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 debts of over $10,775) 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 $10,775.
5. The granting of an order for relief halts all actions against an insolvent company. The order for relief provides the company as well as the creditors with the time to decide on a future course of action. It also brings the court into the process to provide a structure for what might otherwise be a chaotic event, the distribution of assets to the parties involved.
6. A fully secured creditor has an obligation from an insolvent company but holds a collateral interest in assets that have a value in excess of the debt. Thus, these parties can assume that they will suffer no loss regardless of the outcome of the bankruptcy proceedings. A partially secured creditor also has a collateral 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 still exists in connection with the remaining debt. Unsecured creditors have no collateral interest and can only hope to collect 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 still 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 are as follows:
—Claims for administrative expenses,—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 90 days preceding the filing of a
bankruptcy petition (limited to $4,300 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 $1,950 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.
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 will allow 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 since their claims rank below fully secured and partially secured liabilities. Because of this risk, unsecured creditors may feel that they have a better chance of limiting their losses by agreeing to a reorganization plan.
11. The statement of financial affairs reports all assets of the insolvent company at net realizable value whereas liabilities are classified as fully secured, partially secured, with priority, and unsecured. Based on the cash proceeds being anticipated, an estimation can be made of the losses that will 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 process. A number of rather procedural tasks are normally 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 may have to operate the company for a period of time to complete any business still 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 controlled solely by the trustee.
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) current 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 usually be continued so that an attempt can be made to arrive at a plan to save the company. While
the bankruptcy proceeds, control is normally retained by the ownership, a group legally referred to as a debtor in possession.
16. In a Chapter 11 bankruptcy, the debtor in possession (the 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.
17. Numerous types of proposals are to be found in reorganization plans. For example, many will set forth specific ideas for changes to be made in the company's operations (to increase profitability) such as selling 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 spelled out in an attempt to persuade claimants that the company will 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 well as the court) must be convinced that the financial rewards will outweigh the amounts that could be received from a liquidation.
18. To become effective, a reorganization plan must be accepted by all interested parties. For approval, each class of creditors (more than two-thirds in dollar 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 will then confirm the reorganization plan but only if all 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 reduced amount whereas others will probably be satisfied entirely. Unsecured and partially secured liabilities are likely to be settled at an amount below face value. Conversely, fully secured liabilities and any debts incurred during the reorganization period are normally not at risk of being reduced. Thus, if a balance sheet is produced while a company is in reorganization, all liabilities are reported as either subject to compromise or not subject to compromise. The debts subject to compromise are reported at the expected amount of allowed claims rather than at an estimation of the settlement figure.
21. A company going through a Chapter 11 bankruptcy will report specified reorganization items on its income statement separately from operating figures. These reorganization items are reported prior to income tax expense rather than in a manner similar to an extraordinary item. These separately reported figures include gains and losses on the sale of assets necessitated by the reorganization. Professional fees incurred in connection with the reorganization are reported in a similar manner. Any interest revenue that would not have been earned except for the bankruptcy proceeding is also reported as a reorganization item.
22. Professional fees incurred during a reorganization must be expensed as incurred.
23. Fresh start accounting refers to the adjustment of a company's assets and liabilities 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 market value of the assets is less than the total allowed 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, all assets and liabilities are reported at current value. If the reorganization value of the company’s assets is greater than the total value of the individual assets, an intangible asset somewhat like goodwill must be established. Retained earnings must be zero.
24. Fresh start accounting is used by companies emerging from a bankruptcy reorganization if the value of the assets held at that time are less than the allowed claims associated with 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 current 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 must be determined. The figure is normally computed by discounting anticipated future cash flows from the business. This figure is then assigned to the various assets of the company. The total value may well be greater than the current value of the individual assets. If so, the residual amount is recorded as an intangible asset with a title such as "reorganization value in excess of amounts allocable to identifiable assets." This asset is amortized to expense over a period of up to 40 years although a shorter period is highly encouraged.
22.(10 Minutes) (Distribution of cash in a liquidation)
Free Assets:Current Assets ........................................................... $ 35,000Buildings and Equipment ......................................... 110,000
Total ..................................................................... $145,000
Liabilities with Priority:Administrative Expenses .......................................... $ 20,000Salary Payable (only $3,000 per employee)............. 6,000Income Taxes ............................................................. 8,000
Total ..................................................................... $ 34,000
Free Assets After Payment of Liabilities with Priority($145,000 - $34,000) .................................................. $111,000
Unsecured LiabilitiesNotes Payable (in excess of value of security) ...... $ 30,000Accounts Payable ..................................................... 85,000Bonds 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) ............................................ $ 90,00060% of Remaining $30,000 ....................................... 18,000Total Collected ........................................................... $108,000
23.(5 Minutes) (Distribution of assets in a liquidation) .
Liabilities with Priority
Paid first – administrative expense................................ $3,000Paid second – wages up to a maximum of
$4,300 each ................................................................ 8,600Remaining money – government claims to unpaid taxes 400
Total of free assets..................................................... $12,000
The remainder of the salaries and the government claims and all of the unsecured accounts payable will not result in any amount distributed from the liquidation of the Xavier company since no money is left.
24. (8 Minutes) (Distribution of assets to partially secured creditors)
Free Assets:Other Assets .............................................................. $ 80,000Excess from Assets Pledged with fully Secured Creditors
Total ..................................................................... $200,000
Percentage of Unsecured Liabilities to be Paid: $40,000/$200,000 = 20%
Payment on Bond:Value of Pledged Asset.............................................. $130,00020% of Remaining $20,000........................................ 4,000
Total to be Received............................................. $134,000
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 ...................................................... $230,000Excess Liability of Debt One in Excess of Pledged Asset
($210,000 - $180,000) ................................................. 30,000Excess Liability of Debt Two in Excess of Pledged Asset
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.
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 ........................................................... $350,000Liabilities with Priority ................................................... (160,000)
Available for Unsecured Creditors .......................... $190,000
Accounts Payable ........................................................... $390,000Excess of Partially Secured Debt in Excess of PledgedAssets ($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.
Note Payable A (in excess of value of security) ..... $ 20,000Note Payable B (in excess of value of security) ..... 80,000Note Payable C .......................................................... 60,000Accounts Payable ..................................................... 120,000
Total ..................................................................... $280,000Percentage of Unsecured Liabilities To Be Paid: $70,000/$280,000 = 25%
Payment on Note Payable A:Value of Security (land) .................................................. $ 70,00025% of Remaining $20,000 ............................................. 5,000
Total Collected ........................................................... $ 75,000Payment on Note Payable B:Value of Security (building) ........................................... $ 40,00025% of Remaining $80,000 ............................................. 20,000
Total Collected ........................................................... $ 60,000Payment on Note Payable C (unsecured):25% of $60,000 ................................................................ $ 15,000Payment on Administrative Expenses:As a liability with priority, the entire $20,000 is paid.Payment on Accounts Payable (unsecured):25% of $120,000 .............................................................. $ 30,000Payment on Income Taxes Payable:As a liability with priority, the entire $30,000 is paid.
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...................................................... $180,000Note payable A – unsecured portion........................ 10,000Note payable B .......................................................... 250,000
Total ..................................................................... $440,000
Free Assets (except for equipment):Cash ........................................................................... $24,000Accounts receivable.................................................. 28,000Inventory..................................................................... 56,000Land (value does not cover related debt)................ —0—Buildings ($320,000 less coverage of $300,000
in bonds)................................................................ 20,000Total ..................................................................... $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).
Percentage of unsecured liabilities to be paid: $84,000/$210,000 = 40%
Amounts to be collected:Salary payable (liability with priority to be paid
in full)..................................................................... $10,000Accounts payable (unsecured – will collect 40%
of debts of $90,000).............................................. $36,000Note payable (fully secured by land – will collect
entire balance)...................................................... $110,000Bonds 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.
32.(9 Minutes) (Adjusting a company coming out of reorganization to fresh start accounting)
The assets of this company have a fair market value of $700,000 but the reorganization value of $760,000. Thus, an intangible asset 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, stockholder’s 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) .................................... 10,000Inventory ($210,000 - $200,000)...................................... 10,000Buildings ($400,000 - $300,000)...................................... 100,000Reorganization value in excess of amount
allocated to identifiable assets................................. 60,000Retained Earnings (eliminate deficit).................. 70,000Additional Paid-in Capital
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 market 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 in an intangible asset account with a title such as "reorganization value in excess of amounts allocable to identifiable assets."
c. The reorganization value account is an intangible asset that should be amortized to expense over a period of up to 40 years. SOP 90-7 suggests using a life substantially less than 40 years.
36.(40 Minutes) (Prepare journal entries for company emerging from bankruptcy using fresh start accounting)
Preliminary computations:BOOK VALUES PRIOR TO EMERGING FROM REORGANIZATION—Total assets at book value = $710,000 ($100,000 + $112,000 + $420,000 +
$78,000)—Total liabilities at book value = $800,000 ($80,000 + $35,000 + $100,000 +
$200,000 + $185,000 + $200,000)—Total common stock = $240,000 (given) —Deficit = $330,000 (given)—Since the above accounts balance, no additional paid-in capital must exist at
this time.
BOOK VALUES AFTER EMERGING FROM REORGANIZATION—Total assets = $780,000 (reorganization value)—Total liabilities = $340,000 ($5,000 + $4,000 + $100,000 + $50,000 + $71,000 +
$110,000)—Total common stock = $240,000 (returned shares are reissued)—Deficit = -0- (eliminated by the reorganization)—Additional paid-in capital = $200,000 (figure needed to balance above accounts
after reorganization)—Because the company will have 30,000 shares outstanding after the
reorganization, the additional paid-in capital equals $6.66 per share.—Because the company has a reorganization value of $780,000 but the assets
have a market value of only $735,000, an account entitled Reorganization Value In Excess of Amount Allocable to Identifiable Assets must be established for $45,000
JOURNAL ENTRIES—Land and buildings ..................................................... 80,000
Reorganization value in excess of amount allocable toidentifiable assets ................................................ 45,000
—Accounts payable ....................................................... 80,000Note payable ......................................................... 5,000Common stock ($8 per share par value) ............ 8,000Additional paid-in capital ($6.66 per share—see
above, or 1/30 of company total) .................. 6,666Gain on debt discharge ....................................... 60,334
—Note payable ............................................................... 200,000Note payable ......................................................... 50,000Common stock ($8 per share par value) ............ 80,000Additional paid-in capital ($6.66 per share—see
above, or 1/3 of company total) .................... 66,667Gain on debt discharge ....................................... 3,333
To record settlement of note payable due in 2004.
—Note payable ................................................................ 185,000Note payable ......................................................... 71,000Common stock ($8 per share par value) ............ 56,000Additional paid-in capital ($6.66 per share—see
above, or 7/30 of company total) .................. 46,667Gain on debt discharge ....................................... 11,333
—Additional paid-in capital ($334,000 - $200,000) ...... 134,000Gain on debt discharge ........................................... 196,000
Retained earnings (deficit) .................................. 330,000To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.
37.(25 Minutes) (Prepare a balance sheet for a company emerging from bankruptcy reorganization)
a. Smith Corporation must apply fresh start accounting because it meets both requirements established by SOP 90-7:
The reorganization value of $800,000 of the company is less than the allowed claims of $730,000 ($180,000 + $200,000 + $350,000) plus the liabilities incurred following the order for relief of $97,000.
The original owners are left with less than 50 percent (40 percent actually) of the voting stock.
b. Since the company has a reorganization value of $800,000 but only $653,000 can be assigned to specific assets based on market value, the remaining $147,000 is reported as a Reorganization Value in Excess of Amount Allocable to Identifiable Assets.
SMITH CORPORATIONBalance Sheet
December 31, 2001ASSETS
Current Assets:Accounts receivable ................................................. $ 18,000Inventory .................................................................... 111,000 $129,000
Land, Buildings, and Equipment:Land and buildings ................................................... 278,000Machinery ................................................................... 121,000 399,000
Intangible Assets:Patents........................................................................ 125,000Reorganization value in excess of amountallocable to identifiable assets ................................ 147,000 272,000
Total Assets .......................................................... $800,000
LIABILITIES AND STOCKHOLDERS' EQUITYCurrent Liabilities:
Percentage of unsecured debts to be paid: $90,000/$360,000 = 25%—Liabilities with priority collect the entire amount of $36,000—Fully secured liabilities collect the entire amount of $200,000—Partially secured liabilities collect $103,000 from the pledged assets and 25%
of the remaining $77,000 ($19,250) for a total of $122,250.—Unsecured liabilities collect 25% of the $283,000 balance or $70,750.
Total ........................................................................................... $ 38,000Free Assets After Payment of Liabilities With Priority
Notes Payable (in excess of value of buildings) ......................... $ 10,000Bonds Payable (in excess of value of equipment) ...................... 80,000Accounts Payable ........................................................................... 70,000
Total ........................................................................................... $160,000Percentage of Unsecured Liabilities To Be Paid: $32,000/$160,000 = 20%Payment on $65,000 notes payable secured by land will be made in total since the value of the land is greater than the debt.Payment on Notes Payable (secured by buildings):Value of Security (building) ................................................................. $ 68,00020% of Remaining $10,000 .................................................................. 2,000
Total Collected ................................................................................ $ 70,000Payment on Bonds Payable:Value of Security (equipment) ............................................................ $ 35,00020% of Remaining $80,000 .................................................................. 16,000
Total Collected ................................................................................ $ 51,000Payment on Accounts Payable (unsecured):20% of $70,000 ..................................................................................... $ 14,000Payment of Salary Payable:As a liability with priority, the entire $6,000 is paid.Payment of Taxes Payable:As a liability with priority, the entire $10,000 is paid.Payment of Administrative Expenses:As a liability with priority, the entire $22,000 is paid.
41.(20 Minutes) (Reporting of a reorganization and a liquidation)
a. Since the land's net realized value is less than the amount of the note payable, the debt will be reported on a statement of financial affairs as a liability owed to "partially secured creditors." The $80,000 obligation Is disclosed In this manner and then reduced by the $48,000 anticipated cash proceeds. The remaining $32,000 balance will be shown by Anteium as an unsecured nonpriority liability.
The land is still reported as an asset, one pledged with partially secured creditors. The $31,000 cost is revealed within the statement of financial affairs although this information is not considered relevant in a liquidation. The $48,000 net realizable value is reported but is offset by the $80,000 liability; thus, no cash will be available to unsecured creditors unless a greater amount is generated by the sale.
b. Fresh start accounting must be used because the reorganization value is less than the debts and the original owners are left with less than 50 percent of the voting stock.
After the reorganization, the assets will be reported at $82,000 with one $5,000 debt. Since the common stock has a total par value of $40,000, additional paid-in capital must be $37,000.
— Land ........................................................................... 17,000Investments ............................................................... 5,000Reorganization value in excess of amounts assigned
to identifiable assets ........................................... 9,000Additional paid-in capital .................................... 31,000
To adjust asset values to fair market value (a total of $73,000) with a reorganization value account established to bring the total up to $82,000.
— Note payable .............................................................. 80,000Additional paid-in capital (60% of company total) 22,200Gain on discharge of debt .................................. 57,800
To record issuance of stock to bank in settlement ofdebt.
— Accounts payable ...................................................... 20,000Note payable ......................................................... 5,000Gain on discharge of debt .................................. 15,000
To record settlement of accounts payable for 3-year note.
— Gain on discharge of debt ........................................ 72,800
Additional paid-in capital ......................................... 16,200Retained earnings (deficit) .................................. 89,000
To reduce additional paid-in capital balance to correct figure, to close out gain account, and to eliminate deficit as a step in establishing fresh start accounting.
c. The bank will collect a total of $59,000. Obviously, the $50,000 proceeds generated by the land sale must go to the bank with the remaining $30,000 obligation then being ranked as an unsecured-nonpriority liability. Anteium (the insolvent company) will have $15,000 of the $26,000 cash left after paying the $11,000 administrative expenses. Unsecured debts total $50,000 ($30,000 from the note and $20,000 of accounts payable). Thus, 30% of these debts will be paid ($15,000/$50,000). The bank collects an additional $9,000 ($30,000 x 30%); the accounts payable collect $6,000 ($20,000 x 30%).
Balances, 8/8/01 $ 16,000 $763,000 -0- $259,000 $132,000 $150,000 $238,000Investments sold 39,000 (32,000) 7,000Inventory sold 48,000 (69,000) (21,000)Payment is made on note from proceeds of auction (48,000) (48,000)Remaining debt is reclassified (84,000) 84,000Administrative expenses incurred $15,000 (15,000)Land and buildings all sold 315,000 (370,000) (55,000)Payment is made on note from
proceeds of sale (259,000) (259,000)Reclassify liabilities with priority 34,000 (34,000)Equipment sold 84,000 (210,000) (126,000)Receivables collected 34,000 (82,000) (48,000)Administrative expenses paid (15,000 ) (15,000 ) Final balances remaining for unsecured creditors $214,000 - 0 - $34,000 - 0 - - 0 - $200,000 $(20,000 )
b. Total amount available to payliabilities with priority andunsecured creditors (see part a) $214,000
Less: liabilities with priority (34,000 ) Available for unsecured creditors $180,000Percentage of claim to be received by each unsecured creditor ($180,000/$200,000) 90%
43.(40 Minutes) (Prepare journal entries for company emerging from bankruptcy using fresh start accounting)
Company must use fresh start accounting because the reorganization value of $650,000 is less than the company's allowed debts and the original owners hold less than 50 percent of the voting stock after the reorganization.
BOOK VALUES AFTER EMERGING FROM REORGANIZATION—Total assets = $637,000 (reorganization value of $650,000 plus proceeds from
sale of stock of $77,000 less $90,000 value of land and investments used to settle two debts)
—Total liabilities = $350,000 ($130,000 + $40,000 + $180,000)—Total common stock = $160,000 (10,000 additional shares are issued with a
$10 per share par value so that total outstanding shares = 16,000)—Deficit = -0- (eliminated by the reorganization)—Additional paid-in capital = $127,000 (figure needed to balance above
accounts after reorganization)—Because the company has a reorganization value of $650,000 but the assets
have a market value of only $623,000, an account entitled Reorganization Value in Excess of Amount Allocable to Identifiable Assets must be established for $27,000.
Land ............................................................................. 23,000Buildings ..................................................................... 52,000Reorganization value in excess of amount allocable to
—Notes payable - current .............................................. 220,000Cash ......................................................................... 40,000Notes payable (due in 2005) .................................. 130,000Gain on discharge of debt ..................................... 50,000
To record settlement of current notes.
—Accounts payable ....................................................... 129,000Notes payable (due in 2002) .................................. 40,000Gain on discharge of debt ..................................... 89,000
To record settlement of accounts payable.
—Notes payable (due in 2004) ....................................... 325,000Land ......................................................................... 50,000Notes payable (due in 2004) .................................. 180,000Common stock ($10 par value) ............................. 30,000Additional paid-in capital
(3/16 of total computed above) ........................... 23,813Gain on discharge of debt ..................................... 41,187
To record settlement of long-term debt.
—Gain on debt discharge .............................................. 180,187Additional paid-in capital ($127,000 - $79,813) .... 47,187Retained earnings (deficit) .................................... 133,000
To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.
b. According to the statement of financial affairs prepared above, $3,000 cash should be available for unsecured nonpriority creditors. Unfortunately, $50,000 in unsecured nonpriority liabilities exist. Thus, only 6% of these claims will be covered ($3,000/$50,000).
Cash of $11,240 will be paid on the note payable that is secured by plot B. The land is to be sold for $11,000 leaving a $4,000 unsecured debt. Since 6% of this amount is expected to be paid, the holder will only receive an additional $240.
c. As Indicated in part b, only 6% of the unsecured nonpriority claims can be satisfied. Thus, just $1,500 will be paid on the unsecured $25,000 note payable.
d. Selling plot D for $30,000 rather than $27,000 generates an additional $3,000 in available cash. The statement of financial affairs produced above would then report $6,000 as the amount available for unsecured nonpriority claims or 12% of the total ($6,000/$50,000). After plot B is sold for $11,000, the remaining $4,000 of this note is classified as an unsecured nonpriority liability. Since 12% of this amount is to be paid, an additional $480 is transferred to the holder of the note for a total of $11,480.
Book balances, 8/8/01Answer to Problem 45 $ 1,000 $194,000 $6,000 $70,000 $150,000 $ 37,000 $(68,000)
Accounts receivable collected--remaining balance assumedto be uncollectible 18,000 (25,000) (7,000)
Inventory sold 40,000 (100,000) (60,000)Accounts payable discovered 10,000 (10,000)Land and buildings all sold 71,000 (40,000) 31,000Fully secured note paid (70,000) (70,000)Equipment sold 11,000 (14,000) (3,000)Payment made on partially
b. The statement of realization and liquidation prepared in (a) indicates that $81,000 in cash remains. However, $26,000 of this amount must be distributed to the liabilities with priority leaving only $55,000 for the unsecured nonpriority creditors. Since these unsecured liabilities amount to $186,000, only 30% (rounded) ($55,000/$186,000) of each debt will be paid. Thus, a creditor holding a $1,000 claim will receive approximately $300.
47.(30 Minutes) (Prepare Journal entries for company emerging from bankruptcy using fresh start accounting)
The Holmes Corporation must use fresh start accounting because the reorganization value of $225,000 is less than the company's allowed debts and the original owners hold less than 50 percent of the voting stock after the reorganization.
BOOK VALUES AFTER EMERGING FROM REORGANIZATION—Total assets = $248,200 ($225,000 reorganization value plus proceeds of
sale of stock of $36,000 less $12,800 payment made to settle unsecured liabilities [20 percent of $64,000])
—Total liabilities = $118,000 ($18,000 + $70,000 + $30,000)—Total common stock = $105,000 (11,000 additional shares are issued with a
$5 per share par value - total outstanding shared = 21,000)—Deficit = -0- (eliminated by the reorganization)—Additional paid-in capital = $25,200 (figure needed to balance above
accounts after reorganization)
JOURNAL ENTRIES—Reorganization value in excess of amount allocable
to identifiable assets ................................................. 15,000Additional paid-in capital .................................... 15,000
To adjust to total reorganization value as part of freshstart accounting ($225,000 - $210,000).
—Salary payable ............................................................. 18,000Note payable—1 year ................................................ 18,000
To record note issued for accrued salaries.
—Notes payable .............................................................. 140,000Note payable—6 years .............................................. 30,000Common stock ($5 par value) .................................. 25,000Additional paid-in capital
(5/21 of total computed above) ........................... 6,000Gain on discharge of debt ........................................ 79,000
To record settlement of partially secured debt.
—Cash ............................................................................. 36,000Common stock ($5 par value) .................................. 30,000Additional paid-in capital ......................................... 6,000
Cash ................................................................ 12,800Gain on discharge of debt .................................. 51,200
To record payment of unsecured debts—20% paymentmade.
— Gain on debt discharge ............................................ 130,200 Additional paid-in capital ($27,000 - $25,200) ......... 1,800
Retained earnings (deficit) .................................. 132,000To adjust additional paid-in capital to appropriate balance, close out gain, and eliminate deficit balance as part of fresh start accounting.
