Financial reporting under Chapter 11. (includes related articles)by Ratcliffe, Thomas A, and Munter, Paul
Prior to the issuance of SOP 90-7, in November 1990, there existed a diversity of accounting practices related to entities emerging from Chapter 11 reorganization. This problem was confounded by related literature--specifically SFAS 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings." SFAS 15 states that it does not apply to troubled debt restructurings where debtors restate their liabilities generally; rather, it applies to specific debt restructuring transactions. Further, this conclusion was reaffirmed in FASB Technical Bulletin 81-6, "Applicability of Statement 15 to Debtors in Bankruptcy Situations."
While FASB Interpretation 2, "Imputing Interest on Debt Arrangements Made Under the Federal Bankruptcy Act," stated that the conclusions reached in APBO 21, "Interest on Receivables and Payables" applied to bankruptcy cases, Interpretation 2 was superseded by SFAS 15. The result has been confusion for practioners trying to decide whether to follow Interpretation 2 or SFAS 15. Furthermore, there existed no specific guidance related to the restatement of assets for these entities.
SOP 90-7 provides technical guidance to help fill the void in literature related to entities that have filed bankruptcy petitions or where the entities have emerged from Chapter 11 under confirmed plans. The SOP does not apply to debt restructurings outside Chapter 11, nor does it apply to governmental entities or entities that liquidate or adopt liquidation plans under the Bankruptcy Code.
FINANCIAL REPORTING DURING REORGANIZATION
A primary objective of financial reporting for an entity undergoing a reorganization is to reflect the financial evolution of the entity throughout this process. Financial statements for periods including and subsequent to the Chapter 11 filing should clearly distinguish between items, events, and transactions directly associated with the reorganization and those associated with ongoing operations of the entity. According to SOP 90-7, reorganization proceedings do not affect or change the application of GAAP to the preparation of entity financial statements. As a result, during reorganization, an entity in Chapter 11 should apply the principles of historical cost accounting.
Figure 1 illustrates a balance sheet for an entity that filed a Chapter 11 bankruptcy petition. The balance sheet clearly should distinguish pre-petition liabilities subject to compromise from those that are not and identify post-petition liabilities. Pre-petition liabilities are obligations incurred by the entity prior to the filing, including those considered as such by the court. These obligations are considered subject to compromise unless they will not be impaired under the reorganization plan, e.g., when the value of the security interest is greater than the claim. Post-petition liabilities are those incurred subsequent to the bankruptcy filing that are not associated with pre- bankruptcy events.
Liabilities that may be affected by the plan of reorganization should be reported at amounts expected to be allowed, even when ultimately they may be settled for a lower amount. The amount allowed is court- determined and may differ from the actual settlement amount. While it might be argued that pre-petition claims should be reported at their estimated settlement amounts, these claims are required to be reported at allowed amount since they continue to represent the amount of the liabilities until they are settled. Further, use of allowed amounts is consistent with measurement principles used for other pre-petition liabilities and, therefore, comparability is enhanced. Additionally, the conclusion to use allowed amounts is consistent with SFAS 5, "Accounting for Contingencies." Claims not subject to reasonable estimation should also be disclosed and stated in accordance with SFAS 5.
In determining the net carrying amount of debt, debt discounts or premiums as well as debt issue costs should be considered as valuation amounts associated with the debt. When the amount of an allowed claim associated with the debt differs from its carrying amount, the net carrying amount should be adjusted to the allowed amount, including adjustments to premiums or discounts and issue costs. Any gain or loss that results from the adjustment should be reported in "reorganization items" on the statement of income.
Statement of Income
Figure 2 illustrates a statement of income for an entity which has filed a Chapter 11 bankruptcy petition. All income determinants associated with the reorganization and restructuring should be reported separately as "reorganization items," except for those required to be reported under the captions discontinued operations and extraordinary items following APBO 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions."
Prior to SOP 90-7, significant diversity existed related to the accounting for professional fees and similar expenses associated with the reorganization plan. Some entities capitalized these costs and deferred expensing items until the plan was confirmed, and then were applied to reduce the gain on debt adjustments. Others accrued these costs at the filing date while still others expensed these costs as incurred. SOP 90-7 eliminates the inconsistency by requiring that professional fees and similar costs be expensed as incurred. These costs should be reported under the reorganization items caption in the statement of income.
Interest expense is not a reorganization item. It should be reported only to the extent that interest will be paid during the proceeding or that it is probable that it will be either an allowed priority, secured or unsecured claim. To the extent that reported interest differs from contractual interest, the difference should be disclosed; for SEC registrants, this disclosure should be made parenthetically on the face of the statement of income.
To the extent that interest income is earned that would not have been earned without the proceeding, it should be reported as a reorganization item. To the extent that interest can be deemed related to normal invested working capital, it should be reported as a component of operating income.
Statement of Cash Flows
While the FASB stated a preference for the direct approach for reporting operating activities in the statement of cash flows, the alternative indirect approach is much more widely used in practice. However, the direct approach provides cash flow information related to entities in reorganization in a more beneficial way than the alternative indirect approach.
The FASB lists the seven operating items that should be reported separately under the direct approach and encourages further breakdown of these items when it is considered meaningful and feasible. SOP 90-7 requires that cash flows identified as reorganization items be reported separately to the extent feasible.
Figure 3 and 4 illustrate the statement of cash flows for entities where a Chapter 11 bankruptcy petition has been filed. The preferred direct approach, with required supporting schedule, is used in this illustration. If the alternative indirect approach is used, details of operating cash receipts and payments resulting from the reorganization should be disclosed in a supplementary schedule or in the notes to the financial statements.
FINANCIAL REPORTING WHEN ENTITIES EMERGE FROM CHAPTER 11
Entities whose plans of reorganization have been confirmed by the courts should apply the principles discussed herein as of the confirmation date, or as of a later date when all material conditions precedent to the plan have been resolved.
Fresh-start reporting for an entity emerging from Chapter 11 should be used when the reorganization value of the assets of the entity immediately before the confirmation is less than the total of all post- petition liabilities and allowed claims, and when existing voting shareholders immediately before the confirmation receive less than 50% of the voting shares of the emerging entity. The loss of control in these cases should be substantive and not temporary for fresh-start accounting to apply.
During the period the court is determining the adequacy of the disclosure statement of a plan of reorganization, information about reorganization value should be disclosed in the financial statements so that shareholders and creditors can make informed judgments about the plan. Reorganization value most likely should be reported in the pro forma balance sheet that generally is part of the disclosure statement.
The following principles apply in fresh-start accounting. 1. The reorganization value of the entity should be allocated to assets of the entity using the principles enumerated in APBO 16, "Business Combinations," as relates to the purchase method. Any portion of the reorganization value that cannot be attributed to specific tangible and intangible assets should be reported as an intangible asset entitled "reorganization value in excess of amounts allocable to identifiable assets;" this excess should be amortized pursuant to the provisions of APBO 17, "Intangible Assets." 2. Each liability that exists at the plan confirmation date (except deferred taxes) should be reported at the present value of amounts to be paid, discounted using appropriate current interest rates. 3. Deferred tax should be reported under applicable provisions; at this time, the FASB has issued an exposure draft which, if adopted, would supersede SFAS 96. Any tax benefit attributable to pre-confirmation net operating loss carryforwards should first be used to reduce any reorganization value in excess of amounts allocable to specific identifiable assets and any remainder should be reported as a direct addition to paid-in capital. 4. Changes in accounting principles that will be required within the first 12 months of fresh-start accounting should be adopted at the time fresh-start reporting initially is applied.
Notes to the initial financial statements when fresh-start reporting is used should disclose the following: 1. Adjustments made to the historical amounts of individual assets and liabilities.
2. The amount of debt forgiveness.
3. The amount of prior retained earnings or deficit eliminated.
4. Significant matters associated with determining reorganization value (e.g., valuation methods and sensitive assumptions).
Entities Not Using Fresh-Start Reporting
When the criteria for fresh-start accounting are not met, liabilities compromised by confirmed reorganization plans should be reported at the present value of amounts to be paid. Any forgiveness of debt should be reported as an extraordinary item.
Several additional points need to be made concerning entities undergoing a reorganization. First, because SOP 90-7 applies to entities that enter and intend to emerge from Chapter 11 reorganization, quasi-reorganization accounting should not be used at the time of reorganization.
Second, while Chapter 2A of ARB 43, "Restatement and Revision of Accounting Research Bulletins--Form of Statements: Comparative Financial Statements," states that comparable financial statements enhance the usefulness of financial reporting, the Bulletin also requires that comparative financial statements should be comparable from year-to-year. Since fresh-start statements will not be comparable with statements that straddle a confirmation date, comparative statements should not be presented. When SEC, or other regulatory agency, requires the presentation of predecessor financial statements, these statements should not be viewed as a continuum since they are the statements of a different reporting entity and are prepared using a different basis of accounting.
Third, when consolidated financial statements include one or more entities in reorganization with those not in reorganization, condensed combined financial statements should be included for those entities that are in reorganization. The condensed statements should be prepared on the same basis as the consolidated statements. The carrying amounts of any intercompany receivables and payables should be evaluated carefully and disclosed.
And, finally, when earnings per share information is disclosed it should be completed and disclosed in accordance with APBO 15, "Earnings Per Share." When it is probable that additional common stock and/or common stock equivalents will be issued under the reorganization plan, that fact should be disclosed.
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