Answers to Questions Chapter 18 CORPORATE LIQUIDATIONS and REORGANIZATIONS 1 Equity insolvency occurs when a debtor is unable to pay its debts as they come due. Bankruptcy insolvency occurs when a debtor s liabilities exceed the fair value of all assets. 2 A bankruptcy proceeding is designated voluntary if the debtor corporation files the petition to place itself under the protection of the bankruptcy court and involuntary if creditors file the petition to bring the debtor into bankruptcy court. An involuntary petition may be filed by a single creditor with an unsecured claim of $12,300 or more if there are fewer than twelve unsecured creditors. Otherwise, three or more entities with unsecured claims totaling at least $12,300 must file in order to commence an involuntary case. The requirements are the same for Chapter 7 and Chapter 11 cases. 3 The duties of the U.S. trustee are to maintain and supervise a panel of private trustees eligible to serve in Chapter 7 cases, to serve as trustee or interim trustee in some bankruptcy cases, to supervise the administration of bankruptcy cases, and to preside over creditor meetings. Bankruptcy judges still supervise cases in districts without U.S. trustees. 4 The debtor corporation in a bankruptcy case has the following duties: (1) to file a list of creditors, a schedule of assets and liabilities, and a statement of the debtor s financial affairs; (2) to cooperate with the trustee so that the trustee may perform his duties; (3) To surrender all property, including books, documents, records, and so on, to the trustee; and (4) to appear at hearings of the bankruptcy court as required. 5 A trustee is not appointed in all Title 11 cases. In Chapter 7 cases, a trustee will be elected by unsecured creditors if a majority of creditors vote for the trustee, and those creditors hold at least 20 percent of the claims. Otherwise, an appointed interim trustee serves as trustee. In Chapter 11 cases a trustee is appointed only if deemed necessary by the court, but otherwise, the debtor remains in possession of the estate and performs the duties of a trustee. Within 30 days from the time the court orders the appointment of a trustee in a Chapter 11 case, a party in interest may request the election of a trustee.
18-2 Corporate Liquidations and Reorganizations 6 The trustee in a liquidation case takes possession of the debtor s estate, converts estate assets into cash, and distributes the proceeds as directed by the court. They also performs other duties such as investigating the financial affairs of the debtor, providing information about the estate to parties of interest, examining creditor claims and objecting to those that appear improper, operating the debtor s business if authorized to do so by the court, providing financial reports and summaries about the estate to the court, and filing reports on trusteeship as directed by the court. 7 The priority rankings in a Chapter 7 liquidation case are summarized in Exhibit 18 2 of the text. The priorities recognized for unsecured claims (Rank II) are: (1) administrative expenses, (2) claims incurred between an involuntary filing and appointment of a trustee, (3) salary claims up to $10,000 per individual earned within 90 days of filing, (4) employee benefit plan contribution claims up to $10,000 per individual earned within 180 days of filing, (5) individual claims up to $1,800 for goods and services purchased from, but not provided by the debtor, and (6) claims of governmental units for taxes owed by the debtor (subject to time restrictions), including taxes collected and withheld for which the debtor is liable. 8 Four ranks within the unsecured nonpriority claim category (general unsecured claims) are: (1) claims allowed that were timely filed, (2) claims allowed where proof was filed late, (3) claims allowed for fines, penalties or forfeitures, or damages, and arising before the court order for relief or appointment of a trustee, and (4) claims for interest on unsecured claims. 9 The accountant s statement of affairs is a financial statement that is designed to provide information about liquidation values and priority rankings for use by the trustee, the court, creditors, and other interested parties in the debtor s estate. Assets are measured at expected net realizable values in the statement, but book values are also included for reference purposes. 10 A debtor corporation s estate may be liquidated even though the filing is under Chapter 11. This can occur when the case is transferred to Chapter 7 for liquidation. It can also be carried out in accordance with an approved Chapter 11 plan of reorganization that calls for sale and distribution of the proceeds from the debtor corporation s estate. 11 A debtor in possession reorganization case is a Chapter 11 case in which the bankruptcy court does not appoint a trustee, but instead, allows the debtor corporation to carry out the duties that otherwise would be performed by a trustee. 12 A creditor committee can file a plan of reorganization under a Chapter 11 case after 120 days from the date the court order for relief is granted. The order for relief occurs when the debtor or creditor s filing petition is approved by the court. 13 The approval of a plan of reorganization requires acceptance of the plan by at least two-thirds in dollar amount and over half in number of claims in each class of claims. Further, each class of claims must accept the plan or not be impaired under it. A class of claims that would receive nothing if the corporation were liquidated is not impaired if it receives nothing under a plan and, accordingly, acceptance by that class of claims is not required.
Chapter 18 18-3 14 Prepetition liabilities are the liabilities of an enterprise that were incurred prior to a Chapter 11 filing. They are reported at the amounts allowed by the bankruptcy court. Prepetition liabilities subject to compromise are those liabilities that may be impaired by a plan and that are eligible for compromise because they are either unsecured or undersecured. 15 Reorganization value is an estimate of the value of the reconstituted entity that will emerge from reorganization, plus the expected net realizable value of the assets that will be disposed of before reconstitution occurs. It is also described as the fair value of the entity before considering liabilities. Reorganization value approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring. 16 Fresh start reporting should be used by a company emerging from Chapter 11 if the following two conditions are met: (1) the reorganization value of the assets of the emerging entity immediately before the date of confirmation is less than the total of all postpetition liabilities and allowed claims and (2) holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity. 17 Entities not qualifying for fresh start reporting report liabilities compromised by a confirmed reorganization plan in a manner similar to that of a note issued in a noncash transaction under FASB ASC 835. Forgiveness of debt should be reported as an extraordinary item. 2012
18-4 Corporate Liquidations and Reorganizations SOLUTIONS TO EXERCISES Solution E18-1 Solution 18-2 1 b 1 a 2 d 2 d 3 c 3 c 4 d 4 d Solution E18-3 Note receivable from Pat $200,000 Amount secured by inventory items at expected recoverable value (50,000) Unsecured portion of note receivable from Pat 150,000 Expected recovery on the dollar for unsecured claims.35 Expected recovery on unsecured portion of note 52,500 Add: Secured portion 50,000 Total expected recovery on note from Pat $102,500 Solution E18-4 1 On the basis of the reorganization value, Bax qualifies for fresh start reporting because the estimated reorganization value of $2,000,000 is less than the postpetition liabilities and allowed claims. Estimated reorganization value $2,000,000 Liabilities: Postpetition liabilities $1,200,000 Prepetition liabilities 1,500,000 Fully secured debt 900,000 3,600,000 Excess liabilities over reorganization value $1,600,000 2 Old stockholders must retain less than a 50% interest in the new entity. Reorganization value $2,000,000 Less: Payment to prepetition claimants 150,000 1,850,000 Reorganized capital structure: Postpetition liabilities $1,200,000 Notes payable 300,000 Fully secured debt 900,000 New common stock to prepetition claimants 375,000 2,775,000 New common stock to old stockholders $ (925,000)
Chapter 18 18-5 Solution E18-5 Cash available for distribution $200,000 Mortgage payable (secured portion) (100,000) 100,000 Priority claims (administrative expenses and salaries) (20,000) Available for unsecured, nonpriority claims $ 80,000 Unsecured, nonpriority claims: Balance of mortgage payable $ 60,000 Accounts payable 100,000 Unsecured, nonpriority claims $160,000 $80,000 available cash/$160,000 claims = $.50 on the dollar Schedule of Distribution of Available Cash Mortgage payable secured portion $100,000 Unsecured, priority claims 20,000 Mortgage payable unsecured portion ($60,000 $.50) 30,000 Accounts payable ($100,000 $.50) 50,000 Total cash distributed $200,000 2012
18-6 Corporate Liquidations and Reorganizations SOLUTIONS TO PROBLEMS Solution P18-1 1 Entries on trustee s books: March 1, 2011 Cash $ 4,000 Accounts receivable net 8,000 Inventories 36,000 Land 20,000 Buildings net 100,000 Intangible assets 26,000 Accounts payable $50,000 Note payable unsecured 40,000 Revenue received in advance 1,000 Wages payable 3,000 Mortgage payable 80,000 Estate equity 20,000 To record custody of Sco in liquidation. March 2011 Cash $ 7,200 Estate equity 800 Accounts receivable net $ 8,000 To record collection of receivables and recognize loss. Cash $ 19,400 Estate equity 16,600 Inventories $36,000 To record sale of inventories at a loss. Cash $ 90,000 Estate equity 30,000 Land $ 20,000 Buildings net 100,000 To record sale of land and buildings at a loss. Estate equity $ 26,000 Intangible assets $ 26,000 To write off intangible assets at a loss. Estate equity $ 8,200 Administrative expenses payable new $ 8,200 To accrue trustee expenses.
Chapter 18 18-7 Solution P18-1 (continued) 2 Sco in Trusteeship Balance Sheet at March 31, 2011 Assets Cash $120,600 Liabilities And Deficit Accounts payable $ 50,000 Note payable unsecured 40,000 Revenue received in advance 1,000 Wages payable 3,000 Mortgage payable 80,000 Administrative expenses payable new 8,200 Total liabilities 182,200 Less: Estate deficit (61,600) Total liabilities less deficit $120,600 Statement of Cash Receipts and Disbursements from March 1 to March 31, 2011 Cash balance, March 1, 2011 $ 4,000 Add: Cash receipts Collections of receivables $ 7,200 Sale of inventories 19,400 Sale of land and buildings 90,000 116,600 120,600 Less: Cash disbursements (none) 0 Cash balance, March 31, 2011 $120,600 Statement of Changes in Estate Equity from March 1 to March 31, 2011 Estate equity, March 1, 2011 $20,000 Less: Loss on uncollectible receivables $ 800 Loss on sale of inventories 16,600 Loss on sale of land and buildings 30,000 Loss on write-off of intangibles 26,000 Administrative expenses 8,200 81,600 Estate deficit, March 31, 2011 $61,600 2012
18-8 Corporate Liquidations and Reorganizations Solution P18-1 (continued) 3 Entries on trustee s books: April 2011 Mortgage payable $80,000 Cash $80,000 To record payment of secured creditors from proceeds from sale of land and buildings. Administrative expenses payable new $ 8,200 Revenue received in advance 1,000 Wages payable 3,000 Cash $12,200 To record payment of priority liabilities. Accounts payable $15,800 Note payable unsecured 12,600 Cash $28,400 To record payment of $.32 per dollar to unsecured creditors (available cash of $28,400 divided by unsecured claims of $90,000). Accounts payable $34,200 Note payable unsecured 27,400 Estate equity $61,600 To write off remaining liabilities and close trustee s records.
Chapter 18 18-9 Solution P18-2 1 Amount expected to be available for unsecured claims: Total amount expected to be available for all claims $445,000 Less: Payments to secured and priority claims Mortgage payable $220,000 Note payable 75,000 Priority claims 80,000 375,000 Expected to be available for unsecured nonpriority claims $ 70,000 2 Expected recovery per dollar of unsecured claims: Expected to be available (from 1) = $70,000 Unsecured claims ($550,000 - $375,000) = $175,000 Expected recovery on the dollar: $70,000/$175,000 = $.40 3 Expected recovery by class of creditors: Fully secured mortgage payable $220,000 Partially secured note payable $75,000 + ($25,000 $.40) 85,000 Priority unsecured liabilities to priority creditors 80,000 Unsecured nonpriority creditors accounts payable ($150,000 $.40) 60,000 Total $445,000 2012
18-10 Corporate Liquidations and Reorganizations Solution P18-3 1 Ranking of claims: Fully secured: 8. Holders of first mortgage and related interest $228,500 Unsecured priority: 1. Administrative expenses $ 12,500 6. Wages payable up to $4,000 per 47,000 employee 7. Customer claims for merchandise paid for and not delivered (maximum $1,800 per individual) 1,500 5. State government for gross $ 3,000 receipts taxes 3. Local government for property taxes 4,000 7,000 Total unsecured priority claims 68,000 Unsecured nonpriority: 2. Merchandise creditors $99,000 4. Local bank for principal of loan 30,000 6. President for salary due over $4,000 1,000 130,000 4. Interest on unsecured bank loan 4,500 Total unsecured nonpriority claims 134,500 Total all claims $431,000 2 Distribution of available cash: 1st Mortgage holders (100%) $228,500 2nd Administrative expenses (100%) 12,500 3rd Employees (up to $4,000 each) (100%) 47,000 4th Customers for merchandise not delivered (100%) 1,500 5th State government (100%) $ 3,000 Local government (100%) 4,000 7,000 [Remaining cash ($374,500 - $296,500) of $78,000/$130,000 claim of next rank = $.60 return on dollar] 6th Merchandise creditors ($99,000.60) $59,400 Local bank for loan principal ($30,000.60) 18,000 Company president ($1,000.60) 600 78,000 Total distributed (equal to available cash) $374,500
Chapter 18 18-11 Solution P18-4 1 Hanna Corporation Statement of Affairs on June 30, 2011 Assets Realizable Values- Liability Offsets Realizable Value Available for Book for Secured Unsecured Value Creditors Creditors Pledged for partially secured creditors $55,000 Equipment net $28,000 Less: Mortgage note payable and accrued interest (31,000) $ 0 Available for priority and unsecured creditors 2,200 Cash 2,200 15,000 Accounts receivable net 13,500 20,000 Inventories 22,500 Total available for priority and unsecured creditors 38,200 Less: Priority liabilities 12,000 Total available for unsecured creditors 26,200 Estimated deficiency 10,800 $92,200 $37,000 Liabilities And Stockholders Equity Book Secured and Unsecured Non- Value Priority Claims priority Claims Priority liabilities $12,000 Wages payable (assumed under $4,000 per employee) $12,000 Partially secured creditors 31,000 Note payable and accrued interest $31,000 Less: Equipment pledged as security (28,000) $ 3,000 Unsecured creditors 26,400 Accounts payable 26,400 7,600 Rent payable 7,600 Stockholders equity 55,000 Capital stock (39,800) Retained earnings (deficit) $92,200 $37,000 2012
18-12 Corporate Liquidations and Reorganizations Solution P18-4 (continued) 2 Estimated payments per dollar for unsecured creditors Cash available $66,200 Distribution to partially secured and unsecured priority creditors: Note payable and interest $28,000 Administrative expenses 4,000 Wages payable 12,000 44,000 Available to unsecured nonpriority creditors = A $22,200 Note payable and interest (unsecured portion) $ 3,000 Accounts payable 26,400 Rent payable 7,600 Unsecured nonpriority claims = B $37,000 A/B = $22,200/$37,000 = $.60 per dollar Expected recovery for each class of claims Partially secured Note payable and interest Secured portion $28,000 Unsecured portion ($3,000 $.60) 1,800 $29,800 Unsecured priority Administrative expenses $ 4,000 Wages payable 12,000 16,000 Unsecured nonpriority Accounts payable ($26,400 $.60) $15,840 Rent payable ($7,600 $.60) 4,560 20,400 Total payments $66,200
Chapter 18 18-13 Solution P18-5 1 Dawn Corporation in Chapter 7 Statement of Affairs at July 10, 2011 Assets Realizable Realizable Value- Value Book Liability Available for Value Offsets Unsecured Fully secured $210,000 Accounts receivable net $160,000 Less: Notes payable 100,000 $ 60,000 Partially secured 250,000 Land and buildings net $140,000 Less: Mortgage and interest payable 205,000 0 Unsecured 80,000 Cash 80,000 200,000 Inventories 210,000 150,000 Equipment net 60,000 10,000 Intangible assets 0 Available for priority and unsecured 410,000 Priority liabilities 150,000 Available for nonpriority unsecured 260,000 Estimated deficiency 155,000 $900,000 $415,000 Equities Secured and Unsecured- Book Priority Nonpriority Value Claims Claims Priority liabilities $ 50,000 Accounts payable $ 50,000 24,000 Wages payable 24,000 76,000 Taxes payable 76,000 150,000 Fully secured 100,000 Note payable $100,000 Less: Accounts receivable net 160,000 (60,000) Partially secured 205,000 Mortgage and interest payable $205,000 Less: Land and buildings net 140,000 65,000 $ 65,000 Unsecured 350,000 Accounts payable 350,000 300,000 Capital stock (205,000) Retained earnings deficit $900,000 $415,000 2012
18-14 Corporate Liquidations and Reorganizations Solution P18-5 (continued) 2 Claims by Amounts to Amounts to Be Priority Ranks Be Paid Written Off Priority claims Administrative expenses $ 11,000 $ 11,000 Accounts payable 50,000 50,000 Wages payable 24,000 24,000 Taxes payable 76,000 76,000 Fully secured claims Note payable 100,000 100,000 Partially secured claims Mortgage and interest payable 205,000 140,000 $ 26,000 39,000 Unsecured Accounts payable 350,000 210,000 140,000 $816,000 $650,000 $166,000 Calculation of recovery for unsecured nonpriority claims Cash available $650,000 Less: Paid to priority claims (161,000) Less: Paid to fully secured claims (100,000) Less: Paid to partially secured creditors secured portion (140,000) A Cash available for unsecured $249,000 Unsecured claims: Partially secured ($205,000 - $140,000 secured) $ 65,000 Accounts payable nonpriority 350,000 B Total unsecured claims $415,000 A B = $249,000/$415,000 = $.60 recovery on the dollar
Chapter 18 18-15 Solution P18-6 1 Everlast Window Corporation Statement of Affairs on June 30, 2011 Assets Realizable Values- Realizable Liability Value Offsets for Available for Book Secured Unsecured Value Creditors Creditors Pledged for fully secured creditors $230,000 Land and building $170,000 Less: Mortgage payable and accrued interest (165,000) $ 5,000 Available for priority and unsecured creditors 40,000 Cash 40,000 70,000 Accounts receivable net 63,000 50,000 Inventories 42,000 60,000 Machinery net 20,000 50,000 Goodwill 0 Total available for priority and unsecured Creditors 170,000 Less: Priority liabilities 70,000 Total available for unsecured creditors 100,000 Estimated deficiency 65,000 $500,000 $165,000 Liabilities and Stockholders Equity Secured and Unsecured Book Priority Non-priority Value Claims Claims Priority liabilities $ 60,000 Wages payable $ 60,000 10,000 Property taxes payable 10,000 70,000 Fully secured creditors 150,000 Mortgage payable $150,000 15,000 Interest on mortgage payable 15,000 165,000 Unsecured creditors 110,000 Accounts payable $110,000 50,000 Note payable unsecured 50,000 5,000 Interest payable unsecured 5,000 Stockholders equity 200,000 Capital stock (100,000) Retained earnings (deficit) $500,000 $165,000 2 Settlement per dollar of rank 1 unsecured creditors is $.6250 ($100,000 available for unsecured/$160,000 accounts and notes payable). No payment is made for the $5,000 unsecured interest claim. 2012
18-16 Corporate Liquidations and Reorganizations Solution P18-7 1 The reorganization is eligible for fresh start accounting because the liabilities on June 30, 2011 of $16,500 exceed the reorganization value of $16,000 by $500. Also, the common stock of the new entity is allocated $5,000 to prepetition creditors and $2,000 to Lowstep s old stockholders, so that the old stockholders have less than a 50 percent interest in the new entity. 2 Entries to adjust Lowstep s accounts for the reorganization plan: Prepetition liabilities $12,500 Accounts payable (old) $ 800 Wages payable (old) 400 Note payable (new) 3,800 Common stock (new) 5,000 Gain on debt restructuring 2,500 To adjust prepetition liabilities to conform with the plan. Loss on asset adjustments to fair values $ 4,000 Inventories 400 Land 1,000 Buildings net $1,400 Patent 4,000 To adjust assets to their fair values. Common stock (old) $ 7,000 Common stock (new) $2,000 Additional paid-in capital 5,000 To record exchange of common stock. Gain on debt discharge $ 2,500 Additional paid-in capital 5,000 Reorganization value in excess of fair value 1,000 Loss on asset adjustments to fair values $4,000 Deficit 4,500 To eliminate deficit and record adoption of fresh start reporting.
Chapter 18 18-17 Solution P18-7 (continued) 3 Lowstep Corporation Final Balance Sheet as of July 8, 2011 Assets Cash $ 6,700 Trade receivables net 1,000 Inventories 2,000 Land 2,000 Buildings net 1,500 Equipment net 1,800 Reorganization value in excess of fair values 1,000 Total assets $16,000 Liabilities and Stockholders Equity Accounts payable $ 3,000 Accounts payable (old) 800 Wages payable 1,000 Wages payable (old) 400 Notes payable (new) 3,800 Total liabilities 9,000 Common stock (new) 7,000 Total liabilities and stockholders equity $16,000 Note: The final balance sheet of Lowstep Corporation will be the same as the beginning balance sheet of Highstep Corporation. 2012