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Chap 020
Chap 020
Chap 020
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Chapter 20 - Corporations in Finanacial Difficulty
CHAPTER 20
ANSWERS TO QUESTIONS
Q20-1 The nonjudicial actions available to a financially distressed company are debt
restructuring arrangements and creditor's committee management. The judicial actions
available are corporate liquidation (Chapter 7) and corporate reorganization (Chapter
11).
Q20-2 The major difference between a Chapter 7 action and a Chapter 11 action is that
the debtor continues as a business after a Chapter 11 reorganization whereas the
business does not survive a Chapter 7 liquidation.
Q20-3 Under two circumstances an involuntary petition for relief may be filed. The first
circumstance is that the debtor is generally not paying debts as they become due. The
second circumstance is that within the last 120 days a custodian has been appointed by
other creditors, by the debtor, or by some other agency to take possession of the
debtor's assets. If more than 12 creditors exist, then three or more creditors must
combine to file the petition. These three or more creditors must have aggregate
unsecured claims of at least $5,000.
Q20-4 The following items are usually included in the Plan of Reorganization filed as
part of a Chapter 11 reorganization:
All major actions to be taken during the reorganization:
(1) Discontinuances of unprofitable operations
(2) Restructuring of debt with specific creditors
(3) Revaluation of assets and liabilities
(4) Changes in the par value of outstanding stock, or realignment of
stockholders' equity with newly issued shares of voting common stock.
Companies using fresh start accounting revalue their assets to fair values, using the
procedures in FASB 141. An account called Reorganization Value in Excess of the
Amount Assigned to Identifiable Assets is used to record any excess in reorganization
value not assigned to specific assets.
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Chapter 20 - Corporations in Finanacial Difficulty
Q20-7 The financial statements that must be filed by a company during a Chapter 11
reorganization include a complete set of audited financial statements. SOP 90-7
established specific guidelines for these statements, noting that amounts associated with
reorganization should be reported separately.
Q20-8 The rights of creditors with priority in a Chapter 7 liquidation are to receive any
assets available to unsecured creditors after the secured creditors have been satisfied.
Q20-9 The statement of affairs is the basic accounting report made at the beginning of
the liquidation process to present the expected realizable amounts from disposal of the
assets, the order of creditors' claims, and the expected amount unsecured creditors will
receive as a result of the liquidation. In addition, the statement of affairs presents the
book values of the debtor company's balance sheet accounts and the estimated
deficiency to the general unsecured creditors. As a final point, the statement of affairs is
not a going concern report.
Q20-10* A trustee who takes title to the debtor's assets in a liquidation must make a
periodic financial report to the bankruptcy court reporting on the progress of the
liquidation and on the fiduciary relationship held. When the trustee accepts the assets, a
new set of books is opened for the debtor and a new account is created to recognize the
debtor's interest in the net assets accepted by the trustee. A statement of realization and
liquidation is prepared on a monthly basis for the bankruptcy court showing the results of
the trustee's fiduciary actions’ beginning at the point the trustee accepts the debtor's
assets.
Q20-11* Sales of assets are reported in the statement of realization and liquidation as
assets realized in the assets section of the statement.
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Chapter 20 - Corporations in Finanacial Difficulty
SOLUTIONS TO CASES
The options to the creditors are (1) form a creditors' committee, (2) a Chapter 11
reorganization, and (3) a Chapter 7 liquidation. The eventual decision must rest upon the
creditors' assessment of the viability of the rehabilitation of the debtor versus the
liquidation values of the debtor's assets.
Most creditors do not want to see the liquidation of a debtor because, as creditors, they
are in the business of loaning monies, not trying to manage a business or attempting to
obtain as much of a liquidation dividend as possible in a liquidation. Most creditors will
work with the debtor's management as long as possible. Secured creditors have greater
protection of their receivables than do unsecured creditors. However, even most secured
creditors prefer to see a debtor company be rehabilitated after a time of financial
difficulty rather than see the debtor liquidated. The timing of the cash flows is somewhat
dependent on the amount of reduction in debt the creditors are willing to absorb. If the
creditors are willing to work with the debtor, the creditors may eventually realize a
greater percentage of their debt, but it usually takes a longer time to receive the
payments from the debtor.
The creditors' committee is a nonjudicial action that provides for flexibility to both the
creditors and the debtor. The creditors' committee typically works with the debtor
company to enact a plan of settlement of the debtor's indebtedness. In some cases, the
creditors may assume management control of the company, but most creditors are
reluctant to do this because of the added risk of legal action if the company does enter
bankruptcy. Creditors may eventually receive a substantial part, or possibly all, of their
receivables as the debtor is able to "work down" its debt over time.
Chapter 7 liquidations are the final step. The creditors must go through the judicial
process that may take a long time to complete. Liquidation should be used only if no
other alternative is viable. Creditors often receive a smaller portion of their receivables
because of the forced liquidation of the assets and the extensive legal and administrative
costs involved in a liquidation.
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Chapter 20 - Corporations in Finanacial Difficulty
a. The Frequently Asked Questions (FAQs) for the U.S. Bankruptcy Courts state that a U.S.
bankruptcy judge is a district court judicial officer who is appointed by the majority of
judges of the U.S. appeals court to have jurisdiction over bankruptcy matters. As
bankruptcy cases come before a district court, a bankruptcy judge is assigned to the
case. Some courts assign judges based on random assignment while other courts have
a chief judge who seeks to select a judge to assign based on a judge’s experience or
special expertise relevant to the case. Each court will have a written plan or system for
assigning cases.
b. The U.S. Bankruptcy Court’s Website has a link to Official Bankruptcy Forms to be used
in filings before the courts. The forms and instructions for a Voluntary Petition are
available in Part I of the Bankruptcy Forms Manual page. The official form is FORM B1
for a voluntary petition.
A voluntary petition is initiated by the debtor and therefore the information required is
principally related to the debtor, such as name, address, and location of the principal
assets of the debtor. The debtor must declare such items as the number of creditors, the
estimated assets, the estimated debts, the type of petition (i.e., Chapter 7, Chapter 11,
etc.), if sufficient funds will be available to satisfy the unsecured creditors. The debtor
may also be required to file additional exhibits (Exhibit A for publicly traded companies,
Exhibit B is used in personal filings and Exhibit C to describe any property that might
pose a threat of identifiable harm to public health or safety).
c The United States Bankruptcy Courts Website presents a link to Bankruptcy Statistics
that are presented in .pdf format. Statistics are presented for various time periods such
as quarters, fiscal years and calendar years. Note that Case 20-3 asks for the most
recent calendar year ending on December 31.
(1) Total business filings are presented at the top of the form for business and
nonbusiness filings for the twelve month period ended for the most recent year.
Statistics for prior years are also available. Business filings are typically about
34,000 but do fluctuate slightly based on economic conditions. Approximately sixty
percent of these filings are under Chapter 7, about twenty-eight percent under
Chapter 11, and the remainder under various other chapters of the Bankruptcy
Code.
(2) Students should find the Federal judicial district in which their educational institution
is located. The larger states typically have several districts and students may have
to make an assumption for which district they are located. It is instructive to see
that the numbers of filings vary widely by district. The number of filings may differ
due to different economic factors for specific parts of the United States, the nature
of the industrial base in a specific district, the size of a district, and other factors
reflecting business factors across court districts. Students might reflect on why the
number of filings in their Federal court district are different from those in other
districts in other circuits.
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Chapter 20 - Corporations in Finanacial Difficulty
Title 11 of the United States Code may be obtained from several sources through using
a web browser and the search term, “Title 11 of the U.S. Code.” The case asks about
trustees for a Chapter 7 bankruptcy filing.
b. Section 704 of Subchapter 1 of Chapter 7 of Title 11 of the U.S. Code defines the
duties of the trustee. The trustee is responsible for administering the business, is
accountable for all property received, and must evaluate the claims of the creditors to
make sure the claims are valid prior to settlement. The trustee also prepares
periodic reports and summaries of the operations of the business which it provides to
the United States Trustee or Bankruptcy Court. Upon completion of the operations,
the trustee must file a final report on the administration of the estate with the court
and with the United States Trustee.
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Chapter 20 - Corporations in Finanacial Difficulty
Overall, the 2002 bankruptcy of WorldCom resulted in a cumulative net reduction to their
shareholders’ equity of $70.8 billion as of December 31, 2001, and a reduction in
previously reported net income of $17.1 billion and $53.1 billion for the years ended
December 31, 2001, and 2000 respectively. Goodwill of $44.9 billion was reduced to
zero at December 31, 2001. The WorldCom bankruptcy and resultant adjustments
made during the reorganization process are certainly one of the most significant
bankruptcies in U.S. business history.
The following information is taken from WorldCom Inc.’s 10-K for the fiscal year 2002
that was filed with the SEC on March 12, 2004.
b. (Source: Item 3, Legal Proceedings and the MD&A) The primary reason seems to
be that management and the Board of Directors had been informed of very
significant accounting irregularities and needed time to investigate the possible
irregularities, and to protect the company from lawsuits from creditors and others.
For example, on June 26, 2002, the SEC filed a civil suit against the company for its
past financial reports. On April 29, 2002, Bernard Ebbers resigned as President and
Chief Executive Officer. The company undoubtedly felt it needed the protection of
bankruptcy to give it time to study the breadth of its financial and accounting
problems and to reorganize to recover from those problems without additional legal
pressure from its creditors.
c. (Source: Item 3, Legal Proceedings) On June 25, 2002, the company publicly
announced that an internal audit found a number of transfers from line cost expenses
(referred to as access cost expenses) to capital accounts, thus decreasing expenses
and increasing assets. For the year 2001 and the first quarter of 2002, this amount
of transfer was $3.9 billion. In addition to this item, the company was improperly
accounting for impairment tests on its long-lived assets, its acquisitions, its revenue
contracts and several other irregularities. However, it was the accounting for the
access costs as assets when they were clearly expenses that were the primary
accounting irregularity that initiated the internal review.
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Chapter 20 - Corporations in Finanacial Difficulty
C20-4 (continued)
Year Ended Year Ended
December 31, 2001 December 31, 2000
Pre-tax Pre-tax
Item: Revenue income (loss) Revenue income (loss)
Previously reported 35,121 2,375 39,020 7,581
Restatement adjustments:
1. Impairment --- (12,592) --- (47,180)
2. Improper reduction --- (2,933) 6 (1,827)
of access costs
3. Purchase accounting 14 (2,273) (193) (3,567)
4. Long lived asset --- 2,750 --- (1,713)
adjustments
5. International adjustments (749) (899) 18 (487)
6. Revenue related (1,204) (575) (36) (995)
adjustments
7. Adjustments to --- (823) --- (732)
accrued liabilities
8. Embratel and 5,268 (35) 1,127 (325)
Avantel acquisitions
9. Unclassified income/ --- 383 --- (426)
(expense)
10. Other (7) (506) 4 (750)
Total adjustment items 3,322 (17,503) 926 (58,002)
Discontinued Operations (775) 1,323 (602) 449
Adjustment
Revenue, as restated 37,668 39,344
Minority interest adjustment (669) 52
Pre-tax loss, as restated (14,474) (49,920)
Because most of the accounting personnel, including the Chief Financial Officer and
the controller, were terminated shortly after the large scope of the accounting
irregularities were discovered, the company determined that it could not objectively
restate periods prior to the 2000 fiscal year. However, a minor adjustment decrease
of $.7 billion was made to the ending shareholders’ equity as of December 31, 1999.
A brief explanation of each of the 10 adjustment categories above is summarized
from the disclosures in Item 6 of WorldCom’s 2002 10-K.
1. Impairment: The company discovered that impairment tests had not been
performed for goodwill and long-lived assets even though FASB 121 triggers had
occurred. The application of these impairment tests resulted in very significant
writedowns for both 2000 and 2001.
2. Improper reduction of access costs: The primary adjustments for this item were
due to the improper capitalization of access costs that should have been
expensed as incurred in accordance with GAAP.
3. Purchase accounting: The company made numerous acquisitions, including the
MCI acquisition, between 1993 and 2001 and a review of these acquisitions
concluded that a number of errors were found in the application of purchase
accounting valuations and procedures that overstated the amounts capitalized for
the acquisitions.
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Chapter 20 - Corporations in Finanacial Difficulty
C20-4 (continued)
4. Long lived asset accounting: This item includes adjustments to depreciation and
amortization, changes in the estimated useful lives of long-lived assets, including
those acquired in the MCI combination, and other costs that had been
inappropriately capitalized as long-lived assets that should have been expensed.
5. International: Adjustments were made for correcting the U.S. GAAP-based
statements from the foreign accounting principles. In addition, a review of the
functional currency rules resulted in changing the functional currencies for many
of the international subsidiaries from the local currency to the U.S. dollar.
6. Revenue related adjustments: A number of adjustments were made because of
lack of documentation to support the company’s deferral of income under SAB
101. In addition, the company had incorrectly accounted for some contracts as
sales when in fact the company had acted as an agent and should have recorded
just the net of the amounts as income rather than record gross sales and gross
costs.
7. Adjustments to accrued liabilities: Adjustments were made to eliminate improper
accruals of liabilities for items such as legal reserves, employee benefits and tax
liabilities.
8. Embratel and Avantel acquisitions: A review of the Embratel acquisition showed
an incorrect interpretation with regard to not having control over Embratel and
that Embratel should have been consolidated rather than reported net as an
investment. A review of the Avantel relationship to WorldCom resulted in
changing the accounting from an equity investment to a full consolidation.
9. Unclassified income/ (expense): A review of several accrued liability accounts
showed that there was inadequate documentation to support the accruals. Also,
there were other accrued assets and some liabilities recorded on the historical
balance sheet for which there was either no, or inadequate, documentation to
support that the company owned the assets or owed the liabilities.
10. Other: The company made a number of reclassifications, revaluations of
derivatives, intercompany balances, and certain capitalized costs such as
interest, labor and overhead for capital projects.
These adjustments were also carried through the restated balance sheet and
statement of cash flows for 2001 and 2000.
e. (Source: Item 7 of WorldCom’s 2002 10-K) From the date the bankruptcy petition
was filed, July 21, 2002, through the entire reorganization period, the company used
the provisions of SOP 90-7 for accounting and financial reporting purposes. The
“Debtors-In-Possession” heading informs readers of the financial statements that the
company is in bankruptcy reorganization but management still controls the company
under the administration of a bankruptcy trustee. The balance sheet reports pre-
petition liabilities separately from others and liabilities not subject to compromise are
reported separately in both the current and noncurrent sections of the balance sheet.
The income statement separately reports the reorganization gain or loss realized
during the reorganization period.
f. (Source: Item 7 of WorldCom’s 2002 10-K) Towards the beginning of Item 7, the 10-
K reports that the company will adopt fresh-start accounting under the provisions of
SOP 90-7 as of the fresh-start reporting date. The company will revalue its assets
and liabilities, allocate the reorganization value to the assets and liabilities, eliminate
the accumulated deficit in shareholders’ equity, and the company’s new debt and
equity will be recorded.
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Chapter 20 - Corporations in Finanacial Difficulty
SOLUTIONS TO EXERCISES
1. c
2. d
3. c
4. d
5. c
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Chapter 20 - Corporations in Finanacial Difficulty
Recovery
Claims/Interest:
Accounts Payable (80,000) 8,000 (72,000) (72,000) 90
Common shareholders:
Common Stock (100,000) (100,000) 100% (200,000) (200,000)
Additional Paid-In (200,000) 171,000 (29,000) (29,000)
Retained Earnings
Deficit 178,000 (178,000)
Total (622,000) (40,000) (230,000) (203,000) 100% (229,000) (662,000)
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Chapter 20 - Corporations in Finanacial Difficulty
E20-2 (continued)
1. c
2. a
3. d
4. a
5. c
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Chapter 20 - Corporations in Finanacial Difficulty
E20-4 Chapter 7 Liquidation
$101,500
Estimated dividend: = 58%
$175,000
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Chapter 20 - Corporations in Finanacial Difficulty
Pace Corporation
Statement of Realization and Liquidation
Assets
Supplementary Items
Liabilities
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Chapter 20 - Corporations in Finanacial Difficulty
SOLUTIONS TO PROBLEMS
Polydorous Corporation
Plan of Reorganization
Recovery Analysis
Recovery
Pre- Elimination 12%
Confir- of Debt Surviving Cash Secured Common Stock Total Recovery
mation and Equity Debt Notes % Value $ %
Claims/Interest:
Accounts Payable (160,000) 20,000 (40,000) (100,000) (140,000) 88
Pre-confirmation total equities of $700,000 includes $690,000 pre-petition and $10,000 post-petition increase.
Note: Parentheses indicate credit amount.
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Chapter 20 - Corporations in Finanacial Difficulty
P20-6 (continued)
First condition:
Post-petition liabilities $ 10,000
Liabilities deferred pursuant to Chapter 11 proceedings 520,000
Total post-petition liabilities and allowed claims $530,000
Reorganization value (510,000)
Excess of liabilities over reorganization value $ 20,000
Second condition:
Holders of existing voting shares immediately before confirmation
receive 20% of voting shares of emerging entity.
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Chapter 20 - Corporations in Finanacial Difficulty
P20-6 (continued)
Book Fair
Value Value Difference
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Chapter 20 - Corporations in Finanacial Difficulty
P20-6 (continued)
d. Fresh start balance sheet workpaper for company emerging from reorganization: (Worksheet
not required)
Liabilities:
Liabilities Not Subject
to Compromise:
Current Liabilities (10,000) (10,000)
Liabilities Subject
to Compromise (520,000) 520,000
Notes Payable, 12%, secured (340,000) (340,000)
Total Liabilities (530,000) 180,000 -0- -0- (350,000)
Shareholders' Equity:
Preferred Stock (100,000) 100,000
Common Stock (old) (150,000) 150,000
Common Stock (new) (30,000) (70,000) (100,000)
Additional Paid-In Capital (180,000) 180,000
Retained Earnings 80,000 (90,000) 90,000
(80,000) -0-
Total Shareholders' Equity (170,000) (120,000) -0- 190,000 (100,000)
Total Liabilities and
Shareholders’ Equity (700,000) 60,000 -0- 190,000 (450,000)
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Chapter 20 - Corporations in Finanacial Difficulty
P20-6 (continued)
d. Balance sheet for company emerging from Chapter 11 reorganization with fresh start
accounting:
Polydorous Company
Balance Sheet
Emerging Date
Assets:
Cash $ 30,000
Accounts Receivable (net) 110,000
Inventory 18,000
Total Current Assets $158,000
Liabilities:
Accounts Payable $ 10,000
Notes Payable, 12%, secured 340,000
Total Liabilities $350,000
Shareholders' Equity:
Common Stock 100,000
Total Shareholders' Equity $100,000
Total Liabilities and Shareholders' Equity $450,000
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Chapter 20 - Corporations in Finanacial Difficulty
Assets
Estimated
Amount
Available Estimated
Estimated to Gain
Book Current Unsecured (Loss) on
Value Values Claims Realization
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Chapter 20 - Corporations in Finanacial Difficulty
P20-7 (continued)
Equities
Estimated
Book Amount
Value Unsecured
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Chapter 20 - Corporations in Finanacial Difficulty
a. Tower, Inc.
Statement of Affairs
December 31, 20X1
Assets
Estimated
Amount Estimated
Estimated Available to Gain
Book Current Unsecured (Loss) on
Value Values Claims Realization
(1) Assets pledged with fully secured
creditors:
$ 40,000 Accounts receivable $ 40,000
13,000 Land 25,000 $ 12,000
90,000 Building (net) 110,000 20,000
140,000 Machinery (net) 75,000 (65,000)
$250,000
Less: Fully secured claims
from liability side:
Note payable-bank $ 30,000
Mortgage payable and
related interest 132,400 (162,400) $ 87,600
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Chapter 20 - Corporations in Finanacial Difficulty
P20-8 (continued)
Book Amount
Value Liabilities and Stockholders' Equity Unsecured
$444,700
* Common stock, $100,000; retained earnings deficit, ($20,000); cash expended for
travel, ($500); accrued interest receivable, $200; unrecorded employer's payroll
taxes, ($500); unrecorded interest on mortgage, ($2,400); bill for last year's audit,
($5,000); and probable damage suit judgment, ($50,000).
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Chapter 20 - Corporations in Finanacial Difficulty
Hobbes Company
(Debtor-in-Possession)
Income Statement
For the Year December 31, 20X2
Revenue:
Sales $246,000
Reorganization Items:
Professional Fees $(15,000)
Interest Earned on Accumulated Cash
Resulting from Chapter 11 Proceeding 3,000
Total Reorganization Items (12,000)
Discontinued Operations:
Operating Loss, Net-of-Tax $(16,000)
Gain on Sale of Assets, Net-of-Tax 9,000
Net Discontinued Operations (7,000)
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Chapter 20 - Corporations in Finanacial Difficulty
P20-9 (continued)
Hobbes Company
(Debtor-in-Possession)
Statement of Cash Flows
For the Year December 31, 20X2
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Chapter 20 - Corporations in Finanacial Difficulty
P20-9 (continued)
Hobbes Company
(Debtor-in-Possession)
Balance Sheet
December 31, 20X2
Assets
Cash $ 72,000
Accounts Receivable (net) 47,000
Inventory 88,000
Total Current Assets $207,000
Property, Plant, and Equipment (net) 460,000
Total Assets $667,000
Liabilities
Liabilities Not Subject to Compromise:
Current Liabilities (post petition):
Short-Term Borrowings $ 10,000
Accounts Payable - Trade 7,000
Total Liabilities Not Subject to Compromise $ 17,000
Shareholders' Equity
Preferred Stock $ 50,000
Common Stock ($1 par) 50,000
Additional Paid-In Capital 75,000
Retained Earnings (Deficit) (120,000)
Total Shareholders' Equity $ 55,000
Total Liabilities and Shareholders' Equity $667,000
* $10,000 payment approved by the Court, reducing pre-petition bonds payable from
$250,000 to $240,000.
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