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Chapter 10
Insolvency – Liquidation and Reorganization
Multiple Choice
1. A corporation that is unable to pay its debts as they become due is:
a. bankrupt.
b. overdrawn.
c. insolvent.
d. liquidating.
2. When a business becomes insolvent, it generally has three possible courses of action. Which of the
following is not one of the three possible courses of action?
a. The debtor and its creditors may enter into a contractual agreement, outside of formal
bankruptcy proceedings.
b. The debtor continues operating the business in the normal course of the day-to-day operations.
c. The debtor or its creditors may file a bankruptcy petition, after which the debtor is liquidated
under Chapter 7.
d. The debtor or its creditors may file a petition for reorganization under Chapter 11.
3. Assets transferred by the debtor to a creditor to settle a debt are transferred at:
a. book value of the debt.
b. book value of the transferred assets.
c. fair market value of the debt.
d. fair market value of the transferred assets.
4. A composition agreement is an agreement between the debtor and its creditors whereby the creditors
agree to:
a. accept less than the full amount of their claims.
b. delay settlement of the claim until a latter date.
c. force the debtor into a liquidation.
d. accrue interest at a higher rate.
5. In a troubled debt restructuring involving a modification of terms, the debtor’s gain on restructuring:
a. will equal the creditor’s gain on restructuring.
b. will equal the creditor’s loss on restructuring.
c. may not equal the creditor’s gain on restructuring.
d. may not equal the creditor’s loss on restructuring.
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10-2 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
8. An involuntary petition filed by a firm’s creditors whereby there are twelve or more creditors must
be signed by at least:
a. two creditors.
b. three creditors.
c. five creditors.
d. six creditors.
10. Which of the following items is not a specified priority for unsecured creditors in a bankruptcy
petition?
a. Administration fees incurred in administering the bankrupt’s estate.
b. Unsecured claims for wages earned within 90 days and are less than $4,650 per employee.
c. Unsecured claims of governmental units for unpaid taxes.
d. Unsecured claims on credit card charges that do not exceed $3,000.
11. Which statement with respect to gains and losses on troubled debt restructuring is correct?
a. Creditors losses on restructuring are extraordinary.
b. Debtor’s gains and losses on asset transfers and debtor’s gains on restructuring are combined
and treated as extraordinary.
c. Debtor gains and creditor losses on restructuring are extraordinary, if material in amount.
d. Debtor losses on asset transfers and debtor gains on restructuring are reported as a component of
net income.
12. When fresh-start reporting is used according to Statement of Position (SOP) 90-7, the implication is
that a new firm exists. Which of the following statements is not correct about fresh-start
accounting?
a. Assets are reported at fair values.
b. Beginning retained earnings is reported at zero.
c. The fair value of the assets must be less than the post liabilities and allowed claims.
d. The original owners must own less than 50% of the voting stock after reorganization.
14. When a secured claim is not fully settled by the selling of the underlying collateral, the remaining
portion:
a. of the claim cannot be collected by the creditor.
b. remains as a secured claim.
c. is classified as an unsecured priority claim.
d. is classified as an unsecured nonpriority claim.
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15. Layne Corporation entered into a troubled debt restructuring agreement with their local bank. The
bank agreed to accept land with a carrying amount of $360,000 and a fair value of $540,000 in
exchange for a note with a carrying amount of $765,000. Ignoring income taxes, what amount
should Layne report as a gain on its income statement?
a. $0.
b. $180,000.
c. $225,000.
d. $405,000.
16. The following information pertains to the transfer of real estate in regards to a troubled debt
restructuring by Nen Co. to Baker Co. in full settlement of Nen’s liability to Baker:
What amount should Nen report as ordinary gain (loss) on transfer of real estate?
a. $(30,000).
b. $30,000.
c. $120,000.
d. $150,000.
17. The following information pertains to the transfer of real estate in regards to a troubled debt
restructuring by Nen Co. to Baker Co. in full settlement of Nen’s liability to Baker:
18. Dobler Corporation was forced into bankruptcy and is in the process of liquidating assets and paying
claims. Unsecured claims will be paid at the rate of thirty cents on the dollar. Carson holds a note
receivable from Dobler for $75,000 collateralized by an asset with a book value of $50,000 and a
liquidation value of $25,000. The amount to be realized by Carson on this note is:
a. $25,000.
b. $40,000.
c. $50,000.
d. $75,000.
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10-4 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
19. Bad Company filed a voluntary bankruptcy petition, and the statement of affairs reflected the
following amounts:
Estimated
Assets Book Value Current Value
Assets pledged with fully secured creditors $ 900,000 $ 1,110,000
Assets pledged partially secured creditors 540,000 360,000
Free assets 1,260,000 960,000
$2,700,000 $2,430,000
Liabilities
Liabilities with priority $ 210,000
Fully secured creditors 780,000
Partially secured creditors 600,000
Unsecured creditors 1,620,000
$3,210,000
Assume the assets are converted to cash at their estimated current values. What amount of cash will
be available to pay unsecured nonpriority claims?
a. $720,000.
b. $840,000.
c. $960,000.
d. $1,080,000.
21. Dodge Corporation entered into a troubled debt restructuring agreement with their local bank. The
bank agreed to accept land with a carrying value of $200,000 and a fair value of $300,000 in
exchange for a note with a carrying amount of $425,000. Ignoring income taxes, what amount
should Dodge report as a gain on its income statement?
a. $0.
b. $100,000.
c. $125,000.
d. $225,000.
22. The following information pertains to the transfer of real estate in regards to a troubled debt
restructuring by Drier Co. to Cole Co. in full settlement of Drier’s liability to Cole:
What amount should Drier report as ordinary gain (loss) on transfer of real estate?
a. $(25,000).
b. $25,000.
c. $100,000.
d. $125,000.
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23. The following information pertains to the transfer of real estate in regards to a troubled debt
restructuring by Drier Co. to Cole Co. in full settlement of Drier’s liability to Cole:
24. Poor Company filed a voluntary bankruptcy petition, and the settlement of affairs reflected the
following amounts:
Estimated
Assets Book Value Current Value
Assets pledged with fully secured creditors $ 450,000 $ 555,000
Assets pledged partially secured creditors 270,000 180,000
Free assets 630,000 480,000
$1,350,000 $1,215,000
Liabilities
Liabilities with priority $ 105,000
Fully secured creditors 390,000
Partially secured creditors 300,000
Unsecured creditors 810,000
$1,605,000
Assume the assets are converted to cash to their estimated current values. What amount of cash will
be available to pay unsecured nonpriority claims?
a. $360,000.
b. $420,000.
c. $480,000.
d. $540,000.
25. Dooley Corporation was forced into bankruptcy and is in the process of liquidating assets and
paying claims. Unsecured claims will be paid at the rate of thirty cents on the dollar. Cerner holds a
note receivable from Dooley for $90,000 collateralized by an asset with a book value of $60,000
and a liquidation value of $30,000. The amount to be realized by Cerner on this note is:
a. $30,000.
b. $48,000.
c. $60,000.
d. $90,000.
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10-6 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
Problems
10-1 On January 1, 2011, Bargain Mart owed City Bank $1,600,000, under an 8% note with three years
remaining to maturity. Due to financial difficulties, Bargain Mart was unable to pay the previous
year’s interest. City Bank agreed to settle Bargain Mart’s debt in exchange for land having a fair
market value of $1,310,000. Bargain Mart purchased the land in 2003 for $1,000,000.
Required:
Prepare the journal entries to record the restructuring of the debt by Bargain Mart.
10-2 On January 1, 2010, Gannon, Inc. owed BancCorp $12 million on a 10% note due December 31,
2011. Interest was last paid on December 31, 2008. Gannon was experiencing severe financial
difficulties and asked BancCorp to modify the terms of the debt agreement. After negotiation
BancCorp agreed to:
- Forgive the interest accrued for the year just ended,
- Reduce the remaining two years interest payments to $900,000 each and delay the first
payment until December 31, 2011, and
- Reduce the unpaid principal amount to $9,600,000.
Required:
Prepare the journal entries for Gannon, Inc. necessitated by the restructuring of the debt at (1) January 1,
2010, (2) December 31, 2011, and (3) December 31, 2012.
10-3 On January 2, 2011 Stevens, Inc. was indebted to First Bank under a $12 million, 10% unsecured
note. The note was signed January 2, 2005, and was due December 31, 2014. Annual interest was
last paid on December 31, 2009. Stevens negotiated a restructuring of the terms of the debt
agreement due to financial difficulties.
Required:
Prepare all journal entries for Stevens, Inc. to record the restructuring and any remaining transactions
relating to the debt under each independent assumption.
A. First Bank agreed to settle the debt in exchange for land which cost Stevens $8,500,000 and has a
fair market value of $10,000,000.
B. First Bank agreed to (1) forgive the accrued interest from last year (2) reduce the remaining four
interest payments to $600,000 each, and (3) reduce the principal to $9,000,000.
10-4 On December 31, 2011, Community Bank agreed to restructure a $900,000, 8% loan receivable
from Neer Corporation because of Neer’s financial problems. At December 31 there was $36,000 of
accrued interest for a six-month period. Terms of the restructuring agreement are as follows:
- Reduce the loan from $900,000 to $600,000;
- Extend the maturity date by 2 years from December 31, 2011 to December 31, 2013;
- Reduce the interest rate on the loan from 8% to 6%.
Required:
Compute the gain or loss that will be reported by Community Bank.
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10-5 Donnelly Corporation incurred major losses in 2010 and entered into voluntary Chapter 7
bankruptcy in the early part of 2011. By June 1, all assets were converted into cash, the secured
creditors were paid, and $150,000 in cash was left to pay the remaining claims as follows.
Required:
Classify the claims by their Chapter 7 priority ranking, and analyze which amounts will be paid and which
amounts will be written off.
10-6 Davis Corporation filed a petition under Chapter 7 of the U.S. Bankruptcy Act on June 30, 2011.
Data relevant to its financial position as of this date are:
Estimated Net
Book Value Realizable Values
Cash $ 3,000 $ 3,000
Accounts receivable-net 72,000 48,000
Inventories 60,000 72,000
Equipment-net 165,000 87,000
Total assets $300,000 $210,000
Required:
A. Prepare a statement of affairs assuming that the note payable and interest are secured by
a mortgage on the equipment and that wages are less than $4,650 per employee.
B. Estimate the amount that will be paid to each class of claims if priority liquidation expenses
including trustee fees are $24,000 and estimated net realizable values are actually realized.
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10-8 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
10-7 The following data are taken from the statement of affairs of Mitchell Company.
Required:
Compute the amount that will be paid to each class of creditor.
10-8 On February 1, 2011, Hilton Company filed a petition for reorganization under the bankruptcy
statutes. The court approved the plan on September 1, 2011, including the following provisions:
Required:
Prepare journal entries on the books of Hilton Company to give effect to the preceding provisions.
Short Answer
1. The Bankruptcy Reform Act assigns priorities to certain unsecured claims, and each rank must be
satisfied in full before the next–lower rank is paid. Identify the five categories of unsecured creditor
claims.
2. Creditors are classified by law as either secured or unsecured. Distinguish among fully secured,
partially secured, and unsecured creditors.
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1. List the primary types of contractual agreements between a debtor company and its creditors and
briefly explain what is involved in each of them.
3. Distinguish among fully secured, partially se-cured, and unsecured claims of creditors.
4. Five priority categories of unsecured claims must be paid before general unsecured creditors are
paid. Briefly describe what makes up each category.
6. For each of the following debt restructurings, indicate whether a gain is recognized and, if so, how
the gain is measured and reported. (a)Transfer of assets by the debtor to the creditor.(b)Grant of an
equity interest by the debtor to the creditor.(c)Modification of the terms of the payable.
8. One of the officers of a corporation that had just received a discharge in bankruptcy said, “Good,
now we don’t owe anyone.” Is he correct?
From an ethical perspective, some believe that it is never justifiable for an individual or business to declare
bankruptcy. Others believe that some actions are appropriate only in extreme circumstances. Without
question, as stated in the Journal of Accountancy, November 2005,page 51, “the ease with which debtors
have been able to walk away from debt has frustrated creditors for years.”
1. Describe the differences between Chapter 7 (liquidations) and Chapter 11 (reorganizations)from an
ethical standpoint. Who is most likely to be hurt by a Chapter 7 bankruptcy?
2. Discuss the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Do you believe
the changes wrought by this act will serve to protect creditors?
3. The Protection Act of 2005 requires individuals, but not businesses, to undergo a “means” test
before they can seek Chapter 7 relief. Do you believe this change should be applied to businesses as
well? Why or why not?
4. Do you think that you would ever resort to filing for bankruptcy relief yourself? Why or why not?
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10-10 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
ANSWER KEY
1. c 8. b 15. c 22. b
2. b 9. c 16. b 23. a
3. d 10. d 17. a 24. d
4. a 11. d 18. b 25. b
5. d 12. c 19. d
6. c 13. a 20. d
7. a 14. d 21. c
Problems
10-1 Land 310,000
Gain on Disposal of Land 310,000
January 1, 2010
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January 2, 2011
Interest Payable 1,200,000
Note Payable 600,000
Gain on Debt Restructuring 1,800,000
10-5
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10-12 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
10-5 (Continued)
10-6
A.
Davis Corporation
Statement of Affairs
June 30, 2011
Deficiency
Account
Book Value Assets Realizable Value (Loss/Gain)
Pledged with partially secured creditors
$165,000 Equipment-net $87,000
(78,000)
Less: Note payable and accrued interest (96,000) $ 0
Unsecured amount (See below) (9,000)
Free Assets
3,000 Cash 3,000
72,000 Accounts receivable-net 48,000
(24,000)
60,000 Inventories 72,000
12,000
Total net realizable value 123,000
Less: Priority liabilities – wages payable 45,000
Total available for unsecured creditors 78,000
______ Estimated deficiency to unsecured creditors 30,000 ______
$300,000 $108,000
(90,000)
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10-6 (Continued)
Unsecured
Book Value Equities Liabilities
Priority liabilities
$ 45,000 Wages payable (assumed under
$4,650 per employee) $ 45,000
Unsecured creditors
72,000 Accounts payable 72,000
27,000 Rent payable 27,000
Stockholders’ equity
180,000 Capital stock
180,000
(120,000) Retained earnings (deficit) ______
(120,000)
$300,000 $108,000
$ 60,000
Estimated Deficiency $(30,000)
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10-14 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
Partially secured
Note payable and interest
Secured portion $87,000
Unsecured portion ($9,000 × 0.50) 4,500 $91,500
Unsecured priority
Administrative expenses $24,000
Wages payable 45,000 69,000
Unsecured nonpriority
Accounts payable ($72,000 × 0.50 $36,000
Rent payable ($27,000 × 0.50) 13,500 49,500
Total payments $210,000
10-7
*Rounded $130
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10-8
Short Answer
2. Fully secured creditor claims are those with liens against assets whose realizable value is equal to or in
excess of the claim. Partially secured claims are those with liens against assets whose realizable value
is less than the amount of the claim. Unsecured creditors are paid from whatever proceeds remain from
the realization process.
1. Extension of payment periods. The debtor continues to manage the business, and the creditors
merely extend the payment due date(s) for existing debts.
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10-16 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
Formation of a creditor’s committee. The debtor company and its creditors agree to form a
committee of creditors responsible for managing the debtor’s business affairs for the period
during which plans are developed to rehabilitate, reorganize, or liquidate the business.
Voluntary assignment of assets. An insolvent debtor elects to voluntarily place his property
under the control of a trustee for the benefit of his creditors.
2. In a voluntary petition, the debtor files a petition with a bankruptcy court for liquidation under
Chapter 7 or for reorganization under Chapter 11. The bankruptcy judge may refuse a
voluntary petition if refusal is considered to be in the best interest of the creditors.
In an involuntary petition, creditors initiate the action by filing a petition for liquidation or
reorganization with the bankruptcy court. If there are twelve or more creditors, the petition
must be signed by three or more of such creditors whose claims aggregate at least $5,000 more
than the value of any liens on the property of the debtor. If there are fewer than twelve
creditors, the petition may be filed by one or more of such creditors whose claims aggregate at
least $5,000 more than the value of any liens on the debtor’s property.
3. Fully secured claims. Those claims with liens against specific assets whose realizable value is
equal to or in excess of the claim.
Partially secured claims. Those claims with liens against specific assets whose realizable value
is less than the amount of the claim.
Unsecured claims. Those claims that are not secured by liens against specific assets and are,
therefore, paid from whatever total money remains after secured creditors are satisfied. Some
unsecured claims take priority over others under federal bankruptcy law.
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6. a. Transfer of Assets:
The transfer of assets by a debtor to a creditor generally produces two types of gain or loss.
A gain on restructuring of debt is recognized for the excess of the carrying value of the
payable over the fair value of the assets transferred. This gain is reported as a component of
operating income. In addition, a gain or loss on transfer of assets is recognized for the
difference between the fair value and book value of the assets transferred. This gain (loss) is
reported as a component of operating income also.
c. Modification of Terms:
In a modification of terms, the debtor will report a gain on restructuring only if the total
future cash payments specified by the new terms are less than the carrying value of the
payable. The amount of gain is measure as the difference between the total future cash
payments specified by the new terms and the carrying value of the payable.
7. The statement of affairs is an accounting report that is designed to permit interested parties to
determine the total expected amounts that could be realized from the disposition of a
company’s assets, the priorities in the use of the realization proceeds in satisfying claims, and
the potential net deficiency that would result if the assets were realized and claims liquidated.
8. The officer is incorrect. Some claims, such as for taxes, fines, and penalties are not discharged.
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10-18 Test Bank to accompany Jeter and Chaney Advanced Accounting 3rd Edition
10. The purpose of a combining workpaper is to serve as a means by which the trustee’s accounts
are united with the debtor company’s accounts in order to prepare appropriate financial
statements.
11. The purpose of a realization and liquidation account is to report summary realization and
distribution activities of a trustee or receiver to the court. It reports the changes that have
occurred during a period in the monetary items because that is what the court officials are
primarily interested in.
1. In chapter 7 bankruptcy liquidation, firms are assumed to be past the stage of reorganization
and must sell off any un-exempt assets to pay creditors. In contrast, Chapter 11 bankruptcy
allows the firm the opportunity to reorganize its debt and to try to re-emerge as a healthy
organization.
In both cases, the creditors and other claim-holders suffer losses as they will be most likely
getting less return on investment than expected at the time of the initial decision to invest in
the company. From an ethical perspective, a chapter 11 bankruptcy provides the creditors
and other claim-holders a better chance of recovering higher value for their investments
than under chapter 7 as the firm strives to recover and reorganize under chapter 11 but not
under chapter 7.
2. The new law makes sweeping changes to American bankruptcy laws and makes it more
difficult for individuals to file bankruptcy under chapter 7. The new law requires a means test
to determine whether the borrowers have enough resources to pay for their debts. For additional
information, see the following link:
http://en.wikipedia.org/wiki/Bankruptcy_Abuse_Prevention_and_Consumer_Protection_
Act]
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These changes provide more safety for the creditors, who should consequently be better
protected. Individuals who fail the means test may opt instead for Chapter 13, which
involves a repayment of their debt over time.
3. Applying this test to businesses would benefit the creditors and other claim-holders, as they
would feel a slight buffer to their risk, which might stimulate new business as a result of
easier fund raising. It may also prevent businesses from venturing into unduly risky areas as
they would not be able to bail out as easily by filing under chapter 7 if things went wrong
(hence becoming somewhat more risk averse). It would seem to shift the risk balance
somewhat to the shoulders of the entrepreneur from those of the investor.
4. Filing for bankruptcy is never a desirable or ethical option, but sometimes circumstances
may arise that seem to force a business or an individual into this tough situation. Whether
the individual finds another way at such a time or not is a personal issue and an ethical
dilemma, and there is not necessarily a correct answer to this question. The purpose of this
discussion is to get the student to thinking about his or her personal position, and where his
ethical stance would be before the situation arises. Ideally, of course, the student will never
find himself or herself in such a position, but, as the old saying goes, until you’ve walked a
mile in another’s shoes…
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