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Chapter 20 - Corporations in Finanacial Difficulty

CHAPTER 20

CORPORATIONS IN FINANCIAL DIFFICULTY

ANSWERS TO QUESTIONS

Q20-1 The nonjudicial actions available to a financially distressed company are debt
restructuring arrangements and creditor's committee management. The judicial actions
available are corporate liquidation (Chapter 7) and corporate reorganization (Chapter
11).

Q20-2 The major difference between a Chapter 7 action and a Chapter 11 action is that
the debtor continues as a business after a Chapter 11 reorganization whereas the
business does not survive a Chapter 7 liquidation.

Q20-3 Under two circumstances an involuntary petition for relief may be filed. The first
circumstance is that the debtor is generally not paying debts as they become due. The
second circumstance is that within the last 120 days a custodian has been appointed by
other creditors, by the debtor, or by some other agency to take possession of the
debtor's assets. If more than 12 creditors exist, then three or more creditors must
combine to file the petition. These three or more creditors must have aggregate
unsecured claims of at least $5,000.

Q20-4 The following items are usually included in the Plan of Reorganization filed as
part of a Chapter 11 reorganization:
All major actions to be taken during the reorganization:
(1) Discontinuances of unprofitable operations
(2) Restructuring of debt with specific creditors
(3) Revaluation of assets and liabilities
(4) Changes in the par value of outstanding stock, or realignment of
stockholders' equity with newly issued shares of voting common stock.

Q20-5 The account Reorganization Value in Excess of the Amount Assigned to

Identifiable Assets is established during a Chapter 11 fresh start accounting to record
the excess of the reorganization value that is not assigned to specific assets. The
account is an intangible asset and is accounted for in accordance with FASB 142.

Q20-6 A company in Chapter 11 reorganization qualifies for fresh start accounting if

both of the following occur:
1. The reorganization value of the entity's assets of the emerging entity immediately
before the date of confirmation is less than the total of all post-petition liabilities and
allowed claims; and
2. Holders of existing voting shares immediately before confirmation receive less than
50% of the voting shares of the emerging entity.

Companies using fresh start accounting revalue their assets to fair values, using the
procedures in FASB 141. An account called Reorganization Value in Excess of the
Amount Assigned to Identifiable Assets is used to record any excess in reorganization
value not assigned to specific assets.

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Q20-7 The financial statements that must be filed by a company during a Chapter 11
reorganization include a complete set of audited financial statements. SOP 90-7
established specific guidelines for these statements, noting that amounts associated with
reorganization should be reported separately.

Q20-8 The rights of creditors with priority in a Chapter 7 liquidation are to receive any
assets available to unsecured creditors after the secured creditors have been satisfied.

Q20-9 The statement of affairs is the basic accounting report made at the beginning of
the liquidation process to present the expected realizable amounts from disposal of the
assets, the order of creditors' claims, and the expected amount unsecured creditors will
receive as a result of the liquidation. In addition, the statement of affairs presents the
book values of the debtor company's balance sheet accounts and the estimated
deficiency to the general unsecured creditors. As a final point, the statement of affairs is
not a going concern report.

Q20-10* A trustee who takes title to the debtor's assets in a liquidation must make a
periodic financial report to the bankruptcy court reporting on the progress of the
liquidation and on the fiduciary relationship held. When the trustee accepts the assets, a
new set of books is opened for the debtor and a new account is created to recognize the
debtor's interest in the net assets accepted by the trustee. A statement of realization and
liquidation is prepared on a monthly basis for the bankruptcy court showing the results of
the trustee's fiduciary actions’ beginning at the point the trustee accepts the debtor's
assets.

Q20-11* Sales of assets are reported in the statement of realization and liquidation as
assets realized in the assets section of the statement.

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SOLUTIONS TO CASES

C20-1 Creditors' Alternatives

The options to the creditors are (1) form a creditors' committee, (2) a Chapter 11
reorganization, and (3) a Chapter 7 liquidation. The eventual decision must rest upon the
creditors' assessment of the viability of the rehabilitation of the debtor versus the
liquidation values of the debtor's assets.

Most creditors do not want to see the liquidation of a debtor because, as creditors, they
are in the business of loaning monies, not trying to manage a business or attempting to
obtain as much of a liquidation dividend as possible in a liquidation. Most creditors will
work with the debtor's management as long as possible. Secured creditors have greater
protection of their receivables than do unsecured creditors. However, even most secured
creditors prefer to see a debtor company be rehabilitated after a time of financial
difficulty rather than see the debtor liquidated. The timing of the cash flows is somewhat
dependent on the amount of reduction in debt the creditors are willing to absorb. If the
creditors are willing to work with the debtor, the creditors may eventually realize a
greater percentage of their debt, but it usually takes a longer time to receive the
payments from the debtor.

The creditors' committee is a nonjudicial action that provides for flexibility to both the
creditors and the debtor. The creditors' committee typically works with the debtor
company to enact a plan of settlement of the debtor's indebtedness. In some cases, the
creditors may assume management control of the company, but most creditors are
reluctant to do this because of the added risk of legal action if the company does enter
bankruptcy. Creditors may eventually receive a substantial part, or possibly all, of their
receivables as the debtor is able to "work down" its debt over time.

Chapter 11 reorganization offers the creditors a chance to continue having a customer

once the customer solves its immediate financial problems. A reorganization is an
acceptable option if the creditors feel the company would have the basic operating and
financial foundations after the reorganization to become a going concern. Creditors often
accept reduced amounts as settlements of their receivables, or will modify the terms of
existing debt as part of the reorganization agreement.

Chapter 7 liquidations are the final step. The creditors must go through the judicial
process that may take a long time to complete. Liquidation should be used only if no
other alternative is viable. Creditors often receive a smaller portion of their receivables
because of the forced liquidation of the assets and the extensive legal and administrative
costs involved in a liquidation.

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C20-2 Research Related to Bankruptcy

The website for the U.S. Bankruptcy Courts is: www.uscourts.gov/bankruptcycourts.html

a. The Frequently Asked Questions (FAQs) for the U.S. Bankruptcy Courts state that a U.S.
bankruptcy judge is a district court judicial officer who is appointed by the majority of
judges of the U.S. appeals court to have jurisdiction over bankruptcy matters. As
bankruptcy cases come before a district court, a bankruptcy judge is assigned to the
case. Some courts assign judges based on random assignment while other courts have
a chief judge who seeks to select a judge to assign based on a judge’s experience or
special expertise relevant to the case. Each court will have a written plan or system for
assigning cases.

b. The U.S. Bankruptcy Court’s Website has a link to Official Bankruptcy Forms to be used
in filings before the courts. The forms and instructions for a Voluntary Petition are
available in Part I of the Bankruptcy Forms Manual page. The official form is FORM B1
for a voluntary petition.
A voluntary petition is initiated by the debtor and therefore the information required is
principally related to the debtor, such as name, address, and location of the principal
assets of the debtor. The debtor must declare such items as the number of creditors, the
estimated assets, the estimated debts, the type of petition (i.e., Chapter 7, Chapter 11,
etc.), if sufficient funds will be available to satisfy the unsecured creditors. The debtor
may also be required to file additional exhibits (Exhibit A for publicly traded companies,
Exhibit B is used in personal filings and Exhibit C to describe any property that might
pose a threat of identifiable harm to public health or safety).

c The United States Bankruptcy Courts Website presents a link to Bankruptcy Statistics
that are presented in .pdf format. Statistics are presented for various time periods such
as quarters, fiscal years and calendar years. Note that Case 20-3 asks for the most
recent calendar year ending on December 31.
(1) Total business filings are presented at the top of the form for business and
nonbusiness filings for the twelve month period ended for the most recent year.
Statistics for prior years are also available. Business filings are typically about
34,000 but do fluctuate slightly based on economic conditions. Approximately sixty
percent of these filings are under Chapter 7, about twenty-eight percent under
Chapter 11, and the remainder under various other chapters of the Bankruptcy
Code.
(2) Students should find the Federal judicial district in which their educational institution
is located. The larger states typically have several districts and students may have
to make an assumption for which district they are located. It is instructive to see
that the numbers of filings vary widely by district. The number of filings may differ
due to different economic factors for specific parts of the United States, the nature
of the industrial base in a specific district, the size of a district, and other factors
reflecting business factors across court districts. Students might reflect on why the
number of filings in their Federal court district are different from those in other
districts in other circuits.

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C20-3* Selection of Bankruptcy Trustee and Trustee’s Responsibilities

Title 11 of the United States Code may be obtained from several sources through using
a web browser and the search term, “Title 11 of the U.S. Code.” The case asks about
trustees for a Chapter 7 bankruptcy filing.

a. Subchapter 1 of Chapter 7 of Title 11 of the U.S. Code specifies the administration of

a Chapter 7 bankruptcy filing. Section 701 states that the United States Trustee
shall appoint an interim trustee who is a member of the panel of private trustees
established under federal law. Private trustees are persons who have prior financial
expertise and experience and have been approved by a formal review process. After
the appointment of an interim trustee, Section 702 describes how creditors may elect
a trustee under the circumstances in which creditors holding at least twenty percent
of the unsecured claims request that an elected trustee administer the Chapter 7
bankruptcy. A candidate must receive the votes of creditors holding a majority of the
claims of the unsecured creditors.

b. Section 704 of Subchapter 1 of Chapter 7 of Title 11 of the U.S. Code defines the
duties of the trustee. The trustee is responsible for administering the business, is
accountable for all property received, and must evaluate the claims of the creditors to
make sure the claims are valid prior to settlement. The trustee also prepares
periodic reports and summaries of the operations of the business which it provides to
the United States Trustee or Bankruptcy Court. Upon completion of the operations,
the trustee must file a final report on the administration of the estate with the court
and with the United States Trustee.

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C20-4 The Bankruptcy of WorldCom

Overall, the 2002 bankruptcy of WorldCom resulted in a cumulative net reduction to their
shareholders’ equity of $70.8 billion as of December 31, 2001, and a reduction in
previously reported net income of $17.1 billion and $53.1 billion for the years ended
December 31, 2001, and 2000 respectively. Goodwill of $44.9 billion was reduced to
zero at December 31, 2001. The WorldCom bankruptcy and resultant adjustments
made during the reorganization process are certainly one of the most significant
bankruptcies in U.S. business history.

The following information is taken from WorldCom Inc.’s 10-K for the fiscal year 2002
that was filed with the SEC on March 12, 2004.

a. (Source: Item 3, Legal Proceedings) WorldCom filed a voluntary petition for

bankruptcy on July 21, 2002, under Chapter 11, Reorganization.

b. (Source: Item 3, Legal Proceedings and the MD&A) The primary reason seems to
be that management and the Board of Directors had been informed of very
significant accounting irregularities and needed time to investigate the possible
irregularities, and to protect the company from lawsuits from creditors and others.
For example, on June 26, 2002, the SEC filed a civil suit against the company for its
past financial reports. On April 29, 2002, Bernard Ebbers resigned as President and
Chief Executive Officer. The company undoubtedly felt it needed the protection of
bankruptcy to give it time to study the breadth of its financial and accounting
problems and to reorganize to recover from those problems without additional legal
pressure from its creditors.

c. (Source: Item 3, Legal Proceedings) On June 25, 2002, the company publicly
announced that an internal audit found a number of transfers from line cost expenses
(referred to as access cost expenses) to capital accounts, thus decreasing expenses
and increasing assets. For the year 2001 and the first quarter of 2002, this amount
of transfer was $3.9 billion. In addition to this item, the company was improperly
accounting for impairment tests on its long-lived assets, its acquisitions, its revenue
contracts and several other irregularities. However, it was the accounting for the
access costs as assets when they were clearly expenses that were the primary
accounting irregularity that initiated the internal review.

d. (Source: Item 7, Management’s Discussion and Analysis) Item 7 of the company’s

2002 10-K presents a section titled “Restatements and Reclassifications of
Previously Issued Consolidated Financial Statements”. A table is presented that
summarizes the restatement items on revenue and pre-tax income or loss for the
years ended December 31, 2001 and 2000. The major categories of income
statement restatement adjustments are presented below (in $millions), with a brief
explanation of each category following the table: (Parentheses used for decreases in
reported amounts)

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C20-4 (continued)
Year Ended Year Ended
December 31, 2001 December 31, 2000
Pre-tax Pre-tax
Item: Revenue income (loss) Revenue income (loss)
Previously reported 35,121 2,375 39,020 7,581
Restatement adjustments:
1. Impairment --- (12,592) --- (47,180)
2. Improper reduction --- (2,933) 6 (1,827)
of access costs
3. Purchase accounting 14 (2,273) (193) (3,567)
4. Long lived asset --- 2,750 --- (1,713)
adjustments
5. International adjustments (749) (899) 18 (487)
6. Revenue related (1,204) (575) (36) (995)
adjustments
7. Adjustments to --- (823) --- (732)
accrued liabilities
8. Embratel and 5,268 (35) 1,127 (325)
Avantel acquisitions
9. Unclassified income/ --- 383 --- (426)
(expense)
10. Other (7) (506) 4 (750)
Total adjustment items 3,322 (17,503) 926 (58,002)
Discontinued Operations (775) 1,323 (602) 449
Adjustment
Revenue, as restated 37,668 39,344
Minority interest adjustment (669) 52
Pre-tax loss, as restated (14,474) (49,920)

Because most of the accounting personnel, including the Chief Financial Officer and
the controller, were terminated shortly after the large scope of the accounting
irregularities were discovered, the company determined that it could not objectively
restate periods prior to the 2000 fiscal year. However, a minor adjustment decrease
of $.7 billion was made to the ending shareholders’ equity as of December 31, 1999.
A brief explanation of each of the 10 adjustment categories above is summarized
from the disclosures in Item 6 of WorldCom’s 2002 10-K.
1. Impairment: The company discovered that impairment tests had not been
performed for goodwill and long-lived assets even though FASB 121 triggers had
occurred. The application of these impairment tests resulted in very significant
writedowns for both 2000 and 2001.
2. Improper reduction of access costs: The primary adjustments for this item were
due to the improper capitalization of access costs that should have been
expensed as incurred in accordance with GAAP.
3. Purchase accounting: The company made numerous acquisitions, including the
MCI acquisition, between 1993 and 2001 and a review of these acquisitions
concluded that a number of errors were found in the application of purchase
accounting valuations and procedures that overstated the amounts capitalized for
the acquisitions.

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C20-4 (continued)

4. Long lived asset accounting: This item includes adjustments to depreciation and
amortization, changes in the estimated useful lives of long-lived assets, including
those acquired in the MCI combination, and other costs that had been
inappropriately capitalized as long-lived assets that should have been expensed.
5. International: Adjustments were made for correcting the U.S. GAAP-based
statements from the foreign accounting principles. In addition, a review of the
functional currency rules resulted in changing the functional currencies for many
of the international subsidiaries from the local currency to the U.S. dollar.
6. Revenue related adjustments: A number of adjustments were made because of
lack of documentation to support the company’s deferral of income under SAB
101. In addition, the company had incorrectly accounted for some contracts as
sales when in fact the company had acted as an agent and should have recorded
just the net of the amounts as income rather than record gross sales and gross
costs.
7. Adjustments to accrued liabilities: Adjustments were made to eliminate improper
accruals of liabilities for items such as legal reserves, employee benefits and tax
liabilities.
8. Embratel and Avantel acquisitions: A review of the Embratel acquisition showed
an incorrect interpretation with regard to not having control over Embratel and
that Embratel should have been consolidated rather than reported net as an
investment. A review of the Avantel relationship to WorldCom resulted in
changing the accounting from an equity investment to a full consolidation.
9. Unclassified income/ (expense): A review of several accrued liability accounts
showed that there was inadequate documentation to support the accruals. Also,
there were other accrued assets and some liabilities recorded on the historical
balance sheet for which there was either no, or inadequate, documentation to
support that the company owned the assets or owed the liabilities.
10. Other: The company made a number of reclassifications, revaluations of
derivatives, intercompany balances, and certain capitalized costs such as
interest, labor and overhead for capital projects.

These adjustments were also carried through the restated balance sheet and
statement of cash flows for 2001 and 2000.

e. (Source: Item 7 of WorldCom’s 2002 10-K) From the date the bankruptcy petition
was filed, July 21, 2002, through the entire reorganization period, the company used
the provisions of SOP 90-7 for accounting and financial reporting purposes. The
“Debtors-In-Possession” heading informs readers of the financial statements that the
company is in bankruptcy reorganization but management still controls the company
under the administration of a bankruptcy trustee. The balance sheet reports pre-
petition liabilities separately from others and liabilities not subject to compromise are
reported separately in both the current and noncurrent sections of the balance sheet.
The income statement separately reports the reorganization gain or loss realized
during the reorganization period.

f. (Source: Item 7 of WorldCom’s 2002 10-K) Towards the beginning of Item 7, the 10-
K reports that the company will adopt fresh-start accounting under the provisions of
SOP 90-7 as of the fresh-start reporting date. The company will revalue its assets
and liabilities, allocate the reorganization value to the assets and liabilities, eliminate
the accumulated deficit in shareholders’ equity, and the company’s new debt and
equity will be recorded.

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SOLUTIONS TO EXERCISES

E20-1 Multiple-Choice Questions on Chapter 11 Reorganizations [AICPA

Adapted]

1. c

2. d

3. c

4. d

5. c

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E20-2 Recovery Analysis for a Chapter 11 Reorganization

a. Recovery analysis for plan of reorganization:

Taylor Companies, Inc.

Plan of Reorganization
Recovery Analysis
December 31, 20X1

Recovery

Elimination Reduction $2 par

of Debt Surviving of Taylor's Common Stock Total Recovery
and Equity Debt Assets % Value $ %

Post-petition liabilities (30,000) (30,000) (30,000) 100%

Claims/Interest:
Accounts Payable (80,000) 8,000 (72,000) (72,000) 90

Notes Payable, 10% (150,000) 25,000 (125,000) (125,000) 83

Related Interest Payable (16,000) 16,000 -0- 0

Bonds Payable, 12% (200,000) (200,000) (200,000) 100

Related Interest Payable (24,000) 18,000 (6,000) (6,000) 25

Total (470,000) 67,000

Common shareholders:
Common Stock (100,000) (100,000) 100% (200,000) (200,000)
Additional Paid-In (200,000) 171,000 (29,000) (29,000)
Retained Earnings
Deficit 178,000 (178,000)
Total (622,000) (40,000) (230,000) (203,000) 100% (229,000) (662,000)

Note: Parentheses indicate credit amount.

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E20-2 (continued)

b. Journal entries to record reorganization:

(1) Accounts Payable 80,000

Notes Payable, 10% 150,000
Interest Payable 40,000
Cash 6,000
Accounts Receivable (net) 72,000
Land 85,000
Gain on Disposal of Land 40,000
Gain on Discharge of Debt 67,000
Record discharge of debt.

(2) Common Stock ($1 par) 100,000

Additional Paid-In Capital 171,000
Gain on Disposal of Land 40,000
Gain on Discharge of Debt 67,000
Common Stock ($2 par) 200,000
Retained Earnings 178,000
Record change in par value of stock
and elimination of deficit.

E20-3 Multiple-Choice Questions on Chapter 7 Liquidations

1. c

2. a

3. d

4. a

5. c

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E20-4 Chapter 7 Liquidation

a. Schedule to calculate amount available for general unsecured creditors:

Total estimated fair values $471,000

Claims of secured creditors:
Notes payable and interest
(Receivables and Inventory) $115,000
Bonds payable and interest
(Land and Building) 231,000 (346,000)
$125,000
Claims of creditors with priority:
Wages payable $ 9,500
Taxes payable 14,000 (23,500)
Available to general unsecured creditors $101,500

b. Accounts payable $ 95,000

Notes payable and interest $195,000
Less: Secured by receivables and inventory (115,000) 80,000
Total unsecured claims $175,000

$101,500
Estimated dividend: = 58%
$175,000

c. Group Credit Percentage Distributed

Accounts Payable $ 95,000 58% $ 55,100

Wages Payable 9,500 100 9,500
Taxes Payable 14,000 100 14,000
Notes Payable 80,000 58 46,400
and Interest 115,000 100 115,000
Bonds Payable
and Interest 231,000 100 231,000
$471,000

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E20-5* Statement of Realization and Liquidation

Pace Corporation
Statement of Realization and Liquidation

Assets

Assets to be Realized Assets Realized

Old Receivables, net $ 38,000 Old Receivables $ 21,000

Marketable Securities 12,000 New Receivables 47,000
Old Inventory 60,000 Marketable Securities 10,500
Depreciable Assets, net 96,000 Sales of Inventory 75,000

Assets Acquired Assets Not Realized

New Receivables 75,000 Old Receivables, net 17,000

New Receivables, net 28,000
Depreciable Assets 80,000

Supplementary Items

Supplementary Charges Supplementary Credits

Trustee's Fee $ 4,300 Net Loss $ 6,800

Liabilities

Liabilities Liquidated Liabilities to be Liquidated

Old Current Payables $ 22,000 Old Current Payables $ 48,000

Liabilities Not Liquidated Liabilities Incurred

Old Current Payables 26,000

$333,300 $333,300

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Chapter 20 - Corporations in Finanacial Difficulty

SOLUTIONS TO PROBLEMS

P20-6 Chapter 11 Reorganization

a. Recovery analysis for plan of reorganization:

Polydorous Corporation
Plan of Reorganization
Recovery Analysis

Recovery
Pre- Elimination 12%
Confir- of Debt Surviving Cash Secured Common Stock Total Recovery
mation and Equity Debt Notes % Value $ %

Post-petition liabilities (10,000) (10,000) (10,000) 100%

Claims/Interest:
Accounts Payable (160,000) 20,000 (40,000) (100,000) (140,000) 88

Interest Payable (20,000) 10,000 (10,000) (10,000) 50

Notes Payable, 10% (340,000) 60,000 (10,000) (240,000) 30 (30,000) (280,000) 82

Total (520,000) 90,000

Preferred Shareholders (100,000) 50,000 50 (50,000) (50,000)

Common Shareholders (150,000) 130,000 20 (20,000) (20,000)

Retained Earnings Deficit 80,000 (80,000)

Total (700,000) 190,000 (10,000) (60,000) (340,000) 100% (100,000) 510,000

Pre-confirmation total equities of $700,000 includes $690,000 pre-petition and $10,000 post-petition increase.
Note: Parentheses indicate credit amount.

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P20-6 (continued)

b. Analysis for evaluating qualifications for fresh start accounting:

First condition:
Post-petition liabilities $ 10,000
Liabilities deferred pursuant to Chapter 11 proceedings 520,000
Total post-petition liabilities and allowed claims $530,000
Reorganization value (510,000)
Excess of liabilities over reorganization value $ 20,000

Second condition:
Holders of existing voting shares immediately before confirmation
receive 20% of voting shares of emerging entity.

Therefore, both conditions for a fresh start occur, and fresh

start accounting is used to account for the company.

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P20-6 (continued)

c. Entries for execution of plan of reorganization:

(1) Liabilities Subject to Compromise 520,000

Cash 60,000
Notes Payable, 12%, secured 340,000
Common Stock (new) 30,000
Gain on Debt Discharge 90,000
Record debt discharge.

(2) Preferred Stock 100,000

Common Stock (old) 150,000
Common Stock (new) 70,000
Additional Paid-In Capital 180,000
Record exchange of stock for stock.

(3) Reorganization Value in Excess of Amounts

Allocable to Identifiable Assets 30,000
Gain on Debt Discharge 90,000
Additional Paid-In Capital 180,000
Accounts Receivable (net) 30,000
Inventory 7,000
Property, Plant, and Equipment 183,000
Retained Earnings - Deficit 80,000
Record fresh start accounting and eliminate
deficit.

Schedule to support allocation of reorganization value:

Book Fair
Value Value Difference

Cash $ 30,000 $ 30,000 $ -0-

Accounts Receivable (net) 140,000 110,000 (30,000)
Inventory 25,000 18,000 (7,000)
Property, Plant, and
Equipment (net) 445,000 262,000 (183,000)
Reorganization Value in Excess
of Amounts Allocable to
Identifiable Assets -0- 30,000 30,000
Total $640,000 $450,000 $(190,000)

Note: The post-reorganization total fair value is the reorganization value of

$510,000 less the $60,000 paid to fulfill the plan of reorganization.

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P20-6 (continued)

d. Fresh start balance sheet workpaper for company emerging from reorganization: (Worksheet
not required)

Adjustments to Record Company's

Pre- Confirmation of Plan Reorganized
confir- Debt Exchange Fresh Balance
mation Discharge of Stock Start Sheet
Assets:
Cash 90,000 (60,000) 30,000
Accounts Receivable (net) 140,000 (30,000) 110,000
Inventory 25,000 (7,000) 18,000
255,000 (60,000) -0- (37,000) 158,000
Property, Plant,
and Equipment (net) 445,000 (183,000) 262,000
Reorganization Value In
Excess of Amounts
Allocable to
Identifiable Assets 30,000 30,000
Total Assets 700,000 (60,000) -0- (190,000) 450,000

Liabilities:
Liabilities Not Subject
to Compromise:
Current Liabilities (10,000) (10,000)
Liabilities Subject
to Compromise (520,000) 520,000
Notes Payable, 12%, secured (340,000) (340,000)
Total Liabilities (530,000) 180,000 -0- -0- (350,000)

Shareholders' Equity:
Preferred Stock (100,000) 100,000
Common Stock (old) (150,000) 150,000
Common Stock (new) (30,000) (70,000) (100,000)
Additional Paid-In Capital (180,000) 180,000
Retained Earnings 80,000 (90,000) 90,000
(80,000) -0-
Total Shareholders' Equity (170,000) (120,000) -0- 190,000 (100,000)
Total Liabilities and
Shareholders’ Equity (700,000) 60,000 -0- 190,000 (450,000)

Note: Parentheses indicate credit amount.

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P20-6 (continued)

d. Balance sheet for company emerging from Chapter 11 reorganization with fresh start
accounting:

Polydorous Company
Balance Sheet
Emerging Date

Assets:
Cash $ 30,000
Accounts Receivable (net) 110,000
Inventory 18,000
Total Current Assets $158,000

Property, Plant, and Equipment (net) 262,000

Reorganization Value In Excess of Amounts
Allocable to Identifiable Assets 30,000
Total Assets $450,000

Liabilities:
Accounts Payable $ 10,000
Notes Payable, 12%, secured 340,000
Total Liabilities $350,000

Shareholders' Equity:
Common Stock 100,000
Total Shareholders' Equity $100,000
Total Liabilities and Shareholders' Equity $450,000

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Chapter 20 - Corporations in Finanacial Difficulty

P20-7 Chapter 7 Liquidation, Statement of Affairs

a. Name Brand Company

Statement of Affairs
July 31, 20X1

Assets
Estimated
Amount
Available Estimated
Estimated to Gain
Book Current Unsecured (Loss) on
Value Values Claims Realization

(1) Assets pledged with fully secured

creditors:
$ 50,000 Accounts receivable (net) $ 50,000
Less: 12% note payable and
interest (44,000) $ 6,000

80,000 Land $110,000 $ 30,000

162,000 Plant and equipment (net) 150,000 (12,000)
$260,000
Less: Mortgages payable
and interest (234,600) 25,400

(2) Assets pledged with partially

secured creditors:
30,000 Marketable securities $ 22,000 (8,000)
Less: 10% note payable
and interest (29,400)

79,000 Inventory $ 75,000 (4,000)

Less: Accounts payable (105,000)

(3) Free assets:

5,000 Cash $ 5,000 5,000
55,000 Accounts receivable (net) 55,000 55,000
81,000 Inventory 76,000 76,000 (5,000)
7,000 Prepaid insurance 1,500 1,500 (5,500)
250,000 Plant and equipment (net) 190,000 190,000 (60,000)
72,000 Franchises 30,000 30,000 (42,000)

Estimated amount available $388,900

Less: Creditors with priority (45,000)
Net available to unsecured creditors $343,900
Estimated deficiency 82,500
$871,000 $(106,500)

Total unsecured debt $426,400

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Chapter 20 - Corporations in Finanacial Difficulty

P20-7 (continued)

Equities
Estimated
Book Amount
Value Unsecured

(1) Fully secured creditors:

$ 44,000 12% note payable and interest $ 44,000
234,600 Mortgages payable and interest 234,600
$278,600

(2) Partially secured creditors:

29,400 10% note payable and interest $ 29,400
Less: Marketable securities (22,000) $ 7,400

105,000 Accounts payable $105,000

Less: Inventory (75,000) 30,000

(3) Creditors with priority:

-0- Estimated liquidation expenses $ 13,000
20,000 Wages payable 20,000
12,000 Taxes payable 12,000
$ 45,000

(4) Unsecured creditors:

160,000 Accounts payable 160,000
212,000 Notes payable 212,000
17,000 Interest payable 17,000

(5) Stockholders' equity:

240,000 Common stock
(203,000) Retained earnings (deficit)
$871,000 $426,400

b. Percentage to unsecured creditors: $343,900 = 80.65%

$426,400

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Chapter 20 - Corporations in Finanacial Difficulty

P20-8 Chapter 7 Liquidation, Statement of Affairs [AICPA Adapted]

a. Tower, Inc.
Statement of Affairs
December 31, 20X1
Assets

Estimated
Amount Estimated
Estimated Available to Gain
Book Current Unsecured (Loss) on
Value Values Claims Realization
(1) Assets pledged with fully secured
creditors:
$ 40,000 Accounts receivable $ 40,000
13,000 Land 25,000 $ 12,000
90,000 Building (net) 110,000 20,000
140,000 Machinery (net) 75,000 (65,000)
$250,000
Less: Fully secured claims
from liability side:
Note payable-bank $ 30,000
Mortgage payable and
related interest 132,400 (162,400) $ 87,600

(2) Assets pledged with partially

secured creditors:
20,200 Marketable securities $ 19,000
Accrued interest 200
$ 19,200 (1,000)
Less: Notes payable (to bank) (20,000)

(3) Free assets:

1,500 Cash $ 1,500 1,500
35,000 Accounts receivable (after
reclassifying $5,000 of credit
balances to accounts payable) 35,000 35,000
60,000 Finished goods 50,000 50,000 (10,000)
40,000 Raw materials (net of $10,000
of conversion costs) 60,000 60,000 20,000
5,000 Prepaid expenses -0- (5,000)

Estimated amount available for unsecured

creditors, including creditors with priority $234,100
Less: Liabilities with priority (41,500)
Estimated amount available for unsecured creditors $192,600
Estimated deficiency to unsecured
creditors (plug) 18,200
$444,700 $(29,000)
Total unsecured debt $210,800

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Chapter 20 - Corporations in Finanacial Difficulty

P20-8 (continued)

Book Amount
Value Liabilities and Stockholders' Equity Unsecured

(1) Fully secured creditors:

$ 30,000 Notes payable- bank $ 30,000
132,400 Mortgage payable and interest 132,400
Total (deducted on asset side) $162,400

(2) Partially secured creditors:

20,000 Notes payable-bank $ 20,000
Less: Pledged marketable
securities and interest
(from asset side) (19,200) $ 800

(3) Liabilities with priority:

Estimated liquidation expenses $ 11,000
15,000 Wages payable 15,000
15,500 Payroll taxes payable 15,500
Total (deducted on asset side) $ 41,500

(4) Unsecured creditors:

70,000 Accounts payable (after excluding $15,000
of payroll taxes payable and including
$5,000 of credit balances reclassified
from accounts receivable) 70,000
85,000 Notes payable 85,000
5,000 Audit fee of prior year 5,000
50,000 Contingent liability on damage suit 50,000

21,800 (5) Stockholders' equity, after giving effect

to unrecorded items that are properly
bookable as of December 31, 20X1*
($100,000 - $20,000 - $500 + $200
- $500 - $2,400 - $5,000 - $50,000)

$444,700

Total unsecured debt $210,800

* Common stock, $100,000; retained earnings deficit, ($20,000); cash expended for
travel, ($500); accrued interest receivable, $200; unrecorded employer's payroll
taxes, ($500); unrecorded interest on mortgage, ($2,400); bill for last year's audit,
($5,000); and probable damage suit judgment, ($50,000).

b. Estimated settlement per dollar of unsecured liabilities:

Estimated amount available for

unsecured creditors $192,600
= $0.914
Total unsecured debt $210,800

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Chapter 20 - Corporations in Finanacial Difficulty

P20-9 Financial Statements for a Firm in Chapter 11 Proceedings

a. Income statement for a company in reorganization proceedings:

Hobbes Company
(Debtor-in-Possession)
Income Statement
For the Year December 31, 20X2

Revenue:
Sales $246,000

Cost and Expenses:

Cost of Goods Sold 170,000
Selling, Operating, and Administrative 50,000
Interest (contractual interest $51,000) 4,000
$224,000
Earnings before Reorganization Items and
Income Taxes $ 22,000

Reorganization Items:
Professional Fees $(15,000)
Interest Earned on Accumulated Cash
Resulting from Chapter 11 Proceeding 3,000
Total Reorganization Items (12,000)

Income before Income Tax and

Discontinued Operations $ 10,000

Income Tax (5,000)

Income before Discontinued Operations $ 5,000

Discontinued Operations:
Operating Loss, Net-of-Tax $(16,000)
Gain on Sale of Assets, Net-of-Tax 9,000
Net Discontinued Operations (7,000)

Net Loss $ (2,000)

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Chapter 20 - Corporations in Finanacial Difficulty

P20-9 (continued)

b. Statement of cash flows for a company in reorganization proceedings:

Hobbes Company
(Debtor-in-Possession)
Statement of Cash Flows
For the Year December 31, 20X2

Cash Flows from Operating Activities:

Cash Received from Customers $ 264,000
Cash Paid to Suppliers and Employees (206,000)
Interest Paid (4,000)
Net Cash Provided by Continuing Operating
Activities before Reorganization Items $ 54,000

Operating Cash Flows from Reorganization Activities:

Professional Fees $ (15,000)
Interest Received on Cash Accumulated Because
of Chapter 11 Proceeding 3,000
Net Cash Used by Reorganization Items $ (12,000)

Operating Cash Flows from Discontinued Operations:

Net Cash Used by Discontinued Operations $ (3,000)

Net Cash Provided by Operating Activities $ 39,000

Cash Flows Provided by Investing Activities:

Proceeds from Sale of Assets Due to
Chapter 11 Proceeding $ 18,000
Net Cash Provided by Investing Activities $ 18,000

Cash Flows Provided by Financing Activities:

Net Borrowings under Short-Term Financing Plan $ 10,000
Principal Payments on Pre-petition Debt
Authorized by Court (Bonds Payable) (10,000)
Net Cash Provided by Financing Activities $ -0-

Net Increase in Cash $ 57,000

Cash at January 1, 20X2 15,000
Cash at December 31, 20X2 $ 72,000

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Chapter 20 - Corporations in Finanacial Difficulty

P20-9 (continued)

c. Balance sheet for a company in reorganization proceedings:

Hobbes Company
(Debtor-in-Possession)
Balance Sheet
December 31, 20X2

Assets
Cash $ 72,000
Accounts Receivable (net) 47,000
Inventory 88,000
Total Current Assets $207,000
Property, Plant, and Equipment (net) 460,000
Total Assets $667,000

Liabilities
Liabilities Not Subject to Compromise:
Current Liabilities (post petition):
Short-Term Borrowings $ 10,000
Accounts Payable - Trade 7,000
Total Liabilities Not Subject to Compromise $ 17,000

Liabilities Subject to Compromise (pre-petition):

Accounts Payable $ 138,000
Notes Payable, 10% 170,000
Bonds Payable, 12% 240,000*
Accrued Interest Payable 47,000
Total Liabilities Subject to Compromise 595,000
Total Liabilities $612,000

Shareholders' Equity
Preferred Stock $ 50,000
Common Stock ($1 par) 50,000
Additional Paid-In Capital 75,000
Retained Earnings (Deficit) (120,000)
Total Shareholders' Equity $ 55,000
Total Liabilities and Shareholders' Equity $667,000

* $10,000 payment approved by the Court, reducing pre-petition bonds payable from
$250,000 to $240,000.

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