento, California; 42 weekly flights between California and Nevada; and daily service between Vancouver, Canada, and Hawaii. Aloha provides Hawaii with critical airlift for passengers flying between the five major airports throughout the Islands and carries 85 percent of the state’s interisland air freight business. Aloha is also the largest provider of contract aviation services for more than 20 domestic and international air carriers serving Hawaii. Aloha is among Hawaii’s top employers with a workforce of over 3,600 and an annual payroll of $113 million. Aloha’s fleet consists of 13 Next Generation Boeing 737-700s, 10 B737-200s, three dedicated B737-200 freighters and one B737-200 QC. Frequently Asked Questions for Vendors and Suppliers --What is Chapter 11? Chapter 11 is a part of the U.S. Bankruptcy Code that allows companies to restructure under court supervision while they continue normal day-to-day operations. --Why is Aloha filing for Chapter 11? Like other airlines, Aloha has elected to enter Chapter 11 in order to pursue costreduction initiatives needed to offset higher fuel and operating expenses. Through this legal process, our company can restructure its debts and obligations and emerge a stronger competitor. United, Hawaiian and ATA airlines are going through this process in their efforts to lower costs. Our goal is to emerge with a much lower cost structure that will enable Aloha to be more competitive in an industry dominated by low-cost carriers. --When will Aloha emerge from Chapter 11 protection? Aloha hopes to emerge as expeditiously as possible. --What remedies do creditors have in a Chapter 11 proceeding? Creditors are prohibited by law from taking certain collection actions against Aloha. Common examples of prohibited actions including contacting Aloha by McGraw-Hill/Irwin 13-46


telephone, mail or otherwise to demand repayment, taking actions to collect money or obtain property from Aloha, repossessing Aloha’s property, and starting or continuing lawsuits against Aloha. --What if I believe I have a right to a reclamation claim for goods delivered to Aloha? In the limited circumstances where creditors believe they have a right to reclaim goods that were delivered to Aloha, we expect to ask the Court shortly to establish a procedure for protection of the value of the claims of those creditors. --How can vendors or suppliers file a claim for any invoices that were generated prior to the Chapter 11 filing? Upon filing for Chapter 11, Aloha, by law, cannot pay for goods and services received before the filing, unless the Bankruptcy Court otherwise orders. Payment for these pre-petition invoices will be determined by the Bankruptcy Court at a later time. You will have the opportunity to file a claim for any prepetition debt with the Bankruptcy Court, and will receive instructions for filing such claim shortly. --Will payment for goods and services after the Chapter 11 filing date be honored? Aloha will continue to pay for all goods and services provided after the Chapter 11 filing. Please be aware that post-petition suppliers are given “administrative priority status” under the law, providing additional protection to you, so we encourage you to continue providing goods and services to Aloha on normal terms. --What will unsecured creditors receive as payment for their claims? It is too early in the process to accurately forecast any eventual payment of prepetition claims. However, Aloha intends to pay post-petition expenses in the normal course of business. --How can vendors or suppliers receive updates regarding status of payment of outstanding invoices? Please continue to work with your normal contact at Aloha, who can answer your questions, or visit Aloha’s Web Site at www.AlohaAirlines.com for more information.

Communications Case 1 McGraw-Hill/Irwin Hoyle, Schaefer, Doupnik, Advanced Accounting, 9/e


Advanced Accounting MCGRAW-HILL_chapter 13_SOLMAN

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