20

Corporations in financial Difficulty

McGraw-Hill/Irwin

2008 The McGraw-Hill Companies, Inc. All rights reserved.

20-2

Companies in Financial Difficulty

A life cycle exists for businesses as for
individuals. The business press often carries
stories of companies in financial difficulty.
On average, 35,000 businesses file in the U.S.
Bankruptcy Courts each year.
About sixty percent of these are filed under
Chapter 7 as liquidations and the remaining are
filed under Chapter 11 as reorganizations.

20-3

Companies in Financial Difficulty

A company in financial difficulty has a large
number of alternatives, of which bankruptcy
is only a final course.

20-4

Reasons for Financial Difficulty

Companies get into financial difficulty for a large
variety of reasons:

Continued losses from operations

Overextended credit to customers
Poor management of working capital
Inadequate financing
Failure to react to changes in economic
conditions

20-5

Liquidity ProblemsA Vicious Cycle

Failing to make a sufficient level of sales, a
company cannot obtain adequate financing, then
begins to miss debt payments, and the vicious
cycle of financial difficulty is under way.
At this point, outside creditors may decide to
exercise their claims and demand payment of
their receivables.

20-6

Alternative Courses of Action

The debtor company has a number of
alternative courses open to it:
Reach an agreement with its creditors to
postpone required payments.
Turn its assets over to its creditors to liquidate.
Take the legal remedy of bankruptcy.

20-7

Other Reasons for Bankruptcy

A company may petition the courts for
bankruptcy for other reasons, such as to
protect itself from an onslaught of legal suits.
Several companies have also attempted to void
union contracts by petitioning for bankruptcy.
The courts are still defining the exact limits of
bankruptcy, and each case must be decided
individually.

20-8

Courses of Action
Nonjudicial Actions: Formal agreements
between the company and its creditors are
legally binding, but are not administered by
a court. Example: Debt Restructuring.
Judicial Actions: Bankruptcy is a judicial
action administered by bankruptcy courts
and bankruptcy judges provided in the Title 11Bankruptcy, of the United States Code.

20-9

The Bankruptcy Code

The Bankruptcy Code provides for two major
alternatives under the protection of the
bankruptcy court.
These two alternatives are often known by
the chapters of the Bankruptcy Code:
Chapter 11 Reorganization
Chapter 7 Liquidation.

20-10

Chapter 11 Reorganization
Under a Chapter 11 reorganization, the debtor
is provided judicial protection for a rehabilitation
period during which it can eliminate unprofitable
operations, obtain new credit, develop a new
company structure with sustainable operations,
and work out agreements with its creditors.

20-11

Chapter 7 Liquidation
A Chapter 7 liquidation is often administered
by a trustee appointed by the court.
Under a Chapter 7 liquidation, the debtors
assets are sold and its liabilities extinguished
as the business is liquidated.

20-12

Reorganization versus Liquidation

The major difference between a reorganization
and a liquidation is that the debtor continues as
a business after a reorganization, whereas the
business does not survive a liquidation.

20-13

Creditor Accounting for Impaired Loans

FASB 114 presents the creditors accounting
and disclosure standards for impaired loans,
including notes receivable.
A loan is defined as being impaired when it is
probable that the creditor will not be able to
collect all amounts due under the loan
agreement.

20-14

Measurement of Impaired Loans

If the loan is collateral-dependent, that is, the
creditor determines that foreclosure is probable,
the loan value should be measured by using the
fair value of the collateral.
Otherwise, impaired loans are measured based
on the present value of expected future cash
flows, discounted at the loans effective interest
rate at the point of origination of the loan.

20-15

Chapter 11 Reorganization
Chapter 11 of the of the Bankruptcy Code allows
for legal protection from creditors actions during
a time needed to reorganize the debtor company
and return its operations to a profitable level.
Reorganizations are administered by the
bankruptcy court, and trustees are often
appointed by the court to direct the
reorganization.

20-16

Chapter 11 Reorganization
A company in financial distress petitions the
bankruptcy court for protection form its creditors.
If granted protection, the company receives an
order of relief to suspend making any payments
on its prepetition debt.
The company continues to operate while it
prepares a plan of reorganization, which serves as
an operating guide during the reorganization.
The proceeding includes the actions that take
place from the time the petition is filed until the
company completes the reorganization.

20-17

Plan of Reorganization
Most reorganization plans include detailed
discussions of the following:
Disposing of unprofitable operations.
Restructuring of debt with specific creditors.
Revaluation of assets and liabilities.
Reductions or eliminations of claims of
original stockholders and issuance of new
shares to creditors or others.

20-18

Unsuccessful Reorganizations
The major reason for unsuccessful
reorganizations is continuing losses from
operations and no reasonable likelihood of
rehabilitation.
Another common reason is the inability to
consummate a reorganization plan because
of the failure to dispose of an unprofitable
subsidiary. The debtor company then moves
from reorganization into liquidation.

20-19

Chapter 7 Liquidations
Liquidations are administered by the bankruptcy
courts.
The intent in liquidation is to maximize the net
dollar amount recovered from disposal of the
debtors assets.
Bankruptcy courts appoint accountants, attorneys,
or experienced business managers as trustees to
administer the liquidation.
The liquidation process is often completed within
6 to 12 months, during which the trustees must
make periodic reports to the bankruptcy court.

20-20

Classes of Creditors
A very important aspect of liquidation is
determining the legal rights of each creditor
and establishing priorities for those rights.
The Bankruptcy Code specifies three classes of
creditors, whose claims have the following
priorities: (1) secured creditors, (2) creditors with
priority, and (3) unsecured creditors.
The priority of claims determines the order
and source of payment to each creditor.

20-21

Secured Creditors
Secured creditors have liens, or security
interests, on specific assets, often called
collateral.
A creditor with such a legal interest in a
specific asset has the highest priority claim
on that asset. For example, a mortgage
payable is secured by the companys land
and plant.

20-22

Summary--Creditors with Priority

Costs of administering the bankruptcy, including
accounting and legal costs for experts appointed
by the bankruptcy court.
Liabilities arising in the ordinary course of
business during the bankruptcy proceedings.
Certain wages, salaries, or commissions. (limited to
$10,000 per employee in the last 180 days)
Certain contributions to employee benefit plans. (limited
to the same $10,000 as above)
Certain deposits of customers. (Limited to the first
$1,800 per individual)
Unsecured tax claims of government units. (Property,
income, excise, etc.)

20-23

General Unsecured Creditors

The lowest priority is given to claims by general
unsecured creditors.
These creditors are paid only after secured
creditors and unsecured creditors with priority
are satisfied to the extent of any legal limits.
Often, the general unsecured creditors receive
less than the full amount of their claim.

20-24

Statement of Affairs
The accounting 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.

20-25

Statement of Affairs
The statement of affairs presents the balance
sheet accounts in order of priority for liquidation.
The statement of affairs presents estimated
current fair values and expected gains or losses
on the disposal of the assets.

20-26

Trustee Accounting and Reporting

Bankruptcy courts appoint trustees to manage a
company under Chapter 11 reorganizations in
cases of management fraud, dishonesty,
incompetence, or gross mismanagement. The
trustee then attempts to rehabilitate the
business.

20-27

Trustee Accounting and Reporting

In Chapter 7 liquidations, the trustee normally
has the responsibility to expeditiously liquidate
the bankrupt company and pay creditors in
conformity with the legal status of their secured
or unsecured interests.

20-28

Receivership
Sometimes the trustee receives title to all assets
as a receivership, becomes responsible for the
actual management of the debtor, and must
direct a plan of reorganization or liquidation.
A trustee who takes title to the debtors assets in
a liquidation must make periodic financial
reports to the bankruptcy court, reporting on the
progress of the liquidation and on the fiduciary
relationship held.

20-29

Statement of Realization and Liquidation

A monthly report, called a statement of
realization and liquidation, is prepared for the
bankruptcy court. It shows the results of the
trustees fiduciary actions beginning at the point
the trustee accepts the debtors assets.
The statement has three major sections:
Assets
Supplementary items
Liabilities

20-30

Statement of Realization and Liquidation

The statement presents the assets transferred to
the trustee, the additional assets acquired by the
trustee, and the ending balance of unrealized
assets still to be converted into cash.
The statement also reports on the debtors
liabilities discharged by the trustee as well as the
additional liabilities incurred by the trustee.
Supplementary charges include the trustees
administration fees and any cash expenses paid
by the trustee. Supplementary credits may
include any unusual revenue items.