10 10 Insolvency— Insolvency Liquidation and Reorganization Advanced Accounting, Fifth Edition Slide 10-1 Learning Learning Objectives Objectives Slide 10-2 Distinguish between a Chapter 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 debtor’s insolvent position Describe the ways debt may be restructured in a reorganization Insolvency 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 of the Bankruptcy Reform Act; or Debtor or its creditors may file a petition for reorganization under Chapter 11 of the Bankruptcy Reform Act Slide 10-3 Insolvency Insolvency Review: True/False: Insolvency means that a debtor has more current liabilities than current assets False Slide 10-4 Contractual Contractual Agreements 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 Slide 10-5 LO Contractual agreements Contractual Contractual Agreements Agreements Extension of Payment Periods FASB ASC paragraph 470-50-40-6 Provides that where a debt restructuring involves only a modification of terms of payment, the debtor should account for the restructuring prospectively and 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 Slide 10-6 LO Contractual agreements Contractual Contractual Agreements Agreements Composition Agreements (Creditors Accept Less Than Full Amount) Creditors are often given some immediate cash payment, and the amount of the remaining debts and their interest rates are renegotiated Formation of a Creditors’ Committee Committee is responsible for managing the debtor’s business affairs for the period during which plans are developed to rehabilitate, reorganize, or liquidate the business Slide 10-7 LO Contractual agreements Contractual Contractual Agreements Agreements Voluntary Assignment of Assets A debtor may elect to place its property under the control of a trustee for the benefit of its creditors Any proceeds remaining after payment of the creditors, are returned to the debtor Slide 10-8 LO Contractual agreements Bankruptcy Bankruptcy Provisions of the Bankruptcy Reform Act 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) Slide 10-9 LO Voluntary vs involuntary Bankruptcy Bankruptcy Voluntary Petitions A debtor may file a voluntary petition with a bankruptcy court for; liquidation under Chapter or for reorganization under Chapter 11 Filing a voluntary petition constitutes an order for relief Slide 10-10 The bankruptcy petition (either voluntary or involuntary) is an official form that initiates bankruptcy proceedings and establishes an estate consisting of the debtor’s assets LO Voluntary vs involuntary Reorganization Reorganization Under Under Reform Reform Act Act (Chapter (Chapter 11) 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 Slide 10-37 LO Chapter versus Chapter 11 Trustee Trustee Accounting Accounting and and Reporting Reporting Trustee (appointed to assume responsibility of managing the debtor’s business while the reorganization plan is developed or the business is liquidated) takes title to the debtor’s 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 Slide 10-38 No existing liabilities are recorded by the LO Chapter versus Chapter 11 trustee Trustee Trustee Accounting Accounting and and Reporting 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, 2012: Cash $ 26,700 Allowance for uncollectibles $ 16,000 Accounts receivable Inventory Property and Equipment, net 130,400 191,900 590,400 Accumulated depreciation Accounts payable Capital stock Retained earnings (deficit) $ 939,400 211,500 308,400 800,000 (396,500) $ 939,400 Required: Prepare journal entries to record the following on the trustee set of books Slide 10-39 LO Chapter versus Chapter 11 Trustee Trustee Accounting Accounting and and Reporting 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) Accumulated Depreciation 16,000 211,500 TRX Company – in Receivership * 711,900 * ($939,400 – $16,000 - $211,500) Slide 10-40 LO Chapter versus Chapter 11 Trustee Trustee Accounting Accounting and and Reporting Reporting E10-9: Sales were made in the amount of $296,000, of which $31,500 were cash sales Cash Accounts Receivable (new) Sales Slide 10-41 31,500 264,500 296,000 LO Chapter versus Chapter 11 Trustee Trustee Accounting Accounting and and Reporting Reporting E10-9: 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) Slide 10-42 242,200 LO Chapter versus Chapter 11 Trustee Trustee Accounting Accounting and and Reporting Reporting E10-9: Additional inventory was purchased on account in the amount of $127,500 Purchases Accounts Payable (new) Slide 10-43 127,500 127,500 LO Chapter versus Chapter 11 Trustee Trustee Accounting Accounting and and Reporting Reporting E10-9: Cash payments were made as follows: On old accounts payable 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 Slide 10-44 $206,500 327,100 LO Chapter versus Chapter 11 Trustee Trustee Accounting Accounting and and Reporting Reporting E10-9: 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) Allowance for Uncollectibles (new) Slide 10-45 13,000 8,600 LO Chapter versus Chapter 11 Trustee Trustee Accounting Accounting and and Reporting Reporting E10-9: Journal entries were made to record: a Bad debt expense of $21,600, of which $8,600 related to new accounts receivable b Depreciation expense of $32,400 c Write-off of old accounts receivable of $21,000 Depreciation expense 32,400 Accumulated Depreciation 32,400 Allowance for Uncollectibles (old) Account Receivable (old) Slide 10-46 21,000 21,000 LO Chapter versus Chapter 11 Realization Realization and and Liquidation Liquidation Account Account The court expects to receive periodic reports summarizing the realization and distribution activities of the fiduciary The report, realization and liquidation account, has three main sections—assets, liabilities, and revenues and expenses The asset section consists of four parts, illustrated as Assets follows: Assets to be realized Assets realized Assets acquired Slide 10-47 Assets not realized LO Chapter versus Chapter 11 Realization Realization and and Liquidation Liquidation Account Account The court expects to receive periodic reports summarizing the realization and distribution activities of the fiduciary The report, realization and liquidation account, has three main sections—assets, liabilities, and revenues and expenses The liabilities section consists of four parts, illustrated Liabilities as follows: Liabilities liquidated Liabilities to be liquidated Liabilities not liquidated Slide 10-48 Liabilities incurred LO Chapter versus Chapter 11 Realization Realization and and Liquidation Liquidation Account Account FASB issued exposure draft (Oct., 2008) on ‘Going Concern.’ Board decided to carry forward the going concern guidance from AU Sec 341, subject to modifications to align with IFRSs One modification is to change the time horizon for the going concern assessment AU Section 341 states that there is a “responsibility to evaluate whether there is a substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the Slide 10-49 financial statements being audited.” LO Chapter versus Chapter 11 Realization Realization and and Liquidation Liquidation Account Account FASB issued exposure draft (Oct., 2008) on ‘Going Concern.’ IAS 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 The other modification includes using the wording in IAS with respect to the type of information that should be considered in making the going concern assessment (all available information about the future) Slide 10-50 LO Chapter versus Chapter 11 Copyright Copyright Copyright © 2012 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein Slide 10-51