Solution manual Advanced Accounting 9e - Accounting | Trường Đại học Hà Nội

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ACCOUNTING FOR LEGAL REORGANIZATIONS AND LIQUIDATIONS Chapter Outline
I. Because of a myriad of possible financial or business difficulties, a company may become
insolvent, unable to pay its debts as they come due.
A. To ensure the equitable treatment of al parties involved with an insolvent company
(stockholders as wel as creditors), laws have been written to provide structure for the
bankruptcy process in the United States.
B. At present, legal guidance is provided primarily by the Bankruptcy Reform Act of 1978 as amended.
1. This law attempts to arrive at a fair distribution of a debtor's assets.
2. It also seeks to discharge the obligations of an honest debtor.
II. Bankruptcy proceedings can be formal y instigated by either the debtor or a group of creditors.
A. A voluntary petition is filed with the court by the insolvent company while an involuntary
petition must be filed by a minimum number of creditors with a minimum level of debt.
B. After a bankruptcy petition is received, normal y the court wil grant an order for relief to
halt al actions against the debtor.
III. Within the bankruptcy process, determining the appropriate classification of al creditors is
an important step in achieving a fair settlement.
A. Ful y secured creditors hold a col ateral interest in assets of the insolvent company
having a value in excess of the related liability.
B. Partial y secured creditors also have a col ateral interest but the expected net realizable
value wil not satisfy the entire obligation.
C. Some unsecured obligations (including administrative expenses, certain debts to
employees, and government claims for unpaid taxes) have priority over other unsecured debts.
D. The remaining unsecured creditors receive assets from the debtor only after the above claims have been satisfied.
IV. A Statement of Financial Affairs is frequently produced by an insolvent company to disclose
its current financial position.
A. Assets are reported at net realizable value along with the disclosure of any pledged
amounts. Liabilities are classified according to the security or priority of the creditor.
B. A Statement of Financial Affairs is especial y useful if prepared at the beginning of the
bankruptcy process to assist al parties in evaluating the outcome of various actions.
C. Most of the asset balances reported in this statement are merely estimations, projections of future events.
V. Bankruptcy proceedings often conclude with the assets of the debtor being liquidated to
satisfy creditor claims (a Chapter 7 bankruptcy).
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A. A trustee is appointed to oversee termination of business affairs, liquidation of noncash
properties, and distribution of cash resources.
B. The trustee prepares a periodic reporting of activities, frequently in the form of a
Statement of Realization and Liquidation.
1. This statement indicates the book value and classification of remaining assets and liabilities.
2. It also discloses the effects of al transactions that have occurred to date.
Vl. As an alternative to liquidation, a company may seek to stay in business and attempt to
return to solvency (a Chapter 11 bankruptcy).
A. A reorganization plan has to be devised that can win the approval of each class of
creditors and each class of stockholders as wel as the court.
B. Reorganization plans normal y entail a specific course of action designed to save the
company and can include proposed changes in operations, methods of generating
additional working capital, and a settlement of the debts that were in existence on the
day that the order for relief was entered.
Vl . Financial reporting during reorganization.
A. The AICPA Statement of Position 90-7 (SOP 90-7) provides guidance for preparing
financial statements while a company goes through reorganization.
1. Gains, losses, revenues, and expenses that result from reorganization must be
reported separately on the income statement.
2. Professional fees incurred in connection with the bankruptcy must be expensed immediately.
3. Liabilities subject to compromise are reported based on the expected amount of the al owed claims. VIII.
Fresh start accounting may be required when a company emerges from reorganization.
A. Assets are restated to current value but only if the fair value of assets is less than the
al owed claims and the original owners are left holding less than 50 percent of company.
B. The recognition of goodwill may also be required if the reorganization value of the
emerging company is greater than the value of the identifiable assets (both tangible and intangible).
C. Retained earnings is set at zero to indicate that a new entity has been formed. Learning Objectives
Having completed Chapter 13 of this textbook, "Accounting for Legal Reorganizations and
Liquidations," students should be able to fulfil each of the fol owing learning objectives:
1. Understand the necessity of having laws to protect the parties involved with an insolvent company.
2. Identify the Bankruptcy Reform Act of 1978 as the primary legal basis for bankruptcy proceedings in this country.
3. Explain the difference between a voluntary and an involuntary bankruptcy petition.
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4. Describe the purpose of an order for relief.
5. List and describe the categories used to classify creditors during bankruptcy proceedings.
6. Give examples of the types of unsecured liabilities that have priority in a bankruptcy.
7. Produce a Statement of Financial Affairs for an insolvent company.
8. Identify the responsibilities of a trustee in a liquidation (a Chapter 7 bankruptcy).
9. Prepare a Statement of Realization and Liquidation for a business going through liquidation.
10. Indicate possible proposals that might be included in a reorganization plan and the method
by which a plan becomes accepted and confirmed.
11. Produce an income statement during reorganization with reorganization items identified and separately reported.
12. Produce a balance sheet during reorganization with liabilities classified as "subject to
compromise" and "not subject to compromise."
13. Identify companies that are required to apply fresh start accounting when they emerge from reorganization.
14. Apply fresh start accounting to a company emerging from bankruptcy according to SOP 90- 7.
Answers to Discussion Questions What Do We Do Now?
Students are given a chance in this case to look at a non-accounting business decision: the
forcing of a valued client into bankruptcy proceedings. Thurber has already committed several
unfortunate mistakes in this case. For example, he has seen a dramatic slowdown in cash
payments by Abraham and Sons without seeking any further information about the prospects of
the client. Furthermore, he has let the treasurer pressure him into providing additional credit
without any valid justification. He is now being pushed by another company into filing a
bankruptcy petition without adequate assurance that Abraham and Sons has a real problem.
Because Thurber has not acted earlier, he should now request audited financial statements
from Abraham and Sons so that he can make a reasonable decision as to the course of action
to take. Many important figures can be gleaned from these statements including the amount of
the company's working capital, the current ratio, the debt to equity ratio, the trend in sales, the
trend in long-term debt, operating cash flows, the gross profit percentage, any expenses that
have risen at a fast rate, the amount of property that has been mortgaged, and the like. He
should then ask for a meeting with the treasurer (or another officer) of Abraham and Sons. In
this meeting, Thurber should discuss the possibility of having the current debt secured in some
manner as protection. The development of a formal repayment schedule would also be wise.
If Thurber is not satisfied by the financial statements and the discussion with the client, he
should meet with the clothing manufacturer who has cal ed as wel as with a lawyer and/or
accountant. They should discuss possible actions and the outcomes that could result from each.
Inevitably, if loss of the receivable seems probable, filing an involuntary petition for
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bankruptcy may be the wisest course of action to take. However, that procedure should only be
undertaken after adequate study has been made. In the long run, companies do not prosper by
having their clients go into bankruptcy.
Students often address this type of case as either a black or white issue: give more credit or
force them into bankruptcy. The case simply does not provide enough data to arrive at either
choice. Thus, the students should be directed to consider the types of information that could
prove to be beneficial in making this decision. Often, in decision-making, the gathering of
information is the key step in arriving at the proper conclusion.
How Much Is That Building Real y Worth?
Col ege textbooks often present fair value as if it were a known number that was dependable.
Students may view an asset’s fair value as if getting that much money was virtually
assured. Thus, students often believe that producing a statement of financial affairs requires
little more than establishing and reporting what a buyer wil pay for an asset.
This case was written to emphasize that a net realizable value might actual y be no more than a
wild guess. Obviously, the value of most stocks and bonds can be determined with accuracy.
However, many other assets such as the building in this case might eventual y prove to have a
liquidation value that can vary from zero (many deserted buildings are simply never sold
because no one wants to buy that type of building in that particular location even if it is in great
condition) up to a significant amount.
The accountant faces the problem of preparing a statement of financial affairs that requires that
a single number be reported as the value of each asset. Users of this statement can then make
important financial decisions based on the number that is presented. Subsequently, the actual
amount received may be significantly higher or lower than the figure shown. The users of the
information may feel as if they have been mislead when, in fact, the accountant made the best possible estimation.
Given the problems faced in determining fair value, the accountant wil probably seek a very
conservative number for reporting purposes. In most cases, less potential damage will be
created by reporting a relatively low figure. However, use of a particularly low value may tempt
the creditors to al ow the company to reorganize because little would seem to be gained by
forcing liquidation. For this reason, a conservative approach can favor the company attempting to avoid liquidation.
Probably the most important lesson from this case is that decision makers should look with
skepticism on many of the numbers reported as representing fair value. In some cases, fair
value is a figure that can only be estimated and may depend on a number of factors that cannot
be anticipated in advance by the accountant or by anyone else.
Is this the Real Purpose of the Bankruptcy Laws?
During the 1980s, as described in this case, the country saw a rash of bankruptcies that were
filed to resolve major financial problems. Previously, the bankruptcy laws had been used almost
exclusively to settle insolvency problems. However, if a voluntary petition is filed and accepted
by the courts, companies such as Manvil e and A. H. Robins are provided with a method of
settling issues before actual insolvency occurs. Sometimes the final results are good for the
companies but not always. A. H. Robins, for example, had to agree to be bought as one of the
conditions of its reorganization. In effect, the company lost its independence in order to satisfy
the lawsuits resulting from the Dalkon Shield.
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As with many of the discussion questions in this book, this case is simply intended to alert
students to a real-life issue and encourage them to consider the ramifications. To function in
society, accounting students must know more than just the mechanical aspects of a bankruptcy.
What are the objectives of the bankruptcy laws and do these particular cases fal outside of
those objectives? Would either Manvil e or its claimants, for example, have been better served
by having the company slowly pul ed into insolvency over years or perhaps decades? Should a
different set of bankruptcy laws be established for companies having these types of financial
crises? Although these questions are not directly related to accounting, they are the types of
questions that accountants (both as business people and as citizens) need to address. Answers to Questions
1. "Insolvent" refers to a state of financial position whereby a company (or individual) is unable to pay debts as they come due. 2.
In the United States today, the primary piece of federal legislation that governs most
bankruptcy proceedings is the Bankruptcy Reform Act of 1978 and its subsequent amendments. 3.
Bankruptcy cases have two overriding objectives:
— To achieve a fair distribution of assets to the various parties that are involved with an
insolvent company (or individual) and
— To discharge the obligations of an honest debtor.
4. A voluntary bankruptcy petition is one filed by an insolvent company to gain protection from
its creditors. Creditors may also seek to prevent or limit losses by filing their own
(involuntary) petition. Where a company has at least 12 unsecured creditors, a minimum of
three (having total unsecured debts of over $13,475) must sign an involuntary petition. If
fewer than 12 unsecured creditors exist, only one is needed to file the petition but the
minimum debt level remains at $13,475.
5. The granting of an order for relief halts al actions against an insolvent company. The order
for relief provides the company as wel as the creditors with time to decide on a future
course of action. It also brings the court into the process and provides a structure for what
might otherwise be a chaotic event, the distribution of assets to the parties involved.
6. A ful y secured creditor has an obligation from an insolvent company but holds a col ateral
interest in assets that have a value in excess of the debt. Thus, these parties can assume
that they wil suffer no loss regardless of the outcome of the bankruptcy proceedings. A
partial y secured creditor also has a col ateral interest but the liability is larger than the
anticipated proceeds from the realization of the attached assets. A portion of the liability is
covered but a risk of loss stil exists in connection with the remaining debt. Unsecured
creditors have no col ateral interest and can only hope to col ect after the various secured
interests have been satisfied. Obviously, this last group of creditors has the highest chance of incurring a loss.
7. A liability classified "with priority" is stil unsecured. However, because of provisions of the
Bankruptcy Reform Act of 1978, these debts must be paid before any other unsecured
obligations. Thus, the chance of loss is reduced, sometimes significantly. Unsecured
liabilities having priority include the fol owing:
— Claims for administrative expenses,
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— Obligations arising between the date that a bankruptcy petition is filed and the
appointment of a trustee or the issuance of an order for relief.
— Employee claims for wages earned during the 180 days preceding the filing of a
bankruptcy petition (limited to $10,950 per person),
— Employee claims for contributions to a benefit plan earned during the 180 days preceding
the filing of a bankruptcy petition (within certain restrictions),
— Deposits made with the company to acquire goods or services (up to a $2,425 limit),
— Government claims for unpaid taxes.
8. Administrative expenses are classified as liabilities with priority to offer some protection to
those individuals who serve the company during the period of insolvency. Without a
legitimate chance for monetary reward, few people would be willing to provide the various
administrative services needed during the bankruptcy process. Also, these debts were
incurred after the order for relief.
9. In a Chapter 7 bankruptcy, the assets of the insolvent company are liquidated to satisfy the
claims of the creditors. Business activities cease and noncash assets are sold. Conversely,
in a Chapter 11 bankruptcy, the company attempts to survive its financial problems and
return to solvency. A reorganization plan is developed that wil al ow the company to
continue operations and reach a settlement of its debts. This reorganization plan must be
accepted by each class of creditors, each class of stockholders, and the court.
10. Unsecured creditors often face the possibility of absorbing substantial losses in a Chapter 7
liquidation because their claims rank below ful y secured and partial y secured liabilities.
Frequently, little or nothing is expected. As a result of this risk, unsecured creditors may feel
that they have a better chance of limiting their losses by agreeing to a reorganization plan to
keep the company alive as a potential future customer.
11. The statement of financial affairs helps the parties involved with a bankruptcy to anticipate
their potential losses. It reports al assets of the insolvent company at net realizable value
whereas liabilities are classified as ful y secured, partial y secured, with priority, and
unsecured. Based on the potential cash inflows and outflows, an estimation can be made of
the losses that wil be incurred by each group of claimants. A statement of financial affairs is
considered especially useful at the beginning of the bankruptcy process since it can assist
the parties in evaluating the outcome of various possible actions.
12. In general, a trustee is assigned to prevent loss of the insolvent company's assets and
oversee the liquidation and distribution process. A number of rather procedural tasks are
normal y accomplished by the trustee shortly after appointment such as notifying the post
office, changing locks, obtaining possession of corporate records, and opening a new bank
account. Thereafter, the trustee might have to operate the company for a period of time to
complete any business stil in process. The trustee also has the power to void any transfer
made by the debtor within 90 days prior to the filing of the bankruptcy petition if the company
was insolvent at the time. Subsequently, the trustee works to liquidate noncash assets and
make appropriate disbursements to the various claimants. During this entire process, the
trustee needs to make periodic reportings to the court and other interested parties.
13. A trustee can demand the return of any payment (or other asset transfer) made within 90
days prior to the filing of a bankruptcy petition if the company was already insolvent. This
legal procedure is known as the voiding of a preference transfer and is intended to prevent
one party from gaining an unfair advantage over the remaining claimants. In effect, the
payment is viewed as a distribution of the insolvent company's assets, a process that is to
be control ed solely by the trustee and the court.
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14. A statement of realization and liquidation is designed to report (1) the account balances of
the insolvent company at the date the order for relief is entered, (2) the liquidation of
noncash assets, (3) the cash distributions made to the various claimants, (4) any other
transactions incurred during this period, and (5) any remaining asset and liability balances.
15. During the liquidation of an insolvent company, control is turned over to an outside trustee.
However, in a Chapter 11 bankruptcy (a reorganization), operations will usual y be
continued so that an attempt can be made to arrive at a plan to save the company. While
the bankruptcy proceeds, control is normal y retained by the ownership, a group legal y
referred to as the debtor in possession.
16. In a Chapter 11 bankruptcy, the debtor in possession (the present ownership of the
company) is given the initial opportunity of filing a reorganization plan with the court. If a
formal proposal is not put forth by the debtor in possession within 120 days of the order for
relief or is not accepted within 180 days, any interested party has the right to submit a plan.
Bankruptcy proceedings often drag on for lengthy periods because the time limitations can
be extended by the court. However, because of recent changes in the bankruptcy laws, the
debtor’s exclusivity to propose a plan cannot be extended beyond 18 months.
17. Numerous types of proposals are to be found in reorganization plans. For example, many
wil set forth specific ideas for changes to be made in the company's operations (to increase
profitability) such as sel ing assets or terminating complete lines of business. In addition,
most reorganization plans identify sources that will be tapped in the future to generate
additional funding. Proposed changes in management may also be spel ed out in an attempt
to persuade claimants that the company wil have the ability to overcome its past economic
problems. Last, and probably most important, a reorganization plan must include some
anticipated settlement of the claims against the company that were in existence at the time
the order for relief was entered. Before any reorganization plan is approved, the creditors
(as wel as the court) must be convinced that the financial rewards wil outweigh the
amounts that could be received from a liquidation.
18. To become effective, a reorganization plan must be accepted by al interested parties. For
approval, each class of creditors (more than two-thirds in dol ar amount and one-half in
number) must vote for the proposal. Each group of stockholders (two-thirds of the shares
being voted) must also accept the plan. The court wil then confirm the reorganization plan
but only if the court feels that al parties are being treated fairly. The court also has the
authority to confirm a proposal even if not accepted by the creditors or stockholders. This
procedure (known as a "cram down") is only used if the plan is judged to be fair and equitable.
19. A "cram down" is a legal provision whereby the court can confirm a reorganization proposal
for an insolvent company even though the plan has not been accepted by a particular class
of creditors or stockholders. This step is not taken unless the court believes the plan being
put forth is fair and equitable.
20. During reorganization, some debts are in jeopardy of being settled at a significantly reduced
amount whereas others will probably be paid at face value. Unsecured and partial y secured
liabilities are likely to be settled at a lowered figure. Conversely, ful y secured liabilities and
any debts incurred during the reorganization period are normal y not at risk of being
reduced. Thus, if a balance sheet is produced while a company is in reorganization, al
liabilities are reported as either being subject to compromise (reduction) or not being subject
to compromise. The debts subject to compromise are reported at the expected amount of
al owed claims rather than at an estimation of the settlement figure. Such estimations are
often difficult, if not impossible, to make.
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21. A company going through a Chapter 11 bankruptcy wil report specified reorganization items
on its income statement separately from operating figures. However, these reorganization
items are reported prior to income tax expense rather than in a manner similar to an
extraordinary item. These separately disclosed figures include gains and losses on the sale
of assets necessitated by the reorganization. Professional fees incurred in connection with
the reorganization are also reported in a similar manner as wel as any interest revenue that
would not have been earned except for the bankruptcy proceeding.
22. Professional fees incurred during a reorganization must be expensed as incurred. Capitalization is not al owed.
23. “Fresh start accounting” refers to the adjustment of a company's assets to current value at
the time the organization emerges from bankruptcy. A company must use fresh start
accounting if two criteria are met at the time the reorganization is finalized: (1) the fair value
of the assets is less than the total al owed claims as of the date of the order for relief plus
the liabilities incurred during reorganization and (2) the original owners are left with less than
50 percent of the voting stock.
In fresh start accounting, al assets are reported at current value while liabilities are reported
based on the present value of the settlement amounts. If the reorganization value of the
company as a whole is greater than the total fair value of the individual assets, goodwill is reported for the excess.
Initial y, in fresh start accounting, retained earnings must be reported at a zero balance.
24. Fresh start accounting is used by companies that are emerging from a bankruptcy
reorganization if the value of the assets held at that time are less than the al owed claims
associated with company’s liabilities (those present at the date of the order for relief and
those incurred since that date) and the original owners are left with less than 50 percent of
the voting stock of the reorganized company.
25. In fresh start accounting, the tangible and intangible assets of the company are reported at
their fair values. Liabilities are reported at the present value of the future cash flows.
26. When a company emerges from bankruptcy, the reorganization value of its assets as a
whole must be determined. The figure is normal y computed by discounting anticipated
future cash flows from the business. This figure is then assigned to the various assets of the
company based on individual fair values. The total reorganization value may wel be greater
than the current value of the individual assets. If so, the residual amount is recorded as the
intangible account Goodwill. Each year (or more often in some cases) it is reviewed for impairment.
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FIND MORE SLIDES, EBOOKS, SOLUTION MANUAL AND TESTBANK ON WWW.DOWNLOADSLIDE.COM Answers to Problems 1. B 2. D 3. B 4. C 5. A 6. D 7. C 8. B 9. C 10.B 11.A 12.A 13.A 14.B 15.C 16.A 17.C 18.A 19.D 20.C 21.C
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22. (10 Minutes) (Distribution of cash in a liquidation) Free Assets:
Current Assets .......................................................... $ 35,000
Buildings and Equipment ........................................ 110,000
Total .................................................................... $145,000
Liabilities with Priority:
Administrative Expenses ......................................... $ 20,000
Salaries Payable (only $3,000 per employee) .......... 6,000
Income Taxes ........................................................... 8,000
Total .................................................................... $ 34,000
Free Assets After Payment of Liabilities with Priority
($145,000 – $34,000) ................................................ $111,000 Unsecured Liabilities
Notes Payable (in excess of value of security) ...... $ 30,000
Accounts Payable ..................................................... 85,000
Bonds Payable .......................................................... 70,000
Total .................................................................... $185,000
Percentage of Unsecured Liabilities To Be Paid: $111,000/$185,000 = 60 %
Payment On Notes Payable:
Value of Security (land) ............................................ $ 90,000
60% of Remaining $30,000 ....................................... 18,000
Total Collected by holders ....................................... $108,000
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23. (5 Minutes) (Distribution of assets in a liquidation)
Liabilities with Priority
Paid first—administrative expense.........................................................$2,450
Paid second—wages up to a maximum of
$10,950 for Mr. Key.....................................................................................16,950
All remaining money—government claims to unpaid taxes 5800
Total of free assets..................................................................................$25,200
No payments will be made in connection with the remainder of the salaries,
the government claims and all of the unsecured accounts payable since no money is left.
24. (8 Minutes) (Distribution of assets to partially secured creditors) Free Assets:
Other Assets ............................................................. $ 80,000
Excess from Assets Pledged with Fully Secured
Creditors ($116,000 – $70,000) ........................... 46,000
Total .................................................................... $126,000
Liabilities with Priority .................................................. $ 42,000
Free Assets after Payment of Liabilities with Priority
($126,000 – $42,000) ................................................. $ 84,000 Unsecured Liabilities:
Excess of Partially Secured Liabilities Over Pledged
Assets ($130,000 – $50,000) ................................ $ 80,000
Unsecured Creditors ................................................ 200,000
Total .................................................................... $280,000
Percentage of Unsecured Liabilities To Be Paid: $84,000/$280,000 = 30%
Payment On Partially Secured Debt:
Value of Pledged Asset ............................................ $ 50,000
30% of Remaining $80,000 ....................................... 24,000
Total to be Collected by holders ........................ $ 74,000
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25. (8 Minutes) (Distribution of assets to partially secured creditors) Free Assets:
Cash ......................................................................... $50,000
Excess from Assets Pledged with Fully Secured
Creditors ($90,000 – $80,000) .............................. 10,000
Total ...................................................................... $60,000
Liabilities with Priority ................................................... 20,000
Free Assets after Payment of Liabilities with Priority .. $40,000 Unsecured liabilities:
Excess of Partially Secured Liabilities Over
Pledged Assets ($150,000 – $130,000) ................ $ 20,000
Accounts Payable ...................................................... 180,000
Total .................................................................... $200,000
Percentage of Unsecured Liabilities to be Paid: $40,000/$200,000 = 20% Payment on Bond:
Value of Pledged Asset ............................................. $130,000
20% of Remaining $20,000 ........................................ 4,000
Total to be Received by holders ......................... $134,000
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26.(12 Minutes) (Liquidation of assets to satisfy debt)
The holder of Debt Two will receive $100,000 from the sale of the pledged
asset. Since the holder wants to receive $142,000 out of the total debt of
$170,000, the company must be able to generate enough cash to pay off 60
percent of the unsecured liabilities ($42,000/$70,000) after paying 100 percent
of the liabilities with priority ($110,000). Unsecured Liabilities:
Unsecured Creditors ..................................................... $230,000
Excess Liability of Debt One in Excess of Pledged Asset
($210,000 – $180,000) ............................................... 30,000
Excess Liability of Debt Two in Excess of Pledged Asset
($170,000 – $100,000) ............................................... 70,000
Total Unsecured Liabilities ................................. $330,000
Necessary Percentage ................................................... 60%
Cash Needed For These Liabilities ............................... $198,000
In order for the holder of Debt Two to receive exactly $142,000, the other free
assets must be sold for $308,000. With that much money, the liabilities with
priority ($110,000) can be paid with the remaining $198,000 going to the
unsecured debts of $330,000. This 60 percent figure would insure that the
holder of Debt Two would get $100,000 from the pledged asset and $42,000
($70,000 x 60%) from the free assets.
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27. (8 Minutes) (Payments to be made on unsecured and partially secured liabilities)
a. The unpledged assets of $300,000 must be added to any excess to be received
from assets pledged on fully secured debts ($200,000 – $150,000 = $50,000) to
get amount of free assets available of $350,000.
Amount Available .......................................................... $350,000
Liabilities with Priority .................................................. (160,000)
Available for Unsecured Creditors .......................... $190,000
Accounts Payable .......................................................... $390,000
Partially Secured Debt in Excess of Pledged
Assets ($490,000 – $380,000) ....................................... 110,000
Unsecured Liabilities...................................................... $500,000
Distribution to Unsecured Creditors: $190,000/$500,000 = 38%
An unsecured creditor to whom $3,000 is owed can expect to receive $1,140 ($3,000 x 38%).
b. The bank will receive a total of $87,600. The secured interest will generate
$80,000. The remaining $20,000 liability is unsecured so that only an additional
payment of $7,600 (38%) can be expected.
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28. (20 Minutes) (Distribution of assets in a liquidation)
Free Assets: (fair market value)
Cash ......................................................................... $ 10,000
Inventory .................................................................... 60,000
Equipment ................................................................. 50,000
Total .................................................................... $120,000
Liabilities with Priority:
Administrative Expenses ......................................... $ 20,000
Income Taxes ........................................................... 30,000
Total ..................................................................... $ 50,000
Free Assets After Payment of Liabilities With Priority
($120,000 – $50,000) ................................................. $ 70,000 Unsecured Liabilities
Note Payable A (in excess of value of security) ..... $ 20,000
Note Payable B (in excess of value of security) ..... 80,000
Note Payable C ......................................................... 60,000
Accounts Payable ..................................................... 120,000
Total .................................................................... $280,000
Percentage of Unsecured Liabilities To Be Paid: $70,000/$280,000 = 25%
Payment on Note Payable A:
Value of Security (land) ................................................. $ 70,000
25% of Remaining $20,000 ............................................ 5,000
Total Collected ......................................................... $ 75,000
Payment on Note Payable B:
Value of Security (building) .......................................... $ 40,000
25% of Remaining $80,000 ............................................ 20,000
Total Collected ......................................................... $ 60,000
Payment on Note Payable C (unsecured):
25% of $60,000 ............................................................... $ 15,000
Payment on Administrative Expenses:
As a liability with priority, the entire amount due is paid. $ 20,000
Payment on Accounts Payable (unsecured):
25% of $120,000 ............................................................. $ 30,000
Payment on Income Taxes Payable:
As a liability with priority, the entire amount due is paid. $ 30,000
Payment on Administrative Expenses Payable:
As a liability with priority, the entire amount due is paid. $ 20,000
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29.(15 Minutes) (Liquidation of assets to satisfy debt)
Note payable B is unsecured. The holders want at least $125,000 of the total
balance of $250,000; thus, there must be at least enough money available to
pay 50 percent of the unsecured debts. All values are known except for the equipment. Unsecured Liabilities:
Accounts payable ...................................................... $180,000
Note payable A—unsecured portion ........................ 10,000
Note payable B ......................................................... 250,000
Total .................................................................... $440,000
Free Assets (except for equipment):
Cash ......................................................................... $24,000
Accounts receivable .................................................. 28,000
Inventory .................................................................... 56,000
Land (value does not cover related debt) ................ -0-
Buildings ($320,000 less $300,000
in bonds) .............................................................. 20,000
Total .................................................................... $128,000
Less: Liabilities with Priority:
Estimated administrative expenses ......................... (12,000)
Taxes payable to government .................................. (20,000)
Total free assets except for equipment .............. $96,000
In order for unsecured creditors to receive 50 percent of their claims, $220,000
in free assets must be available (50 percent of $440,000). At present only
$96,000 is available. Thus, $124,000 must be received from the liquidation of
the equipment ($220,000 – $96,000).
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30. (15 Minutes) (Payment of various liabilities in a liquidation) Free Assets:
Cash .................................................................... $30,000
Receivables (30 percent collectible) ........................ 15,000
Inventory .................................................................... 39,000
Land (value in excess of secured note:
$120,000 – $110,000) ............................................ 10,000
Total .................................................................... $94,000
Less: Liabilities with priority
Salary payable (below maximum) ....................... (10,000)
Free assets available ........................................... $84,000 Unsecured Liabilities:
Accounts payable ...................................................... $90,000
Bonds payable (less secured interest in
building: $300,000 – $180,000) ............................ 120,000
Unsecured liabilities ............................................ $210,000
Percentage of unsecured liabilities to be paid: $84,000/$210,000 = 40% Amounts to be paid for:
Salary payable (liability with priority to be paid
in full) .................................................................... $10,000
Accounts payable (unsecured—will collect 40%
of debts of $90,000).............................................. $36,000
Note payable (fully secured by land—will collect
entire balance) ..................................................... $110,000
Bonds payable (partially secured—will collect
$180,000 from building and 40 percent of the
remaining $120,000) ............................................. $228,000
31.(2 Minutes) (Reporting of debts during liquidation)
Because of the uncertainty of the amount that will be paid on an unsecured
debt, no attempt is made in financial reporting to anticipate the payment.
Liabilities are reported at the expected amount of the allowed claim. In this
case, the creditors apparently have a legitimate claim of $200,000.
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32.(9 Minutes) (Adjusting a company coming out of reorganization to fresh start accounting)
The individual assets of this company have a total fair value of $700,000 but a
reorganization value of $760,000. Thus, an intangible asset (Goodwill) equal to
the $60,000 must be recognized.
In addition, the retained earnings deficit must be eliminated and all other asset
and liability accounts adjusted to the value on the day that the company exits from bankruptcy.
Because common stock was transferred directly from the previous owners to
the creditors, no entry is needed for the stock account. However, because the
reorganization value is $760,000 but liabilities are $300,000, stockholders’
equity must be $460,000. Since retained earnings will be zero and common
stock will remain $330,000, additional paid-in capital should be adjusted to $130,000.
Receivables ($90,000 - $80,000) .................................... 10,000
Inventory ($210,000 - $200,000)...................................... 10,000
Buildings ($400,000 - $300,000) ..................................... 100,000
Goodwill ......................................................................... 60,000
Retained Earnings (eliminate deficit) ................. 70,000
Additional Paid-in Capital
($130,000 – $20,000)........................................ 110,000
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33.(15 Minutes) (Prepare income statement for company going through a
bankruptcy reorganization) ADDISON CORPORATION Income Statement
Revenues ...................................................................... $ 467,000 Costs and expenses:
Cost of goods sold ................................................... $ 211,000
Rent expense ............................................................ 16,000
Salary expense ......................................................... 70,000
Depreciation expense .............................................. 22,000
Advertising expense ................................................ 24,000
Interest expense ....................................................... 4,000 (347,000)
Earnings before reorganization items and tax effects . 120,000 Reorganization items:
Loss on closing of branch ...................................... (109,000)
Professional fees ..................................................... (71,000)
Interest revenue ........................................................ 32,000 (148,000)
Loss before income tax benefit ................................... (28,000)
Income tax benefit (20 percent) ................................... 5,600
Net loss .................................................................... $(22,400)
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34.(15 Minutes) (Description of balance sheet for a company emerging from
bankruptcy reorganization)
a. SOP 90-7 holds that a company should be considered a new entity (so that
current values would be applicable for reporting purposes) if two criteria are
met. Otherwise, the company is simply considered to be a continuation of the
old concern, a company that should continue to report its historical cost figures.
The first criterion is that the fair value of the assets of the emerging company
must be less than the allowed claims as of the date of the order for relief (plus
liabilities incurred during reorganization).
The second criterion is that the original owners must be left with less than 50
percent of the voting stock of the emerging company.
Whenever both of these criteria are met, the company's assets should be
reported at current values.
b. Under fresh start accounting, the assets of the company are adjusted to
current value on the date that it successfully emerges from bankruptcy
reorganization. A reorganization value for the entity’s assets as a whole is first
determined by discounting the cash flows that are anticipated. This balance is
assigned to identifiable assets (both tangible and intangible) in the same
manner as in a purchase combination. Any amount of the reorganization value
that exceeds the assigned total is recorded as goodwill.
c. The reorganization value in excess of the value of the identified assets and
liabilities is reported as the intangible asset goodwill. Goodwill is reviewed
each year for impairment.
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