Advance Accounting Chapter 10

Advanced
Accounting
Jeter Chaney
Insolvency
Liquidation and
Reorganization
Prepared by Sheila Ammons, Austin Community College
Learning Objectives
Distinguish between a Chapter 7 and a Chapter 11 bankruptcy.
Describe the five priority categories of unsecured claims and list
the order in which they are settled.
Distinguish between a voluntary and involuntary bankruptcy
petition.
Distinguish among fully secured, partially secured, and
unsecured claims of creditors.
Describe contractual agreements that the debtor and its creditors
may enter into outside of formal bankruptcy proceedings to
resolve the debtors insolvent position.
Describe the ways debt may be restructured in a reorganization.
2
Copyright 2015. John Wiley & Sons, Inc. All rights reserved.
Insolvency
Insolvency refers to the inability of a debtor to pay its
obligations as they become due.
Although the Bankruptcy Reform Act provides for
relief of all types of insolvent debtors, including
individuals, our discussion will concentrate on the
provisions of the act dealing with insolvent business
entities.
3
Insolvency
When a business becomes insolvent, it generally has
three possible courses of action:
Debtor and its creditors may enter into a contractual
agreement, outside bankruptcy;
Debtor or its creditors may file a bankruptcy
petition, after which the debtor is liquidated under
Chapter 7 of the Bankruptcy Reform Act; or
Debtor or its creditors may file a petition for
reorganization under Chapter 11 of the Bankruptcy
Reform Act.
4
Insolvency
Review:
True/False: Insolvency means that a debtor has more
current liabilities than current assets.
False
5
Contractual Agreements
A business that is unable to pay its obligations may
reach an accommodation with its creditors.
Possibilities generally include:
An extension of payment periods.
Composition agreements.
Formation of a creditors committee.
Voluntary assignment of assets.
6
LO 5 Contractual agreements.
Extension of Payment Periods
FASB ASC paragraph 470-50-40-6:
Where a debt restructuring involves only a modification of
terms of payment,
the debtor should account for the restructuring, prospectively
from the time of restructuring and
should not change the carrying amount of the payable, unless
the carrying amount exceeds the total future cash payments
of principal and interest specified by the new terms.
No gain is recognized when the restructuring involves an
extension of the payment period only.
7
Composition Agreements
A composition agreement is an agreement between the
debtor and its creditors under which the creditors agree to
accept less than the full amount of their claims.
Creditors are often given some immediate cash payment,
and the amount of the remaining debts and their interest
rates are renegotiated.
The benefit to the creditors is that they receive an
immediate cash payment and expect to eventually receive
more than they would if the debtor were forced to liquidate.
8
Formation of a Creditors Committee
Responsible for managing the debtors business affairs for the period
during which plans are developed to rehabilitate, reorganize, or
liquidate the business.
Often, an extension of payment periods for debtor obligations is
agreed to while the committee deliberates the ultimate disposition of
the business.
If the decision is to rehabilitate the business, the agreement may
include the cancellation or restructuring of existing debts and
possible infusion of new capital by the creditors.
If the decision is to liquidate the business, the debtors property
may be turned over to a trustee.
9
Voluntary Assignment of Assets
A debtor may elect to place its property under the
control of a trustee for the benefit of its creditors.
Purpose of the assignment
Permit the trustee to sell the property and distribute
the proceeds among the creditors.
Any proceeds remaining after payment of the
creditors, are returned to the debtor.
10
Bankruptcy
Provisions of the Bankruptcy Reform Act of 1978
apply to individuals, corporations, and partnerships,
as well as to municipalities seeking voluntary relief
from their creditors.
A business, unable to pay its obligations, may attempt to
negotiate with its creditors. If an agreement cannot be
reached, a legal petition for bankruptcy will be initiated
by either the
debtor (a voluntary petition) or its
creditors (an involuntary petition).
11
LO 3 Voluntary vs. involuntary petitions.
Bankruptcy
Voluntary Petitions
A debtor may file a voluntary petition with a bankruptcy court
for
liquidation under Chapter 7 or
reorganization under Chapter 11.
Filing a voluntary petition constitutes an order for relief, which
prohibits the start or continuation of legal action against the
debtor by its creditors .
The bankruptcy petition (either voluntary or involuntary) is an
official form that initiates bankruptcy proceedings and
establishes an estate consisting of the debtors assets.
12
Bankruptcy
Involuntary Petitions
Creditors initiate the action by filing a petition for
liquidation or reorganization with the bankruptcy court.
The bankruptcy court will generally enter an order for
relief against the debtor only if evidence indicates that
the debtor, in fact, has not been paying its debts as they
become due.
13
Bankruptcy
Secured and Unsecured Creditors
Secured creditors are those whose claims are secured by liens
or pledges of specific assets.
If the proceeds from the sale of a pledged asset(s) exceed the
secured claim, the excess proceeds are available for distribution
to unsecured creditors.
Secured creditors are paid first with the proceeds from the
sale of specific assets upon which they have liens.
Thereafter, unsecured creditors, including those having
priority, are paid from whatever proceeds remain from the
realization process.
14
LO 4 Secured and unsecured creditors.
Bankruptcy
Review:
True/ False: Voluntary bankruptcy petitions may be filed
under either Chapter 7 or Chapter 11 of the Reform Act.
True
15
Bankruptcy
Review:
True/ False: Unsecured creditors with priority will receive
full satisfaction before secured creditors are paid.
False
16
Liquidation (Chapter 7)
A voluntary or involuntary petition for liquidation may be filed
under Chapter 7 of the Reform Act.
Upon filing, the bankruptcy court must decide whether to accept
or dismiss the petition.
Dismissals occur infrequently.
Debtor may dispute an involuntary petition.
If the petition is accepted
An order for relief is entered and the bankruptcy court will
appoint an interim trustee until a permanent trustee is
selected.
The court must call a meeting of the debtors creditors.
17 11.
LO 1 Chapter 7 versus Chapter
Reorganization Under Reform Act (Chapter

11)
Creditors of an insolvent debtor may believe their
long-range interests would be served by rehabilitating
or reorganizing the debtor.
In such a case:
Creditors and debtor may agree to a plan for
reorganization. or
Debtor or creditors may prefer to file with the
bankruptcy court a petition for reorganization under
Chapter 11 of the Reform Act.
18 11.

11)
Fresh Start Accounting and Quasi Reorganization
When firms emerge from bankruptcy, FASB ASC paragraphs
852-10-45-19 to 20 provide for fresh start accounting
(implication is that a new firm exists).
Assets and liabilities are reported at fair values.
Beginning retained earnings is reported at zero.
Two conditions must exist:
Fair value of assets must be less than the post liabilities and
allowed claims and
Original owners must own less than 50% of the voting stock
after reorganization.
19 11.

11)
Fresh Start Accounting and Quasi Reorganization
Quasi reorganization
Three steps are required:
1) Authorization from creditors and stockholders is
required.
2) All assets are revalued to fair values with losses
recorded in retained earnings.
3) The deficit in retained earnings is eliminated by
charging to (reducing) paid-in capital.
20 11.

11)
Accounting for Reorganizations Troubled Debt
Restructurings
Debt may be restructured in any one (or a combination)
of the following methods:
The debtor may transfer assets in full settlement of
the payable.
The debtor may give an equity interest in its firm in
full settlement of the payable.
The creditor may modify terms of the payable.
21 11.

11)
Accounting for Reorganizations Troubled Debt Restructurings
Transfer of Assets
A debtor that transfers assets to a creditor in full settlement of a
payable recognizes a gain on the restructuring.
The gain is measured by the excess of the carrying value of the
payable over the fair value of the assets transferred.
The difference between the fair value and the carrying amount of
the assets transferred is a gain or loss and is reported as a
component of net income for the period of transfer.
The gain on restructuring is included in net income in the period
of the restructuring.
22 11.

11)
Restructurings
Grant of an Equity Interest
A debtor that issues an equity interest in its firm to a creditor in
full settlement of a payable shall account for the equity interest
at its fair value.
Difference between the fair value of the equity interest issued
and the carrying amount of the payable is reported as a gain on
restructuring.
Debtor determines its gain based on undiscounted cash
flows.
23 11.

11)
Restructurings
Modification of Terms
A debtor, in a troubled debt restructuring involving only
modification of terms of a payable, accounts for the
effects of the restructuring prospectively from the time of
restructuring.
The carrying value of the payable is not changed at the
time of restructuring unless the carrying value exceeds the
total future cash payments specified by the new terms.
24 11.

11)
Review:
True/False: In a reorganization involving a transfer of
assets, the debtor will recognize a gain on restructuring
measured by the excess of the carrying value of the
payable settled over the book value of the assets
transferred.
False
25 11.
Reorganization Transfer of
Assets
E10-3: Bar Company, which is in financial difficulty
and in the process of a voluntary reorganization, has
agreed to transfer to a creditor a copyright it owns in
full settlement of a $150,000 note payable and $15,000
in accrued interest. The copyright, which originally cost
$100,000, has an accumulated amortization balance of
$55,000 and a current fair value of $95,000.
26 11.
Assets
E10-3 a. Prepare the journal entries on Bar Companys books
to record the transfer of the copyright.
Copyright
50,000
Gain on Transfer of Assets
50,000
Revalue copyright to fair value. $95,000 ($100,000 - $55,000)
Notes Payable
Accrued Interest Payable
Accumulated Amortization Copyright
150,000
15,000
55,000
Copyright ($100,000 + $50,000)
150,000
Gain on Debt Restructuring
70,000
27 11.
Assets
E10-3 b. Explain the proper treatment of any gain or loss
recognized in (a).
The gain on transfer of assets ($50,000) should be reported

as a separate component (assuming material in amount) of
operating income; the gain on restructuring ($70,000)
should also be reported as a separate component of
operating income.
28 11.
Assets
E10-3 c. Assuming the fair value of the copyright was $30,000,
repeat the requirement in (a).
Loss on Transfer of Assets
15,000
Copyright
15,000
Revalue copyright to fair value. $30,000 ($100,000 - $55,000)
Notes Payable
150,000
15,000
Accumulated Amortization Copyright
55,000
Copyright ($100,000 - $15,000)
85,000
Gain on Debt Restructuring ($165,000 - $30,000)
135,000
29 11.
Reorganization Modification of
Terms
E10-4: Lake Company, a major creditor of financially
troubled Spain Company, has agreed to modify the
terms of a debt owed to Lake Company. The debt
consists of a $900,000, 12% note that is due currently
along with accrued interest of $95,000. Lake Company
agreed to extend the due date of the note and accrued
interest for three years and to reduce the interest rate to
5% per annum (on both maturity value and accrued
interest), with interest to be paid annually.
30 11.
Terms
E10-4 a. Should a gain on restructuring be recognized by Spain
Company? Explain.
No gain should be recognized because the total future cash
payments specified by the new terms of $1,144,250 ($995,000
carrying value plus 3 years interest at $49,750 per year) exceed
the current carrying value of the debt, $995,000.
31 11.
Terms
E10-4 b. Prepare the entry that should be made on Spain
Companys books on the date of restructure.
Note Payable
900,000
95,000
Restructured Debt
995,000
32 11.

11)
Review:
True/ False: Restructuring gains that arise from troubled
debt restructurings are reported by the debtor as
extraordinary gains.
False
33 11.

11)
The Accounting Statement of Affairs
A plan for reorganization must show that creditors will receive
as much as if the debtor were liquidated.
The Statement of Affairs is an accounting report that is
designed to permit the user to determine:
the total expected amounts that could be realized on the
disposition of the 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.
34 11.

11)
E10-7: Ball Company is facing bankruptcy proceedings. A balance sheet
and other information are presented below:
Ball Company Balance Sheet - June 30, 2015
Accounts receivable and inventory are each pledged as security on individual notes
payable in the amount of $100,000 each.
35 11.

11)
E10-7: Statement of Affairs
36

11)
E10-7: Statement of Affairs
* ($255,000) loss - $130,400 gain = $124,600 deficiency

37

11)
E10-7: Deficiency Account
38

11)
Review:
True/ False: The statement of affairs is a report designed
to estimate the amount expected to be earned by a debtor
company during the time period needed to complete a
reorganization.
False
39 11.
Trustee Accounting and

Reporting
Trustee (appointed to assume responsibility of managing the
debtors business while the reorganization plan is developed or
the business is liquidated) takes title to the debtors assets and
is accountable to the court, the creditors, and other parties for
the subsequent utilization or realization of the assets.
If new books are opened (frequently used approach):
Trustee records the assets at their book values.
No existing liabilities are recorded by the trustee, but
liabilities occurred later are recorded.
Payment of preexisting debts reduces the assets for which
the trustee is accountable.
40 11.

Reporting
E10-9: TRX Company has been forced into receivership. The
trustee has decided to open a new set of books to distinguish
between transactions occurring before and after the appointment.
The following account balances were reported on September 1,
2015:
Required: Prepare journal entries, on the trustee set of books, to

record the following.
41 11.

Reporting
E10-9: Record the receipt of TRX Company assets.
Cash
26,700
Accounts Receivable (old)
130,400
Inventory
191,900
Property and Equipment
590,400
Allowance for Uncollectibles (old)
16,000
Accumulated Depreciation
211,500
TRX Company in Receivership *
711,900
* ($939,400 $16,000 - $211,500)

42 11.

Reporting
E10-9: 1. Sales were made in the amount of $296,000, of which
$31,500 were cash sales.
Cash
31,500
Accounts Receivable (new)
264,500
Sales
296,000
43 11.

Reporting
E10-9: 2. Receivables were collected in the following amounts:
Old receivables $ 76,800
New receivables 242,200
Cash
319,000
Accounts Receivable (old)
76,800
Accounts Receivable (new)
242,200
44 11.

Reporting
E10-9: 3. Additional inventory was purchased on account in the
amount of $127,500.
Purchases
127,500
Accounts Payable (new)
127,500
45 11.

Reporting
E10-9: 4. Cash payments were made as follows:
On old accounts payable
$206,500
On new accounts payable
61,600
For operating expenses
46,000
For trustee fees
13,000
TRX Company in Receivership
206,500
Accounts Payable (new)
61,600
Operating Expenses
46,000
Trustee Expenses
13,000
Cash
327,100
46 11.

Reporting
E10-9: 5. Journal entries were made to record:
a. Bad debt expense of $21,600, of which $8,600 related to new
accounts receivable.
Bad Debt Expense
21,600
Allowance for Uncollectibles (old)
13,000
Allowance for Uncollectibles (new)
8,600
47 11.

Reporting
E10-9: 5. Journal entries were made to record:
b. Depreciation expense of $32,400.
c. Write-off of old accounts receivable of $21,000.
b. Depreciation expense
32,400
Accumulated Depreciation
32,400
c. Allowance for Uncollectibles (old)
21,000
Account Receivable (old)
21,000
48 11.
Realization and Liquidation

Account
The court expects to receive periodic reports summarizing the
realization and distribution activities of the fiduciary.
The legal report, realization and liquidation account, has three main
sectionsassets, liabilities, and revenues and expenses.
The assets section consists of four parts, illustrated as follows:
Assets
Assets to be realized
Assets realized
Assets acquired
Assets not realized
LO 1
49
Chapter 7 versus Chapter 11.

Account
The liabilities section consists of four parts, illustrated as follows:
Liabilities
Liabilities liquidated
Liabilities to be liquidated
Liabilities not liquidated
Liabilities incurred
50 11.

Account
The revenues and expenses section lists the supplementary expenses
incurred and revenues received by the trustee during the period.
Revenues and Expenses

Supplementary charges
Supplementary credits
51 11.
Going Concern Presumption

FASB issued a proposed accounting standards update on June 26, 2013,
relating to the disclosure of uncertainties about an entitys going concern
presumption.
The proposed update outlines managements responsibilities in evaluating
the entitys going concern uncertainties. The entity would be required to:
Evaluate going concern uncertainties at each annual and interim
reporting period and
Provide footnote disclosures if it is
More likely than not that the entity will not be able to meet its
obligations with 12 months of the financial statement date (without
taking actions outside the normal course of business) or
Known or probable that the entity will not be able to meet its
obligations within 24 months after the financial statements are
issued.
52
Going Concern Presumption

IAS 1, Presentation of Financial Statements, requires that an entity consider
all available information about the future, which is at least, but is not limited
to, twelve months from the end of the reporting period when assessing
whether the going concern assumption is appropriate.
IFRS:
Does not address guidance on the liquidation basis of accounting.
Provides a single threshold for disclosures of going concern uncertainties.
Disclosures start when management is aware of material uncertainties
related to events or conditions that may cast significant doubt on an
entitys ability to continue as a going concern.
IFRS does not define the terms material uncertainty or significant
doubt.
53 11.

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Prepared by Sheila Ammons, Austin Community College

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Gain on Transfer of Assets

Revalue copyright to fair value. $95,000 ($100,000 - $55,000)

Copyright ($100,000 + $50,000)

Gain on Debt Restructuring

The gain on transfer of assets ($50,000) should be reported

Revalue copyright to fair value. $30,000 ($100,000 - $55,000)

Accrued Interest Payable

Accumulated Amortization Copyright

Copyright ($100,000 - $15,000)

Gain on Debt Restructuring ($165,000 - $30,000)

Accrued Interest Payable

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

* ($255,000) loss - $130,400 gain = $124,600 deficiency

Reorganization Under Reform Act (Chapter

Reorganization Under Reform Act (Chapter

Trustee Accounting and

Trustee Accounting and

Required: Prepare journal entries, on the trustee set of books, to

Trustee Accounting and

Accounts Receivable (old)

Property and Equipment

Allowance for Uncollectibles (old)

TRX Company in Receivership *

* ($939,400 $16,000 - $211,500)

Trustee Accounting and

Accounts Receivable (new)

Trustee Accounting and

Accounts Receivable (old)

Accounts Receivable (new)

Trustee Accounting and

Accounts Payable (new)

Trustee Accounting and

On new accounts payable

For operating expenses

For trustee fees

TRX Company in Receivership

Accounts Payable (new)

Trustee Accounting and

Allowance for Uncollectibles (old)

Allowance for Uncollectibles (new)

Trustee Accounting and

c. Allowance for Uncollectibles (old)

Account Receivable (old)

Realization and Liquidation