Chapter - 5

• Bankruptcy
• Liquidation and Reorganization

© 2003 The McGraw-Hill Companies, Inc.,

All Rights Reserved
 Scope of Chapter
• Reasons for Business Failures
• The Bankruptcy Code
• Bankruptcy Liquidation
• Bankruptcy Reorganization

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 Reasons For Bankruptcy
• Poor Management.
• Excessive Debt.
• Inadequate Accounting.
• Inability to pay liabilities as they become
due.

3
 Reasons For Bankruptcy
• Unsecured Creditors often resort to lawsuits
to satisfy their unpaid claims.
• Secured Creditors may force foreclosure
proceedings for real property or may
repossess personal property that collateralizes
a security agreement.

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 Reasons For Bankruptcy
• Internal Revenue Services may seize the
assets, for failure to pay FICA and income
taxes withheld from employees.
• A business enterprise may be unable to pay its
liabilities even though the current fair values
of its assets exceed its liabilities.

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 Reasons For Bankruptcy
• An enterprise may experience a severe cash
shortage in times of price inflation because of
the lag between the purchase or production
of goods at inflated costs and the recovery of
the inflated costs through increased selling
prices.
• State of insolvency.

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 Insolvent Means
• With reference to an entity other than a
partnership and a municipality, financial
condition such that the sum of such entity’s
debts is greater than all of its property, at a
fair valuation exclusive of –.
1. Property transferred, concealed, or removed with intent to
hinder, delay, or defraud such entity’s creditors; and.
2. Property that may be exempted from property of the estate
under … this title.

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 Insolvent Means
• With reference to a partnership, financial
condition such that the some of such
partnership’s debts is greater than the
aggregate of, at fair valuation –.
– All of such partnership’s property, exclusive of property of the
kind specified in subparagraph 1 above; and.
– The sum of the excess of the value of each general partner’s
non-partnership property, exclusive of property of the kind
specified in subparagraph 2 above, over such partner’s non-
partnership debts;

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 Insolvent Means
• The terms insolvent and bankruptcy often are
used as interchangeable adjectives. Such
usage technically is incorrect.
• Insolvent refers to the financial condition of a
person or business enterprise.
• Bankrupt refers to the legal state of a person
or business enterprise.

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 The Bankruptcy Code
• For the first 89 years under the constitution,
the United States had a national bankruptcy
law for a total of only 16 years.
• During the periods in which national
bankruptcy laws were not in effect, state laws
on insolvency prevailed.

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 The Bankruptcy Code
• In 1898 a Bankruptcy Act was enacted that as
amended, remained in effect for 80 years. This
made state laws on insolvency to be relatively
dormant.
• In 1978 the Bankruptcy Reform Act
established the present Bankruptcy Code.

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 The Bankruptcy Code
• In 1980 the Bankruptcy Tax Act established a
uniform group of income tax rules for
bankruptcy and insolvency.
• In 1994 the Bankruptcy Code was amended by
the Bankruptcy Reform Act of 1994.

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 The Bankruptcy Code
• The U.S. Supreme Court may prescribe by
general rules the various legal practices and
procedures under the Bankruptcy Code. Thus,
the Federal Rules of Bankruptcy Procedures
established by the Supreme Court constitute
important interpretations of provisions of the
Bankruptcy Code.

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 Bankruptcy Liquidation
• The process of bankruptcy liquidation under
Chapter 7 of the Bankruptcy Code involves the
realization (sale) of the assets of an individual
or a business enterprise and the distribution
of the cash proceeds to the creditors of the
individual or enterprise.

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 Bankruptcy Liquidation
• Creditors having security interests
collateralized by specific assets of the debtor
generally are entitled to obtain satisfaction of
all or part of their claims from the assets
pledged as collateral.

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 Bankruptcy Liquidation
• The Bankruptcy Code provides for priority
treatment for certain unsecured creditors; their
claims are satisfied in full, if possible, from
proceeds of realization of the debtor’s non-
collateralized assets.
• Unsecured creditors without priority receive
cash, in proportion to the amounts of their
claims.

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 Bankruptcy Liquidation
• Thus, there are four classes of creditors in a
bankruptcy liquidation:
– Fully secured creditors.
– Partially secured creditors.
– Unsecured creditors with priority.
– Unsecured creditors without priority.

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 Debtor’s (Voluntary) Petition
• Under chapter 7 of Bankruptcy Code, any
person may file petition in a federal
bankruptcy court for voluntary liquidation.
• Certain entities such as a rail road, an
insurance company, a bank, a credit union, or
a savings and loan association can not file
voluntary petition under chapter 7.

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 Debtor’s (Voluntary) Petition
• The voluntary petition must be accompanied
by supporting documents exhibiting
petitioner’s debts and property.
• The debts are classified as –.
– Creditors having priority.
– Creditors holding security.
– Creditors having unsecured claims without
priority.

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 Debtor’s (Voluntary) Petition
• The debtor’s property is reported as follows –.
– Real Property.
– Personal Property.
– Property claimed as exempt.
• Valuations of property are at market or current fair values.
• The debtor’s bankruptcy petition must also be accompanied
by statement of financial affairs (different from accounting
statement).

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 Creditors’ (Involuntary) Petition
• If a debtor other than a farmer, a nonprofit organization, or
one of the types precluded from filing voluntary petitions
owes amounts to 12 or more unsecured creditors who are not
employees, relatives, stockholders, or other “insiders”, three
or more of the creditors having unsecured claims totaling $
10,000 or more may file in a federal bankruptcy court a
creditors’ petition for bankruptcy, also known as an
involuntary petition.

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 Creditors’ (Involuntary) Petition
• If fewer than 12 creditors are involved, one or
more creditors having unsecured claims of $
10,000 or more may file the petition.
• The creditors’ petition for bankruptcy must
claim either.
– The debtor is not paying debts as they come due
or.
– Within 120 days prior to the date of the petition, a
custodian was appointed for or had taken
possession of the debtor’s property.
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 Unsecured Creditors With Priority
• The following unsecured debts are to be
paid in full, in the order specified if
adequate cash is not available for all, out
of a debtor’s estate before any cash is
paid to other unsecured creditors:
1. Administrative Costs.

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 Unsecured Creditors With Priority
2. Claims arising after the commencement of a
creditors’ bankruptcy proceeding but before
appointment of a trustee or order for relief.
3. Claims for wages, salaries, and commissions,
including vacation, severance, and sick leave
pay not in excess of $ 4,000 per claimant,
earned within 180 days before the date of
filing the petition for bankruptcy.

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 Unsecured Creditors With Priority
4. Claims for contributions to employee benefit
plans arising within 180 days before the date
of filing the petition. The limit of such claim is
$ 4,000 times the number of employees
covered by the plans, less the aggregate
amount paid to the covered employees
under priority 3 above.

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 Unsecured Creditors With Priority
5. Claims by producers of grain or fishermen
against storage or processing facilities, not in
excess of $ 4,000 per claimant.
6. Claims for cash deposited for goods or services
for the personal, family, or household use of the
depositor, not in excess of $1,800 per claimant.

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 Unsecured Creditors With Priority
7. Claims for alimony, maintenance, or support
of a spouse, former spouse, or child of the
debtor, under a separation agreement,
divorce decree, or court order.
8. Claims of governmental entities for various
taxes, subject to varying time limitations.

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 Property Claimed As Exempt
• Certain property of petitioner is not included
in the debtor’s estate.
• Residential Property.
• Life Insurance Policies payable upon death to
spouse or relative.

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Roles of Court, Creditors & Trustee
• The federal bankruptcy court oversees all aspects
of bankruptcy proceedings.
• The first acts of the court is either to dismiss the
petition or to grant an order for relief under the
bankruptcy code.
• The court appoints an interim trustee after the
order for relief, to serve permanently or until a
trustee is elected by the creditors.

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Roles of Court, Creditors & Trustee
• Within 10 to 30 days after the order for relief,
court calls a meeting of the creditors. At the
meeting, the “outsider” creditors appoint a
trustee to manage the debtor’s estate.
• The trustee assumes custody of the debtor’s
nonexempt property.

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Roles of Court, Creditors & Trustee
• Trustee continues the operation of debtor’s
business if directed by the court.
• Trustee realizes the free assets of the operating
the debtor’s estate, and pay cash to unsecured
creditors.
• The trustee is responsible for keeping accounting
records to enable the filing of a final report with
the court.

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Roles of Court, Creditors & Trustee
• The bankruptcy code empowers the trustee to invalidate a
preference, defined as the transfer of cash or property to an
“outsider” creditor for an existing debt, made while the
debtor was insolvent and within 90 days of filing the
bankruptcy petition, provided the transfer caused the
creditor to receive more cash or property than would be
receive in the bankruptcy liquidation. The trustee may
recover from the creditor the cash or property constituting
the preference and include it in the debtor’s estate.

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 Discharge of Debtor
• Once the debtor’s property has been liquidated,
all secured and priority creditors’ claims have
been paid, and all remaining cash has been paid
to unsecured and non-priority creditors, the
debtor mar receive a discharge, defined as a
release of debtor from all un-liquidated debts,
except followings:

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 Discharge of Debtor
– The taxes payable to United States or any state or
subdivision, including taxes attributable to improper
preparation of tax returns.
– Debts resulting from the debtor.’
– Debts resulting from the debtor’s obtaining
money or property under false pretense or willful
conversion of the property of others.
– Debts arising from embezzlement or other
fraudulent acts of debtor.

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 Discharge of Debtor
– Amounts payable for alimony, maintenance or child
support.
– Debts for willful and malicious injuries to the persons
or property of others.
– Debts for fines, penalties, or forfeitures payable to
governmental entities, other than for tax penalties.
– With certain exceptions, debts for educational loans
made, insured, or guaranteed by governmental
entities or by nonprofit universities or colleges.

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 Discharge of Debtor
• A debtor will not be discharged if any crimes,
misstatements, or other malicious acts were
committed by the debtor in connection with the
court proceedings. In addition, a debtor will not
not be discharged if the current bankruptcy
petition was filed within six years of a previous
bankruptcy discharge to the same debtor.

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 The Statement of Affairs
• The accountant’s role in liquidation is concerned with proper
reporting of the financial condition of the debtor and
adequate accounting and reporting of the debtor’s estate.
• A business enterprise that enters bankruptcy liquidation is a
quitting concern, not a going concern.
• The financial statement designed for a business enterprise
entering liquidation is the statement of affairs.

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 The Statement of Affairs
• The purpose of the statement of affairs is to display the assets
and liabilities of the debtor enterprise from a liquidation
viewpoint.
• The assets displayed in the statement of affairs are valued at
current fair values; carrying amounts are presented on a
memorandum basis.
• Assets and liabilities are classified according to the rankings
and priorities set forth in the Bankruptcy Code.

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 Accounting & Reporting for Trustees
• The accounting records of the debtor should be used during
the period that a trustee carries on the operations of the
debtor’s business.
• An accountability technique should be used once the trustee
begins realization of the debtor’s assets.
• The interim and final reports of the trustee to the bankruptcy
court are a statement of cash receipts and payments, a
statement of realization and liquidation, supporting exhibits
of assets not yet realized and liabilities not yet liquidated.

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 Bankruptcy Reorganization
• Chapter 11 of bankruptcy code provides for
the court-supervised reorganization of a
debtor business enterprise.
• Reorganization involves the reduction of
amounts payable to some creditors, other
creditors’ acceptance of equity securities of
the debtor for their claims, and revision of the
par or stated value of the common stock of
the debtor.

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 Bankruptcy Reorganization
• A debtor’s petition for reorganization may be
filed by a railroad or by any “person” eligible
to petition for liquidation except a
stockbroker or a commodity broker.
• Requirements for creditors’ petition for
reorganization are the same as those for a
liquidation petition.

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 Bankruptcy Reorganization
• During the process of reorganization,
management or owner of the business
enterprise may continue to operate the
enterprise as debtor in possession.
Alternatively, the bankruptcy court may
appoint a trustee to manage the enterprise.

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 Bankruptcy Reorganization
• A trustee is appointed because of fraud,
dishonesty, incompetence, or gross
mismanagement by current owners or
managers. A trustee may be appointed to
protect the interests of creditors or
stockholders of the enterprise.
• In some reorganization cases an examiner to
investigate possible fraud or mismanagement
by the current management.

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 Bankruptcy Reorganization
• Among the powers and duties of the trustee are the
following:
– Prepare and file in court a list of creditors of each class and their
claims and a list of stockholders of each class.
– Investigate the acts, conduct, property, liabilities, and business
operations of the enterprise, consider the desirability of continuing
operations, and formulate a plan for such continuance for submission
to the bankruptcy judge.
– Report to the bankruptcy judge any facts ascertained as to fraud
against or mismanagement of the debtor enterprise.

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 Plan & Accounting for Reorganization
• The plan of reorganization submitted by the
management or trustee to the bankruptcy
court is given to the debtor enterprise’s
creditors and stockholders, to the U.S.
Secretary of the Treasury, and possibly to the
SEC.

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Plan & Accounting for Reorganization
• The plan must include provisions altering or
modifying the interests and rights of the
creditors and stockholders, as well as a
number of additional provisions.
• SEC may review the plan and may be heard in
the bankruptcy court’s consideration of the
plan.

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 Plan & Accounting for Reorganization
• Before the plan is confirmed by court, it must be accepted by
a majority of creditors, whose claims must account for two-
thirds of the total liabilities, and by stockholders owning at
least two-thirds of the outstanding capital stock of each class.
• If one or more classes of stockholders or creditors has not
accepted a plan, the bankruptcy court may confirm the plan if
the plan is fair and equitable to the non-acceptors.

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 Plan & Accounting for Reorganization
• The accounting for a reorganization typically
requires journal entries for adjustments of
carrying amounts of assets; reductions of par
or stated value of capital stock; extensions of
due dates and revisions of interest rates of
notes payable; exchanges of equity securities
for debt securities; and the elimination of a
retained earnings deficit.

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 Plan & Accounting for Reorganization
• The elimination of a retained earnings is
associated with fresh start reporting for a
reorganized enterprise whose liabilities
exceed the reorganization value of its assets.
• Because of changes in the ownership of
common stock of such an enterprise, it is no
longer controlled by former stockholder
group, and it is a new reporting enterprise.

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 Plan & Accounting for Reorganization
• Accountants must be careful to avoid charging
post-reorganization operations with losses
that arose before the reorganization.
• Disclosure of Reorganization: The elaborate
and often complex issues involved in a
bankruptcy reorganization are disclosed in a
note to the financial statements for the period
in which the plan of reorganization was
carried out.

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Thank you!

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