Chapter 39
Bankruptcy
39.2 Alternatives Available to Troubled Companies
(b) Assignment for Benefit of Creditors
(c) Bankruptcy Court Proceedings
(iii) Chapter 12—Adjustment of Debt of a Family Farmer with Regular Annual Income
(iv) Prepackaged/Prenegotiated Chapter 11 Plans
(d) Accountant's Services in Proceedings
39.3 General Provisions of Bankruptcy Code
(b) Timing of Petition—Tax Considerations
(c) Accounting Services—Data Required in the Petition
(d) Adequate Protection and Automatic Stay
(ii) Accounting Services—Determining Equity in Property
(e) Executory Contracts and Leases
(i) Limitations on Executory Contracts
(ii) Accounting Services—Rejection of Executory Contracts
(i) Exceptions to Preferential Transfers
(ii) Accounting Services—Search for Preferential Payments
(i) Leveraged Buyout as a Fraudulent Transfer
(ii) Accounting Services—Search for Fraudulent Transfers
(ii) Accounting Services—Preventing Unauthorized Transfers
(ii) Accounting Services—Setoffs
39.4 Handling of Claims Under Chapter 11
39.5 Operating Under Chapter 11
(ii) Accounting Services—Assisting Debtor in Providing Information to Secured Lender
(i) Definition of Adequate Information
(f) Accounting Services—Assistance to Debtor
(i) Liquidation Value of Assets
(ii) Projections of Future Operations
(g) Accounting Services—Assistance to Creditors' Committee
(i) Assistance in the Bargaining Process
(ii) Evaluation of Debtor's Projections
(iv) Review of Plan and Disclosure Statement
(h) Accounting for the Reorganization
(i) Requirements for Fresh Start Reporting
(ii) Allocation of Reorganization Value
(iv) Reporting by Debtors Not Qualifying for Fresh Start
(i) Accounting for the Impairment of Long-Lived Assets Under Chapter 11
39.7 Reporting Requirements in Bankruptcy Cases
39.8 Sources and Suggested References
This chapter contains a brief description of the Bankruptcy Code, a discussion of the services that can be rendered by the accountant, and an introduction to the problems faced by accountants working in the bankruptcy area.
The debtor's first alternatives to resolve the debtor's financial problems are to locate new financing, to merge with another company, or to find some other basic solution to its situation that avoids the necessity of discussing its problems with representatives of creditors. If none of these alternatives is possible, the debtor may be required to seek a remedy from creditors, either informally (out of court) or with the help of judicial proceedings.
The debtor may request a meeting with a few of the largest creditors and one or two representatives of the small claimants to effect an informal agreement. The function of such a committee may be merely to investigate, consult, and give advice to the debtor, or it may involve actual supervision of the business or liquidation of the assets. An informal settlement usually involves an extension of time (a moratorium), a pro rata settlement (composition), or a combination of the two. The details of the plan are worked out between the debtor and creditors, the latter perhaps represented by a committee. Such extralegal proceedings are most successful when there are only a few creditors, adequate accounting records have been kept, and past relationships have been amicable. The chief disadvantage of this remedy is that there is no power to bind those creditors who do not agree to the plan of settlement.
A remedy available under state law to a corporation in serious financial difficulties is an assignment for the benefit of creditors. In this instance, the debtor voluntarily transfers title to its assets to an assignee, which then liquidates them and distributes the proceeds among the creditors. Assignment for the benefit of creditors is an extreme remedy because it results in the cessation of the business. This informal liquidation device (although court-supervised in many states) is like the out-of-court settlement devised to rehabilitate the debtor, in that it requires the consent of all creditors or at least their agreement to refrain from taking action. The appointment of a custodian over the assets of the debtor gives creditors the right to file an involuntary bankruptcy court petition.
Proceedings brought in the federal courts are governed by the Bankruptcy Code. Normally it is necessary to resort to such formality when suits have been filed against the debtor and its property is under garnishment or attachment or is threatened by foreclosure or eviction.
Bankruptcy court proceedings are generally the last resort for the debtor whose financial condition has deteriorated to the point where it is impossible to acquire additional funds. When the debtor finally agrees that bankruptcy court proceedings are necessary, the liquidation value of the assets often represents only a small fraction of the debtor's total liabilities. If the business is liquidated, the creditors get only a small percentage of their claims. The debtor is discharged of its debts and is free to start over; however, the business is lost and so are all the assets. Normally, liquidation proceedings result in large losses to the debtor, the creditors, and the business community in general. Chapter 7 of the Bankruptcy Code covers the proceedings related to liquidation. Another alternative under the Bankruptcy Code is to seek some type of relief so that the debtor, with the help of the bankruptcy court, can work out agreements with creditors and be able to continue operations. Chapters 11, 12, and 13 of the Bankruptcy Code provide for this type of operation.
Title 11 U.S. Code contains the bankruptcy law. The Code is divided into nine chapters:
Chapter 1 | General Provisions |
Chapter 3 | Case Administration |
Chapter 5 | Creditors, the Debtor, and the Estate |
Chapter 7 | Liquidation |
Chapter 9 | Adjustment of Debts of a Municipality |
Chapter 11 | Reorganization |
Chapter 12 | Adjustment of Debts of a Family Farmer with Regular Income |
Chapter 13 | Adjustment of Debts of an Individual with Regular Income |
Chapter 15 | Ancillary and Other Cross-Border Cases |
Chapters 1, 3, and 5 apply to all proceedings under the Code except Chapter 9, where only specified sections of Chapters 1, 3, and 5 apply. A case commenced under the Bankruptcy Code—Chapters 7, 9, 11, 12, or 13—is referred to as a Title 11 case. Chapter 13, which covers the adjustment of debts of individuals with regular income, is beyond the scope of this presentation because it can be used only by individuals with unsecured claims of less than $360,475 (through March 31, 2013) and secured claims of less than $1,081,400 (through March 31, 2013). The dollar amount of the debt limits for a Chapter 13 petition (as well as dollar amounts for other purposes) are to be increased to reflect the change in the Consumer Price Index for All Urban Consumers on April 1 every third year. The amounts are to be rounded to the nearest $25 multiple. The next three-year-period adjustment will be made on April 1, 2013. Provisions relating to Chapter 11 are discussed in detail in a separate section.
Chapter 15 was added by the 2005 Act to provide effective mechanisms for relief to foreign debtors in the United States. Chapter 15 encourages fair and efficient administration of cross-border insolvencies protecting the interests of both creditors and debtors as well as other interested entities.
Chapter 7 is used only when the corporation sees no hope of being able to operate successfully or to obtain the necessary creditor agreement. Under this alternative, the corporation is liquidated and the remaining assets are distributed to creditors after administrative expenses have been paid. An individual debtor may be discharged from liabilities and entitled to a fresh start. A corporation's debt is not discharged.
The decision as to whether rehabilitation or liquidation is best also depends on the amount that can be realized from each alternative. The method resulting in the greatest return to the creditors and stockholders should be chosen. The amount received from liquidation depends on the resale value of the firm's assets minus the costs of dismantling and legal expenses. The value of the firm after rehabilitation must be determined (net of the costs of achieving the remedy). The alternative leading to the highest value should be followed.
Financially troubled debtors often attempt an informal settlement or liquidation out of court; if it is unsuccessful, they will then initiate proceedings under the Bankruptcy Code. Other debtors, especially those with a large number of creditors, may file a petition for relief in the bankruptcy court as soon as they recognize that continuation of the business under existing conditions is impossible.
As soon as the order for relief has been entered, the U.S. trustee appoints a disinterested party from a panel of private trustees to serve as the interim trustee. The functions and powers of the interim trustee are the same as those of an elected trustee. Once an interim trustee has been appointed, the creditors meet to elect a trustee that will be responsible for liquidating the business. If a trustee is not elected by the creditors, the interim trustee may continue to serve in the capacity of the trustee and carry through with an orderly liquidation of the business.
The objective of the trustee is to liquidate the assets of the estate in an orderly manner. Once the property of the estate has been reduced to money and the security claims have been satisfied to the extent allowed, then the property of the estate is distributed to the holders of the claims in the order specified by the Bankruptcy Code. The first order, of course, is priority claims; when they have been established, the balance goes to unsecured creditors. After all the funds have been distributed, the remaining debts of an individual are discharged. As mentioned earlier, if the debtor is a corporation, the debts are not discharged. Thus it is necessary for the corporation to cease existence. Any funds subsequently coming into the corporate shell would be subject to attachment.
To help farmers resolve some of their financial problems, Congress passed Chapter 12 of the Bankruptcy Code. It became effective November 26, 1986, and was scheduled to expire several times. On a few occasions, the legislation expired before Congress extended it for an additional time period. The 2005 Act provided for Chapter 12 to be permanent and was expanded to include fisherman with regular income.
Prior to Chapter 12, a family farmer in need of financial rehabilitation had to file either a Chapter 11 or 13 petition. Most family farmers, because they have too much debt to qualify, cannot file under Chapter 13 and are limited to Chapter 11. Many farmers have found Chapter 11 needlessly complicated, unduly time-consuming, inordinately expensive, and, in too many cases, unworkable. Chapter 12 is designed to give family farmers an opportunity to reorganize their debts and keep their land. According to legislative history, Chapter 12 gives debtors the protection from creditors that bankruptcy provides while, at the same time, it prevents abuse of the system and ensures that farm lenders receive a fair repayment.
In order to file a petition, an individual or an individual and spouse engaged in farming operations must have total debt that does not exceed $3,792,650 (through March 31, 2013), and at least 50 percent of noncontingent, liquidated debts (excluding debt from principal residence unless debt arose out of family operations) on the date the petition is filed must have arisen out of farming. Additionally, more than 50 percent of the petitioner's gross income for the taxable year prior to the filing of the petition must be from farming operations.
A corporation or partnership may file if more than 50 percent of the outstanding stock or equity is owned by a family and:
Similar provisions apply to family fisherman except that the aggregate debt limit is $1,757,475 (through March 31, 2013) and at least 80 percent of the debt is from commercial fishing operations.
Only the debtor can file a plan in a Chapter 12 case. The requirements for a plan in Chapter 12 are more flexible and lenient than those in Chapter 11. In fact, only four requirements are set forth in Section 1205 of the Bankruptcy Code.
The plan can alter the rights of secured creditors with an interest in real or personal property, but there are a few restrictions. To alter the right of the secured claim holder, the debtor must satisfy one of these three requirements:
If a holder of an allowed unsecured claim does not accept the plan, then the court may not approve the plan unless the value of the property to be distributed is equal to at least the amount of the claim and the plan provides that all of the debtor's projected disposable income to be received within three years, or longer if directed by the court, after the first payment is made will be a part of the payments under the plan.
To facilitate the operation of the business and the development of a plan, Section 1206 of the Bankruptcy Code allows family farmers to sell assets not needed for the reorganization prior to confirmation without the consent of the secured creditor, provided the court approves such a sale.
The income tax effects of transactions proposed in a Chapter 12 plan could affect the feasibility of the plan in some cases. Section 1231(b) allows bankruptcy courts to authorize the proponents of Chapter 12 plans to request determinations of the federal state and local income tax effects of the proposed plan. The determination is limited to questions of law. Section 1231(b) also provides that in the event of an actual controversy, the court may declare the tax effects of a proposed plan after the earlier of the date on which the governmental unit responds to the request or 270 days after the request.
The Service issued Rev. Proc. 2006-521 to provide guidance for the Chapter 12 debtor to follow in asking the bankruptcy court to determine the tax effect of the plan. First the regulation provides that if a Chapter 12 plan proponent is authorized by the bankruptcy court to request a determination of the income tax effects of a proposed plan, then a request must first be filed with the Internal Revenue Service. The written request must be filed with the Centralized Insolvency Operation, PO Box 21126, Philadelphia, PA 19114 (marked “Request for Determination of Tax Effects of Chapter 12 Plan”).
Before filing a Chapter 11 plan, some debtors develop a plan and obtain approval of the plan by all impaired classes of claims and interests. The court may accept the voting that was done prepetition provided that the solicitation of the acceptance (or rejection) was in compliance with applicable nonbankruptcy laws governing the adequacy of disclosure in connection with the solicitation. For example, in the case of a public company, the proponent of the plan would be required to follow the guidelines issued by the Securities and Exchange Commission (SEC). If no nonbankruptcy law is applicable (i.e., nonpublic company), then the solicitation must have occurred after or at the time the holder received adequate information as required under Section 1125 of the Bankruptcy Code.
It is often necessary for a Chapter 11 plan to be filed for several reasons, including these three:
Since the professional fees and other costs, including the cost of disrupting the business, of a prepackaged plan are generally much less than costs of a regular Chapter 11 bankruptcy, a prepackaged bankruptcy may be the best alternative.
The use of a prenegotiated plan is common among public companies today. A prenegotiated plan is a modification of the prepackaged bankruptcy in that the voting is completed after the petition has been filed rather than before the plan is filed. In a prenegotiated plan, the debtor reaches an agreement with the major creditors and then files a plan either at the time or shortly after the Chapter 11 petition is filed. For public companies, the filing of the petition before voting allows all documents related to the plan to be filed with the bankruptcy court and eliminates the need to follow the SEC requirements in the voting process.
One of the first decisions that must be made at an early meeting of the debtor with bankruptcy counsel and accountants is whether it is best to liquidate (under provisions of state law or Bankruptcy Code), to attempt an out-of-court settlement, to seek an outside buyer, or to file a Chapter 11 petition. To decide which course of action to take, it is also important to ascertain what caused the debtor's current problems, whether the company will be able to overcome its difficulties, and, if so, what measures will be necessary. Accountants may be asked to explain how the losses occurred and what can be done to avoid them in the future. To help with this determination, it may be necessary to project the operations over at least the next quarter, often referred to as a 13-week forecast, and to indicate the areas where steps will be necessary in order to earn a profit.
For existing clients, the information needed to make a decision about the course of action to make may be obtained with limited additional work; however, for a new client, it is necessary to perform a review of the client's operations to determine the condition of the business. Once the review has been completed, the client normally must decide to liquidate the business, attempt an informal settlement with creditors, or file a Chapter 11 petition, unless additional funds can be obtained or a buyer for the business is located. For example, where the product is inferior, the demand for the product is declining, the distribution channels are inadequate, or other similar problems exist that cannot be corrected, either because of the economic environment or management's lack of ability, it is normally best to liquidate the company immediately.
The decision whether a business should immediately file a Chapter 11 petition or attempt an out-of-court settlement depends on several factors. Among them are these eight:
A voluntary case is commanded by the debtor's filing of a bankruptcy petition under the appropriate chapter.
An involuntary petition can be filed by three or more creditors (if 11 or fewer creditors, only one creditor is necessary) with unsecured claims of at least $14,425 (through March 31, 2013) and can be initiated only under Chapter 7 or 11. An indenture trustee may be one of the petitioning creditors. The court allows a case to proceed only if (1) the debtor generally fails to pay its debts as they become due, provided such debts are not the subject of a bona fide dispute; or (2) within 120 days prior to the petition a custodian was appointed or took possession. The latter excludes the taking of possession of less than substantially all property to enforce a lien.
The timing for filing the petition is important. For example, if the debtor delays filing the petition until the creditors are about to force the debtor into bankruptcy, the debtor may not be in a position to effectively control its destiny. If the petition is filed when the problems first develop and while the creditors are reasonably cooperative, however, the debtor is in a much better position to control the proceeding. If possible, it is best to file the petition near the end of the month or, even better, near the end of the quarter, to avoid a separate closing of the books.
Tax factors should also be considered in deciding when to file the petition. For example, if a debtor corporation that has attempted an unsuccessful out-of-court settlement decides to file a petition, the tax impact of the out-of-court action should be considered. If, in the out-of-court agreement, the debtor transferred property that resulted in a gain and a substantial tax liability, it would be best for the debtor to file the petition after the end of the current taxable year. By taking this action, the tax claim is a prepetition tax claim and not an administrative expense. If the tax claim is a prepetition claim, interest and penalties stop accruing on the day the petition is filed and the debtor may provide in the plan for the deferral of the tax liability up to six years. If the tax claim is an administrative expense, penalties and interest on any unpaid balance will continue to accrue and the provision for deferred payment of up to six years does not apply.
The accountant must supply the attorney with certain information necessary for filing a Chapter 11 petition. This would normally include these items:
The debtor must also file any additional reports or documents that may be required by local rules or by the U.S. trustee.
A petition filed under the Bankruptcy Code results in an automatic stay of the actions of creditors. The automatic stay is one of the fundamental protections provided the debtor by the Bankruptcy Code. In a Chapter 7 case, it provides for an orderly liquidation that treats all creditors equitably. For business reorganizations under Chapter 11, 12, or 13, it provides time for the debtor to examine the problems that forced it into bankruptcy court and to develop a plan for reorganization. As a result of the stay, no party, with minor exceptions, having a security or adverse interest in the debtor's property can take an action that will interfere with the debtor or his or her property, regardless of where the property is located, until the stay is modified or removed. Section 362(a) provides a list of eight kinds of acts and conduct subject to the automatic stay.
Under Section 362 of the Bankruptcy Code, a tax audit, a demand for a tax return, or the issuance of a notice and demand for payment for such assessment is not considered a violation of the automatic stay.
The stay of an act against the property of the estate continues, unless modified, until the property is no longer the property of the estate. The stay of any other act continues until the case is closed or dismissed, or the debtor is either granted or denied a discharge. The earliest occurrence of one of these events terminates the stay.
The court may grant relief after notice and hearing, by terminating, annulling, modifying, or conditioning the stay. The court may grant relief for cause, including the lack of adequate protection of the interest of the secured creditor. With respect to an act against property, relief may be granted under Chapter 11 if the debtor does not have any equity in the property and the property is not necessary for an effective reorganization.
Section 361 identifies three acceptable ways of providing adequate protection.
The granting of relief when the debtor does not have any equity in the property solves the problem of real property mortgage foreclosures where the bankruptcy court petition is filed just before the foreclosure takes place. It was not intended to apply if the debtor is managing or leasing real property, such as a hotel operation, even though the debtor has no equity, because the property is necessary for an effective reorganization of the debtor.
The automatic stay prohibits a secured creditor from enforcing its rights in property owned by the debtor until the stay is removed.
The Supreme Court held in In re Timbers of Inwood Forest Associates [484 U.S. 365 (1988)] that creditors having collateral with a value less than the amount of the debt are not entitled to interest during the period that their property is tied up in the bankruptcy proceeding.
If relief from the stay is granted, a creditor may foreclose on property on which a lien exists, may continue a state court suit, or may enforce any judgment that might have been obtained before the bankruptcy case.
The accountant may assist either the debtor or the creditor in determining the value of the collateral to help determine if there is any equity in the property. As a result of the Timbers decision, the court is more closely considering the prospects for successful reorganization. In cases where there is considerable question about the ability of the debtor to reorganize, courts are now allowing the stay to be removed, providing there is no equity in the property. The debtor, creditors' committee, or secured creditor(s) may ask accountants to provide evidences as to the ability of the debtor to reorganize.
Section 365(a) provides that the debtor or trustee, subject to court approval, may assume, assign, or reject any executory contract or unexpired lease of the debtor. For nonresidential real property leases, the debtor must make a decision to assume, assign, or reject the lease within 120 days after the petition is field. Only a 90-day extension will be granted, unless the landlord agrees to a larger extension. This limitation of 210 days, added by the 2005 Act, has made it more difficult for large retail companies to reorganize successfully under Chapter 11. If a lease is not assumed by the end of the time period, it is presumed that the lease is rejected. A decision regarding all other leases must be made prior to confirmation of a plan in Chapter 11. In the case of a Chapter 7 petition, the decisions must be made regarding the assumption or rejection of all leases within 60 days, unless an extension is granted.
Executory contracts are contracts that are “so far unperformed that the failure of either [the bankrupt or nonbankrupt] to complete performance would constitute a material breach excusing the performance of the other.”2 This definition seems to have been adopted by Congress in the statement that “executory contracts include contracts under which performance remains due to some extent on both sides.”3 However, before a contract can be assumed, Section 361 indicates that the debtor or trustee must:
To be rejected, the contract must still be an executory contract. For example, the delivery of goods to a carrier before the petition is filed, under terms that provide that the seller's performance is completed upon the delivery of the goods to the carrier, would not be an executory contract in Chapter 11. Furthermore, the seller's claim would not be an administrative claim. If, however, the terms provide that the goods are received on delivery to the buyer, the seller under Uniform Commercial Code Section 2–705 would have the right to stop the goods in transit and the automatic stay would not preclude such action. If the goods are delivered, payment for such goods would be an administrative expense.
The damages allowable to the landlord of a debtor from termination of a lease of real property are limited to the greater of one year or 15 percent of the remaining portion of the lease's rent due not to exceed three years after the date of filing or surrender, whichever is earlier. This formula compensates the landlord while not allowing the claim to be so large as to hurt other creditors of the estate. The damages resulting from the breach of an employment contract are limited to one year following the date of the petition or the termination of employment, whichever is earlier.
The accountant may render several services relating to the rejection of executory contracts, including these three:
To the extent possible, this assessment should be made at the beginning of the case to help reduce the expenses of administration during the Chapter 11 case. Amounts paid for rent for the period after filing petition to the date of rejection are considered administrative expenses. Each lease needs to be analyzed to determine if there is equity in the lease or if the debtor needs it to successfully reorganize.
The Bankruptcy Code grants to the trustee or debtor in possession (DIP) the right to avoid certain transfers and obligations incurred. For example, Section 544 allows the trustee to avoid unperfected security interest and other interests in the debtor's property. Thus, if the creditor fails to perfect a real estate mortgage, the trustee may be able to avoid that security interest and force the claim to be classified as unsecured rather than secured.
The trustee needs these powers and rights to ensure that actions by the debtor or by creditors in the prepetition period do not interfere with the objective of the bankruptcy laws, to provide for a fair and equal distribution of the debtor's assets through liquidation—or rehabilitation, if this would be better for other creditors involved.
In addition the trustee has the power to avoid preferences, fraudulent transfers, and postpetition transfers.
A preferential payment as defined in Section 547 of the Bankruptcy Code is a transfer of any of the property of a debtor to or for the benefit of a creditor, for or on account of an antecedent debt made or suffered by the debtor while insolvent and within 90 days before the filing of a petition initiating bankruptcy proceedings, when such transfer enables the creditor to receive a greater percentage of payment than it would receive if the debtor were liquidated under Chapter 7. Insolvency is presumed during the 90-day period. A transfer of property to an insider between 90 days and one year before the filing of the petition is also considered a preferential payment. An officer, director, or person in control of the corporation would be considered an insider. Action to recover a preferential payment received by a third party that benefited an officer or other insider may only be taken against the officer or other insider and not against the third party. For example, if a president paid off a loan that he personally guaranteed six months before the petition was filed, the payment would be recoverable as a preference from the president, but not from the bank. Preferences include the payment of money, a transfer of property, assignment of receivables, or the giving of a mortgage on real or personal property.
A preferential payment is not a fraud but rather a legitimate and proper payment of a valid antecedent debt. The voidability of preferences is created by law to effect equality of distribution among all the creditors. The 90-day period (one year for transactions with insiders) prior to filing the bankruptcy petition has been arbitrarily selected by Congress as the time period during which distributions to the debtor's creditors may be redistributed to all the creditors ratably. During this period, a creditor who accepts a payment is said to have been preferred and may be required to return the amount received and later participate in the enlarged estate to the pro rata extent of its unreduced claim.
Section 547(c) contains eight exceptions to the power the trustee has to avoid preferential transfers. Five of the assumptions are discussed next.
The trustee or DIP will attempt to recover preferential payments. Section 547(f) provides that the debtor is presumed to be insolvent during the 90-day period prior to bankruptcy. This presumption does not apply to transfers to insiders between 91 days and one year prior to bankruptcy. This presumption requires the adverse party to come forth with some evidence to prove the presumption. The burden of proof, however, remains with the party in whose favor the presumption exists. Once this presumption is rebutted, insolvency at the time of payment is necessary, and only someone with the training of an accountant is in a position to prove insolvency. The accountant often assists the debtor or trustee in presenting evidence showing whether the debtor was solvent or insolvent at the time payment was made. In cases where new management is in charge of the business or where a trustee has been appointed, the emphasis is often on trying to show that the debtor was insolvent in order to recover the previous payments and increase the size of the estate. The creditors' committee likewise wants to show that the debtor was insolvent at the time of payment to provide a larger basis for payment to unsecured creditors. Of course, the specific creditor recovering the payment looks for evidence to indicate that the debtor was solvent at the time payment was made.
Any payments made within the 90 days preceding the bankruptcy court filing and that are not in the ordinary course of business should be reviewed very carefully to see if the payments were preferences. Suspicious transactions would include anticipations of debt obligations, repayment of officers' loans, repayment of loans that have been personally guaranteed by officers, repayment of loans made to personal friends and relatives, collateral given to lenders, and sales of merchandise made on a countra account basis.
Business debts of less than $5,850 (through March 31, 2013) are not recoverable. If the amount is less than $11,725 (through March 31, 2013), actions must be filed in the federal district where the business is located.
In seeking to find voidable preferences, the accountant has two crucial tasks: to determine the earliest date on which insolvency can be established within the 90-day period (one year for insiders) and to report to the trustee's attorney questionable payments, transfers, or encumbrances that have been made by the debtor after that date. It is then the attorney's responsibility to determine the voidable payments. However, the accountant's role should not be minimized, for it is the accountant who initially determines the suspect payments. See Newton for a discussion of the procedures to follow in a search for preferences.4
Fraudulent transfers and obligations are defined in Section 548 and include transfers that are presumed fraudulent regardless of whether the debtor's actual intent was to defraud creditors. A transfer may be avoided as fraudulent when made within two years prior to the filing of the bankruptcy petition, if the debtor made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud existing or real or imagined future creditors. Also avoidable are constructively fraudulent transfers where the debtor received less than a reasonably equivalent value in exchange for such transfer or obligation and (1) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation; (2) was engaged in business, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; or (3) intended to incur, or believed that the debtor would incur, debts that would burden the debtor's ability to pay as such debts matured.
Under Section 544 of the Bankruptcy Code, fraudulent transfers may also be recovered under state law for payments made between one and six years. Section 546 provides that any action to recover a preference or a fraudulent transfer under Section 548 through the Bankruptcy Code or under Section 544 through state law must commence the action within two years after the order for relief or if a trustee is appointed during the second year after the petition is filed within one year after the trustee is appointed.
In the determination of fraudulent transfers, insolvency is defined by Section 101(32) as occurring when the present fair salable value of the debtor's property is less than the amount required to pay its debts. The fair value of the debtor's property is also reduced by any fraudulently transferred property, and for an individual, by the exempt property under Section 522.
A fraudulent transfer may occur in a leveraged buyout (LBO). For example, in a LBO transaction where the assets of the debtor were used to finance the purchase of the debtor's stock and the debtor became insolvent, operated with an unreasonably small capital, or incurred debt beyond the ability to repay, a fraudulent transfer may have occurred. Note that the transfer may have been made without adequate consideration because the debtor corporation received no benefit from the proceeds from the loan that were used to retire former stockholder's stock.
It is important for the accountant to ascertain when a fraudulent transfer has in fact occurred because it represents a possible recovery that could increase the value of the estate. It can, under certain conditions, prevent the debtor from obtaining a discharge. To be barred from a discharge as the result of a fraudulent transfer, the debtor must be an individual, and the proceedings must be under Chapter 7 liquidation or the trustee must be liquidating the estate under a Chapter 11 proceeding.
In ascertaining if the debtor has made any fraudulent transfers or incurred fraudulent obligations, the independent accountant would carefully examine transactions with related parties within the year prior to the petition or other required period, look for the sale of large amounts of fixed assets, review liens granted to creditors, and examine all other transactions that appear to have arisen outside the ordinary course of the business.
Section 549 allows the trustee to avoid certain transfers made after the petition is filed. To be avoidable, transfers must not be authorized either by the court or by an explicit provision of the Bankruptcy Code.
The trustee can avoid transfers made under Section 303(f) and 542(c) of the Bankruptcy Code even though authorized. Section 303(f) authorizes a debtor to continue operating the business before the order for relief in an involuntary case. Section 549 does, however, provide that a transfer made prior to the order for relief is valid to the extent of value received. Thus, the provision of Section 549 cautions all persons dealing with a debtor before an order for relief has been granted to evaluate the transfers carefully. Section 542(c) explicitly authorizes certain postpetition transfers of real property of the estate made in good faith by an entity without actual knowledge or notice of the commencement of the case.
To prevent unauthorized transfers, the accountant should see that these three procedures are operative:
Setoff is that right existing between two parties to net their respective debts where each party, as a result of unrelated transactions, owes the other an ascertained amount. The right to setoff is an accepted practice in the business community today. When one of the two parties is insolvent and files a bankruptcy court petition, the right to setoff has special meaning. Once the petition is filed, the debtor may compel the creditor to pay the debt owed and the creditor may in turn receive only a small percentage of the claim—unless the Bankruptcy Code permits the setoff.
The Bankruptcy Code gives the creditor the right to offset a mutual debt, providing both the debt and the credit arose before the commencement of the case. Major restriction on the use of setoff prevents the creditor from unilaterally making the setoff after a petition is filed. The right to setoff is subject to the automatic stay provisions of Section 362 and the use of property under Section 363. Thus, a debtor must obtain relief from the automatic stay before proceeding with the setoff. This automatic stay and the right to use the amount subject to setoff are possible only when the trustee or DIP provides the creditor with adequate protection. If adequate protection—normally in the form of periodic cash payments, additional or replacement collateral, or other methods that will provide the creditor with the indubitable equivalent of its interest—is not provided, then the creditor may proceed with the offset as provided in Section 553.
Section 553(b) contains a penalty for those creditors who, when they see the financial problems of the debtor and threat of the automatic stay, elect to offset their claim prior to the petition. The Code precludes the setoff of any amount that is a betterment of the creditor's position during the 90 days prior to the filing of the petition. Any improvement in position may be recovered by the DIP or trustee. The amount to be recovered is the amount by which the insufficiency on the date of offset is less than the insufficiency 90 days before the filing of the petition. If no insufficiency exists 90 days before the filing of the petition, then the first date within the 90-day period where there is an insufficiency should be used. Insufficiency is defined as the amount by which a claim against the debtor exceeds a mutual debt owing to the debtor by the holder of such claim. The amount recovered is considered an unsecured claim.
In addition to developing a schedule that helps determine the amount of the penalty, the accountant may assist in determining the amount of debt outstanding.
One area where the avoiding power of the trustee is limited is in a request for reclamation. Section 546(c) provides that under certain conditions, the creditor has the right to reclaim goods if the debtor received the goods while insolvent during the 45 days prior to the filing of the petition. To reclaim these goods, the seller must demand in writing, within 20 days after the petition was filed. If the seller does not make a timely demand for reclamation, the seller has the right to an administrative expense claim for goods delivered within 20 days prior to bankruptcy.
Chapter 30 of Title 28, U.S. Code, provides for the establishment of the U.S. trustee program. The attorney general is responsible for appointing one U.S. trustee in each of the 21 regions, and one or more assistant U.S. trustees perform the supervisory and appointing functions formerly handled by bankruptcy judges. They are the principal administrative officers of the bankruptcy system. The judicial districts of Alabama and North Carolina are not part of the U.S. Trustee program. In these districts, some of the functions performed by the U.S. trustee in other districts are assigned to an administrator in the bankruptcy court.
The U.S. trustee establishes, maintains, and supervises a panel of private trustees that are eligible and available to serve as trustee in cases under Chapter 7 or 11. Also, the U.S. trustee supervises the administration of the estate and the trustees in cases under Chapters 7, 11, 12, or 13. The intent is not for the U.S. trustee system to replace private trustees in Chapters 7 and 11. Rather, the system should relieve the bankruptcy judges of certain administrative and supervisory tasks and thus help to eliminate any institutional bias or the appearance of any such bias that may have existed in the prior bankruptcy system.
The U.S. trustees are responsible for the administration of cases. They appoint the committees of creditors with unsecured claims and also appoint any other committees of creditors or stockholders authorized by the court. If the court deems it necessary to appoint a trustee or examiner, a U.S. trustee makes this appointment (subject to court approval) and also petitions the court to authorize such an appointment.
U.S. trustees monitor applications for compensation and reimbursement for officers and accountants and other professionals retained in the case, raising objections when deemed appropriate. Other responsibilities include monitoring plans and disclosure statements, creditors' committees, and the progress of the case.
A claim antedating the filing of the petition that is not a priority claim or that is not secured by the pledge of property is classified as an unsecured claim. Claims where the value of the security interest is less than the amount of the claims are divided into a secured and an unsecured part.
A proof of claim or interest is deemed filed in a Chapter 11 case provided the claim or interest is listed in the schedules filed by the debtor, unless the claim or interest is listed as disputed, contingent, or unliquidated. A creditor is thus not required to file a proof of claim if it agrees with the debt listed in the schedules. It is, however, advisable for creditors to file a proof of claim in most situations. Creditors who for any reason disagree with the amount admitted on the debtor's schedules, such as allowable prepetition interest on their claims, or creditors desiring to give a power of attorney to a trade association or lawyer, should always prepare and file a complete proof of claim. Special attention must also be devoted to secured claims that are undersecured.
Section 506 provides that if a creditor is undersecured, the claim will be divided into two parts. The first part is secured to the extent of the value of the collateral or to the extent of the amount of funds subject to setoff. The balance of the claim is considered unsecured. The value to be used to determine the amount of the secured claim is, according to Section 506(a), to “be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditors' interest.” Bankruptcy Rule 3012 provides that any party in interest may petition the court to determine the value of a secured claim.
Thus, the approach used to value property subject to a lien for a Chapter 7 may be different from that for a Chapter 11 proceeding. Even within a Chapter 11 case, property may be valued differently. For example, fixed assets that are going to be sold because of the discontinuance of operations may be assigned liquidation values, whereas assets that will continue to be used by the debtor may be assigned going concern values. Although courts have to determine value on a case-by-case basis, it is clear that the value is to be determined in light of the purpose of the valuation and the proposed disposition or use of the property.
Section 1111(b) allows a secured claim to be treated as a claim with recourse against the debtor in Chapter 11 proceedings (i.e., where the debtor is liable for any deficiency between the value of the collateral and the balance due on the debt) whether the claim is nonrecourse by agreement or by applicable law. This preferred status terminates if the property securing the loan is sold under Section 363 or is to be sold under the terms of the plan, or if the class of which the secured claim is a part elects application of Section 1111(b)(2).
Another available section under Section 1111(b) is that a class of undersecured creditors can elect to have its entire claim considered secured. A class of creditors will normally be only one creditor. For example, in Chapter 11 cases where most of the assets are pledged, very little may be available for unsecured creditors after paying administrative expenses. Thus, the creditor might find it advisable to make the Section 1111(b)(2) election. If, however, there will be a payment to unsecured creditors of approximately 75 cents per dollar of debt, the creditor may not want to make this election.
The purpose of the election is to provide adequate protection to holders of secured claims where the holder is of the opinion that the collateral is undervalued. Also, if the treatment of the part of the debt that is accorded unsecured status is so unattractive, the holder may be willing to waive his unsecured deficiency claims. The class of creditors making this election has the right to receive full payment for its claims over time. If the members of the class do not approve the plan, the court may confirm the plan as long as the plan provides that each member of the class receives deferred cash payments totaling at least the allowed amount of the claim. However, the present value of these payments as of the effective date of the plan must be at least equal to the value of the creditors' interest in the collateral. Thus, a creditor who makes the election under Section 1111(b)(2) has the right to receive full payment over time, but the value of that payment is required only to equal the value of the creditor's interest in the collateral.
The actual, necessary costs of preserving the estate, including wages, salaries, and commissions for services rendered after the commencement of the case, are considered administrative expense. Any tax including fines or penalties is allowed unless it relates to a tax-granted preference under Section 507(a)(8). Compensation awarded a professional person, including accountants, for postpetition services is an expense of administration. Expenses incurred in an involuntary case subsequent to the filing of the petition but prior to the appointment of a trustee or the order for relief are not considered administrative expenses. They are, however, granted second priority under Section 507. Administrative expenses of a Chapter 11 case that is converted to Chapter 7 are paid only after payment of Chapter 7 administrative expenses.
Section 503(b)(9) grants administrative expense status for “the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor's business.” As a result of this provision, more prepetition planning is required on the part of debtors to avoid placing orders for goods associated with product lines or stores that will be shutdown at, or immediately after, the filing of the petition.
Section 507 provides for these 11 priorities:
Priority claims in a Chapter 11 case must be provided for in the plan.
Several accounting firms and other businesses have developed models to handle the processing of claims of both small and large debtors. Some of their features include these six:
One system uses a multifield database to help debtors deal with the complexities of a bankruptcy. Creditors' files can be sorted in terms of classes of creditors, priorities of claims, and so on, and then alphabetically within these categories. Notices sent to creditors include all the necessary information, such as the amount of a claim and its current status. Ongoing information that changes over time is constantly updated. This could include the extent to which proofs of claim differ from the recorded debt, the assessment of market values of collateral pledged as security, other assets that are not pledged as security, distributions made during the course of a Chapter 11 case, and changes to or withdrawals of claims. Automatically prepared and mailed notices keep creditors current on the proceedings of a case. The system, through automatic mailings, answers telephone inquiries as they are entered.
No order is necessary under the Bankruptcy Code for the debtor to operate the business in Chapter 11. Sections 1107(a) and 1108 grant the debtor all the rights, powers, and duties of a trustee, except the right to compensation under Section 330 and provide that the trustee may operate the business unless the court directs otherwise. Thus, the debtor will continue to operate the business unless a party in interest requests that the court appoint a trustee. Until action is taken by management to correct the problems that caused the adverse financial condition, the business will most likely continue to operate at a loss. If the creditors believe new management is necessary to correct the problem, they will press for a change in management or the appointment of a trustee.
In most large bankruptcies as well as in many smaller cases, the management is replaced, often by turnaround specialists, who have particular expertise in taking over troubled companies. They often eliminate the unprofitable aspects of the company's operations, reduce overhead, and find additional financing as part of the turnaround process. Once the plan has been confirmed, turnaround specialists frequently move on to other troubled companies. In small cases where management is also the stockholders, creditors are apt to be uncomfortable with existing management, which may have created the problems.
The debtor or trustee must be able to use a secured party's collateral, or in most situations there would be no alternative but to liquidate the business. Section 363(c) gives the trustee or debtor the right to use, sell, or lease property of the estate in the ordinary course of business without a notice and a hearing. As a result of this provision, the debtor may continue to sell inventory and receivables and use raw materials in production without notice to secured creditors and without court approval. The use, sale, or lease of the estate's property other than in the ordinary course of business is allowed only after notice and an opportunity for a hearing. Under Section 363 of the Bankruptcy Code, companies, with court approval, may sell all of a large percent of the assets of the company. As noted below in Section 39.6(b) of this chapter, the sale of all or a large percentage of the debtor's assets is viewed as a very viable option to the development of a plan.
One restriction on the use of the property of the bankruptcy estate is placed on the trustee or debtor where cash collateral is involved. Cash collateral is cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents where the estate and someone else have an interest in the property. Also included would be the proceeds of noncash collateral, such as inventory and accounts receivable and proceeds, products, offspring, and rents, profits, or property subject to a security interest, if converted to proceeds of the type defined as cash collateral, provided the proceeds are subject to the prepetition security interest.
To use cash collateral, the creditor with the interest must consent to its use or the court, after notice and hearing, must authorize its use. The court may authorize the use, sale, or lease of cash collateral at a preliminary hearing if there is a reasonable likelihood that the DIP will prevail at the final hearing. The Bankruptcy Code also provides that the court is to act promptly for a request to use cash collateral.
In many cases, a company cannot operate unless it can obtain use of its cash collateral. For example, cash in bank accounts subject to setoff or collections from pledged receivables and inventory prior to the filing of the petition are not available for use until the company obtains the consent of the appropriate secured creditor or of the court.
Thus, an immediate concern of many companies that need to file a Chapter 11 petition is how to procure enough cash to operate for the first week or so after filing the petition. Often the best way to obtain the use of the cash is to get approval from the secured creditor prior to the filing of the petition. Accountants can work with the debtor in putting together information for the secured lender that may result in the pledge of additional property or an extension of a receivable or inventory financing agreement for the release of cash to allow operation of the business once the petition is filed.
In most Chapter 11 proceedings, the debtor must obtain additional financing in order to continue the business. Although the debtor was allowed to obtain credit under prior law, the power granted to the debtor under the Bankruptcy Code is broader. Section 364(a) allows the debtor to obtain unsecured debt and to incur unsecured obligations in the ordinary course while operating the business. This right is automatic unless the court orders otherwise. Also, the holder of these claims is entitled to first priority as administrative expenses.
If the debtor is unable to obtain the necessary unsecured debt under Section 364(a), the court may authorize the obtaining of credit and the incurring of debt by granting special priority for claims. These priorities may include:
DIP financing may be obtained from the existing lender or from a new lender. Most all major banks are involved in DIP financing as well as several other financial entities, including funds that are established to make loans to companies in Chapter 11 and on emergence from Chapter 11. At times, existing creditors will lend to the Chapter 11 debtor in order to prevent other lenders from obtaining a position that may be superior to that of the existing lender. The bankruptcy court may allow the debtor to prime the position of the existing lender. However, for the court to authorize the obtaining of credit with a lien on encumbered property that is senior or equal to the existing lien, the debtor must not be able to obtain credit by other means and the existing lien holder must be adequately protected.
Credit obtained other than in the ordinary course of business must be authorized by the court after notice and a hearing. Where there is some question whether the credit is related to the ordinary course of business, the lender should require court approval.
The number of 363 sales has recently increased compared to the number of plans approved. Banks and other financial institutions are less willing to lend funds for the time period necessary for businesses to reorganize, but may be willing to provide funds for a shorter period while the debtor implements a 363 sale. Additionally, creditors appear to be less patient today than they were in the 1980s and early 1990s, asking debtors to sell the business or in some cases filing a motion asking the court to provide for a 363 sale.
Asset sales are not restricted to the middle market or smaller cases. For example, companies like Polaroid (received $56.5 million cash for assets of its Identification Systems Business Division), Fruit of the Loom (business operations purchased by Berkshire Hathaway, Inc.), and LTV Corporation (sold its integrated steel assets to WL Ross & Co.) completed significant asset sales as a part of their Chapter 11 filing.
The Bankruptcy Code provides that a trustee can be appointed in certain situations based on facts in the case and not related to the size of the company or the amount of unsecured debt outstanding. The trustee is appointed only at the request of a party in interest after a notice and hearing. A party in interest includes the debtor, the trustee (in other contexts), creditors' or stockholders' committees, creditors, stockholders, or indenture trustees. Also, a U.S. trustee, while not a party in interest, may petition the court for an appointment of a trustee.
Section 1104(a) states that a trustee be appointed:
1. For cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case, or similar cause, but not including the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor; or
2. If such appointment is in the interest of creditors, any equity security holders, and other interests of the estate, without regard to the number of holders of securities of the debtor or the amount of assets or liabilities of the debtor.
The U.S. trustee is responsible for the appointment of the trustee from a panel of qualified trustees, once the appointment has been authorized by the court. It also appears that the U.S. trustee would have the right to replace trustees who fail to perform their functions properly.
The Bankruptcy Code, as originally enacted, provided that in a Chapter 7 case, the interim trustee appointed by the U.S. trustee would serve as the trustee unless a trustee is elected by a majority of at least 20 percent of the unsecured creditors voting in an election at a meeting of creditors under Section 341 of the Bankruptcy Code. In most Chapter 7 cases, the interim trustee serves as the trustee. The Bankruptcy Reform Act of 1994 modified Section 1104 of the Bankruptcy Code to provide that on request of a party in interest (made within 30 days after the court authorized the appointment of a trustee), the U.S. trustee must call a meeting of unsecured creditors for the purpose of electing a Chapter 11 trustee. This change has encouraged the U.S. trustee to seek input from creditors before making trustee appointments.
Under the Bankruptcy Code, the trustee's major functions are to (1) operate the business and (2) conduct an investigation of the debtor's affairs. Under certain conditions, it may be best to leave the current management in charge of the business, without resolving the need for the investigation of the debtor. The Code provides for the appointment of an examiner to perform this function. Section 1104(b) states that if a trustee is not appointed:
on request of a party in interest, and after notice and hearing, the court shall order the appointment of an examiner to conduct such an investigation of the debtor as is appropriate, including an investigation of any allegations of fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor of or by current or former management of the debtor, if
1. Such appointment is in the interest of creditors, any equity security holders, and other interests of the estates; or
2. The debtor's fixed, liquidated, unsecured debts, other than debts for goods, services, or taxes, or owing to an insider, exceed $5 million.
The function of the examiner is to conduct an investigation into the actions of the debtor, including fraud, dishonesty, mismanagement of the financial condition of the debtor and the operation of the business, and the desirability of the continuation of such business. The report is to be filed with the court and given to any creditors' committee, stockholders' committees, or other entities designated by the court. In addition to these two provisions, Section 1106(b) also states that an examiner may perform other functions as directed by the court. In some cases, the court has expanded the role of the examiner. For example, the bankruptcy judges may prefer to see additional controls exercised over the management of the debtor but may not see the need to incur the costs of the appointment of a trustee. These functions are assigned to the examiner.
Accountants may serve as examiners, and in some regions U.S. trustees have expressed a preference for appointing accountants in certain situations. Where a financial investigation is needed, an accountant may be the most qualified person to perform as an examiner. In many cases where the role of the examiner has been expanded, accountants were serving as examiners.
Several different types of reports are required while the debtor is operating the business in a Chapter 11 reorganization proceeding. The nature of the reports and the time period in which they are issued depend to some extent on local rules and on the type of internal controls of the debtor and the extent to which large losses are anticipated.
Districts establish local bankruptcy rules that generally apply to all cases filed in that particular district. These rules cover some of the procedural matters that relate to the handling of a bankruptcy case, including appearance before the court, forms of papers filed with the court, assignment of case, administration of case, employment of professionals, and operating statements. The rules for the filing of operating statements have become primarily the responsibility of the U.S. trustee and, as a result, the specific procedures for these statements are those of the U.S. trustee.
One statement required by all regions is an operating statement—profit and loss statement. This statement may include, in addition to the revenue and expense accounts needed to determine net income on the accrual basis, an aging of accounts payable (excluding prepetition debts) and accounts receivable, status of payments to secured creditors, analysis of tax payments, analysis of insurance payments and coverage, and summary of bankruptcy fees that have been paid or are due.
The U.S. trustee also requires cash receipts and disbursement statements. In some cases, it may be necessary to prepare this statement for each bank account of the debtor. For example, the U.S. trustee for the central district of California requires that the debtor, in addition to the regular account, establish separate accounts for payroll and taxes. Separate cash receipts and disbursement statements are also required for each account.
The U.S. trustee office is in the process of developing uniform standards for operating reports that would apply to all regions.
An independent accountant may assist the debtor in the preparation of these monthly operating reports. See Section 39.7(c) in this chapter.
In November 1990, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) No. 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code, which represents the first major pronouncement to be issued on financial reporting by companies in bankruptcy. The SOP applies to any company that files a Chapter 11 petition after December 31, 1990. In addition, the provisions regarding fresh start reporting apply to any entity that has its plan confirmed after June 30, 1991. SOP No. 90-7 is now Accounting Standards Codification (ASC) 852.
SOP No. 90-7 (ASC 852) was designed to eliminate some of the significant divergences in accounting for bankruptcies and to increase the relevance of financial information provided to debtors, creditors, stockholders, and other interested parties who make decisions regarding the reorganization, especially the reorganization plan, of the debtor. The SOP (ASC 852) applies to financial reporting by companies that have filed Chapter 11 petitions and expect to reorganize as going concerns, and to companies that emerge from Chapter 11 under confirmed plans. It does not apply to companies that are restructuring their debt outside of Chapter 11 or to those that adopt Chapter 11 plans of liquidation. It deals with how to report the activities of the Chapter 11 company during the reorganization proceeding and how to report the emergence of the company from Chapter 11.
A major objective of financial statements issued by the debtor in Chapter 11 should be to reflect the financial evolution of the debtor during the proceeding. Thus, for financial statements issued in the year the petition is filed and in subsequent years, a distinction should be made between transactions and events directly associated with the reorganization, as opposed to those related to the ongoing operations of the business. This principle is reflected in several significant areas of the financial statements.
Paragraphs 23 to 26 of SOP No. 90-7 (ASC 852-10-45-2 to 45-7; 852-210-10-60-3) provide specific guidance for the preparation of the balance sheet during the reorganization.
Liabilities subject to compromise should be separated from those that are not and from postpetition liabilities. Liabilities that are subject to compromise include unsecured claims, undersecured claims, and fully secured claims that may be impaired under a plan. Paragraph 23 (ASC 852-10-45-2) indicates that if there is some uncertainty as to whether a secured claim is undersecured or will be impaired under the plan, the entire amount should be included with prepetition claims subject to compromise.
In view of this provision, it is expected that most prebankruptcy claims will be reported initially as liabilities subject to compromise. There are a number of reasons for this. For example, at the time the balance sheet is prepared, the collateral may not have been appraised. Also, it might be determined as the case progresses that estimated cash flows from property are less than anticipated. All security interests may not have been fully perfected. Due to these and other factors, it is not unusual for claims that appeared fully secured at the onset of a case to be found to be compromised during the proceedings.
Paragraph 26 of SOP No. 90-7 (ASC 852-10-45-7) also indicates that circumstances arising during the reorganization may require a change in the classification of liabilities between those subject to compromise and those not subject to compromise.
The principal categories (such as priority claims, trade debt, debentures, institutional claims, etc.) of the claims subject to compromise should be disclosed in the notes to the financial statements. Note that the focus of the reporting requirement is on providing information about the nature of the claims rather than whether the claims are current or noncurrent.
Liabilities that are not subject to compromise consist of postpetition liabilities and liabilities not expected to be impaired under the plan. They are reported in the normal manner and thus should be segregated into current and noncurrent categories if a classified balance sheet is presented.
Liabilities that may be affected by the plan should be reported at the amount expected to be allowed even though they may be settled for a lesser amount. For example, once the allowed amount of an existing claim is determined or can be estimated, the carrying value of the debt should be adjusted to reflect that amount. Paragraph 25 of SOP No. 90-7 (ASC 852-10-45-6) provides that debt discounts or premiums as well as debt issue costs should be viewed as valuations of the related debt. When the allowed claim differs from the net carrying amount of the debt, the discount or premium and deferred issue costs should be adjusted to the extent necessary to report the debt at the allowed amount of the claim. If these adjustments are not enough, then the carrying value of the debt will be adjusted. The gain or loss resulting from the entries to record these adjustments is to be reported as a reorganization item as described on the next page.
Prepetition claims that become known after the petition is filed, such as a claim arising from the rejection of a lease, should also be reported on the basis of the expected amount of the allowed claim and not at an estimate of the settlement amount. Paragraph 48 of SOP No. 90-7 (ASC 852) suggests that these claims should be reported at the amount allowed by the court because that is the amount of the liability until it is settled and the use of the allowed amount is consistent with the amounts at which other prepetition liabilities are stated.
Financial Accounting Standards Board (FASB) Statement No. 5, Accounting for Contingencies (ASC 4506) applies to the process of determining the expected amount of an allowed claim. Claims that are not subject to reasonable estimation should be disclosed in the notes to the financial statements based on the provisions of ASC 450. Once the accrual provisions of ASC 450 are satisfied, the claims should be recorded.
The objective of reporting during the Chapter 11 case is to present the results of operations of the reporting entity and to clearly separate those activities related to the normal operations of the business from those related to the reorganization. Thus, revenues, expenses (including professional fees), realized gains and losses, and provisions for losses resulting from the Chapter 11 reorganization and restructuring of the business should be separately reported. According to paragraph 27 of SOP 90-7 (ASC 852-10-45-9), items related to the reorganization (except for the reporting of discontinued operations which are already reported separately) should be reported in a separate category within the income (loss) from operations section of the statement of operations. Appendix A in SOP 90-7 (ASC 852-10-55-3) contains an example of the form to use for operating statements issued during a Chapter 11 case. The part of the operating statement that relates to the reporting of reorganization items is shown next.
Earnings before reorganization items and income tax benefits | 47 |
Reorganization items: | |
Loss on disposal of facility | (60) |
Professional fees | (50) |
Provision for rejected executory contracts | (10) |
Interest earned on accumulated cash resulting from Chapter 11 proceeding | 1 |
(119) | |
Loss before income tax benefit and discontinued operations | $(72) |
Note that the reader of the statement of operations is able to determine the amount of income generated from continuing operations without the impact of the reorganization being reflected in these totals. While determining the part of income that relates to ongoing operations will involve some judgment on the part of management, a reasonable estimate of the segregation will be much more beneficial to the reader than including all items in the same category, as is current practice.
These five provisions relate to the operating statements:
Paragraph 31 of SOP 90-7 (ASC 852-10-45-13) indicates that reorganization items should be disclosed separately within the operating, investing, and financing categories of the statement of cash flows. SOP 90-7 (ASC 852) also indicates that reorganization items related to operating cash flows are better reflected if the direct method is used to prepare the statement of cash flows. An example of the statement of cash flows issued during a Chapter 11 case using the direct approach is found in Appendix A of SOP 90-7 (ASC 852-10-55-3).
SOP 90-7 (ASC 852) indicates that if the indirect method is used, the details of the operating cash receipts and payments resulting from the reorganization should be disclosed in a supplementary schedule or in the notes to the financial statement. The footnote or supplementary schedule should include the information from the reorganization section of the statement of cash flows that is presented earlier.
It would also be acceptable to reflect this information in the cash flow statement, as shown next:
Net loss | $(118) |
Adjustment to determine net cash provided by operating items | |
before reorganization items: | |
Depreciation | |
Loss on disposal of facility | 60 |
Provision for rejection of executory contracts | 10 |
Loss on discontinued operations | 56 |
Increase in postpetition liabilities and other liabilities | 250 |
Increase in accounts receivable | (180) |
Reorganization items | 49 |
Net cash provided by operating activities before reorganization items | 147 |
Reorganization items | |
Interest received on cash accumulated because of the Chapter 11 proceeding | 1 |
Professional fees paid for services rendered in connection with the Chapter 11 proceeding | (50) |
Net cash provided by reorganization items | (49) |
Net cash provided by operating activities | $98 |
Any reorganization items included in financing and investing activities should also be disclosed separately.
The accountant advises and gives suggestions to the debtor and attorney in drawing up a plan. Section 1121 of the Bankruptcy Code provides that only the debtor may file a plan of reorganization during the first 120 days of the case (unless a trustee has been appointed). This period may be extended; however, the 2005 Act provides that the time period may not be extended beyond 18 months after the petition was filed. This breathing period permits the debtor to hold lawsuits and foreclosures in status quo and to determine economic causes of its financial predicament while developing a plan. Using the schedules of assets and liabilities, statement of affairs, and past and projected financial statements, the debtor and its accountant examine the liabilities of the debtor and the value of the business and explore sources of funding for the plan such as enhanced profitability, partial liquidation, issuing debt securities, or outside capitalization. They outline the classes of debt that cannot be deferred or reduced and negotiate with the rest.
Section 1122 provides that claims or interests can be divided into classes provided each claim or interest is substantially similar to the others of such class. In addition, a separate class of unsecured claims may be established consisting of claims that are below or reduced to an amount the court approves as reasonable and necessary for administrative convenience. For example, claims of less than $10,000, or those creditors who will accept $10,000 as payment in full of their claim, may be placed in one class, and the claimants will receive the lesser of $10,000 or the amount of their claim. All creditors or equity holders in the same class are treated the same, but separate classes may be treated differently.
Generally, all unsecured claims, including claims arising from rejection of executory contracts or unexpired leases, are placed in the same class except for administrative expenses. They may, however, be divided into different classes if separate classification is justified. The Bankruptcy Code does not require placing all claims that are substantially the same in the same class.
Courts have stated that Section 1122(a) “does not require that similar claims must be grouped together, but merely that any group created must be homogeneous.”
The items that may be included in the plan are listed in Section 1123. Certain items are listed as mandatory and others are discretionary. The seven mandatory provisions are:
In addition to these requirements, the plan may also include these five provisions:
In determining the classes of creditors' claims or stockholders' interests that must approve the plan, it is first necessary to determine if the class is impaired. Section 1124 states that a class of claims or interest is impaired under the plan unless the plan leaves unaltered the legal, equitable, and contractual rights of a class, cures defaults that led to acceleration of debts, or pays in cash the full amount of their claims.
A party cannot solicit the acceptance or rejection of a plan from creditors and stockholders affected by the plan unless they receive a written disclosure statement containing adequate information as approved by the court. Section 1125(b) requires that the court must approve this disclosure statement, after notice and a hearing, as containing adequate information.
Section 1125(a) states that adequate information means information of a kind, and in sufficient detail, as far as is reasonably practicable in light of the records, that would enable a hypothetical reasonable investor typical of holders of claims or interests of the relevant class to make an informed judgment about the plan. This definition contains two parts. First it defines adequate information, and then it sets a standard against which the information is measured. It must be the kind of information that a typical investor of the relevant class, not one that has special information, would need to make an informed judgment about the plan.
Section 1125(a)(1) provides that adequate information need not include information about other possible proposed plans.
As noted, the information disclosed in the statement should be adequate to allow the creditor or stockholder to make an informed judgment about the plan. The next seven items describe the types of information that might be included.
Prior to the confirmation hearing on the proposed plan, the proponents of the plan will seek its acceptance. Once the results of the vote are known, the debtor or other proponent of the plan will request confirmation of the plan.
The holder of a claim or interest, as defined under Section 502, is permitted to vote on the proposed plan. Voting is based on the classification of claims and interests. A major change from prior law is that the acceptance requirements are based on those actually voting and not on the total value or number of claims or interests allowed in a particular class. The secretary of the Treasury is authorized to vote on behalf of the United States when the United States is a creditor or equity security holder.
A class of claim holders has accepted a plan if at least two-thirds in amount and more than one-half in number of the allowed claims for that class that are voted are cast in favor of the plan. For equity interests, it is necessary only that votes totaling at least two-thirds in amount of the outstanding securities in a particular class that voted be cast for the plan. The majority in number requirement is not applicable to equity interests.
Section 1129(a), which contains the requirements that must be satisfied before a plan can be confirmed, is one of the most important sections of the Bankruptcy Code. The 13 provisions follow
Accountants can provide considerable services to their client relating to the formulation of the plan, some of which are described in the next subsections.
Section 1129(a)(7) provides that each holder of a claim must either accept that plan or receive or retain interest in property of a value that is at least equal to the amount that would have been received or retained if the debtor were liquidated under Chapter 7. Accountants can help the debtor establish these values.
Section 1129(a)(11) contains the feasibility standard of Chapter 11 requiring that confirmation of the plan of reorganization is not likely to be followed by liquidation or further reorganization (unless contemplated). The accountant may assist the debtor or trustee to formulate an acceptable plan by projecting the ability of the debtor to carry out and perform the terms of the plan. To establish feasibility, the debtor must project the profitability potential of the business. Where the plan calls for installment payments, the accountant may be requested to prepare or review projected budgets, cash flow statements, and statements of financial position. The creditors must be assured by the projected income statement and cash flow statement that the debtor will be in a position to make the payments as they become due. The forecast of the results of operations and financial position should be prepared on the assumption that the proposed plan will be accepted, and the liability and asset accounts should reflect the balance that would be shown after all adjustments are made relative to the debt forgiveness. Thus, interest expense is based on the liabilities that will exist after the discharge occurs.
Not only are cash projections needed for the feasibility test as mentioned in the previous paragraph, but they are an important part of the negotiation process. The creditors want to receive the maximum amount possible in any Chapter 11 plan and often want the payment in cash as of the effective date of the plan. The creditors realize, however, that if their demands are beyond the ability of the debtor to make payments, the plan will not work and they will not receive the payments provided for in the plan. Cash flow projections assist both parties in developing reasonable conclusions regarding the value of the entity emerging from Chapter 11. In some reorganizations, there is considerable debate over cash flow projections and the discount rate to be used in determining the value of the debtor's continuing operations, to which must be added the amount to be realized on the sale of nonoperating assets plus excess working capital. Once the debtor and its creditors' committee can agree on the basic value of the entity, it is easier to negotiate the terms of the plan.
During the formulation of the plan, the accountant can assist the debtor considerably by helping to determine the reorganized value of the debtor or to assess the valuation of an investment banker or other specialists. If the accountant develops the cash projections supporting the valuation, he or she will be precluded from being independent for SEC purposes. Once the debtor has determined an estimate of the value of the entity that will emerge from bankruptcy, the accountant can provide assistance to the debtor in negotiating the terms of the plan with the creditor.
Also of considerable help in evaluating a plan is a pro forma balance sheet showing how the balance sheet will look if the plan is accepted and all provisions of the plan are carried out. By using reorganization models or simulation models, the pro forma balance sheet may be prepared based on several possible courses of action that the debtor could take. The pro forma balance sheet illustrates the type of debt equity position that would exist under different alternatives.
This pro forma balance sheet should reflect the debts at discounted values. Assets are generally presented at their historical cost values unless the debtor has made a decision to apply the concept of quasi reorganization. A pro forma balance sheet that reflects the reorganized values of the entity is of considerable benefit to the debtor in developing the terms for a plan.
Once the terms of the proposed plan have been finalized, the pro forma balance sheet based on historical values reflecting these terms is generally included in the disclosure statement that must be submitted prior to or at the time votes are solicited on the plan. The pro forma balance sheet reflecting reorganized values, however, provides information for the creditors and stockholders that is much more relevant in making an informed judgment about how to vote on the plan.
Accountants can develop a model to help the debtor in developing a plan. The outcome of a reorganization plan depends on a variety of assumptions, including the creditors' willingness to accept different mixes of cash and securities, economic trends, possible sources for financing continuing operations or acquisitions, and many other factors. Using a model, these assumptions can be altered one at a time with all else held constant, and the possible courses of action can be analyzed according to the needs of management. Using this technique, creditors or the debtor can identify potential problem areas and request clarifications. Once these clarifications have been received and entered into the system, a new set of comparisons is made, and the process is repeated until both sides are satisfied that the most favorable course is being pursued. Breakdowns of reorganization plans by computer models allow debtors and creditors to focus on the financial data most relevant to the case at hand.
The following subsections describe several of the services that the accountant can render for the creditors' committee or for a committee of equity holders.
One of the basic functions performed by the creditors' committee is to negotiate a settlement and then make its recommendation to the other creditors. The accountant should be familiar with the bargaining process that goes on between the debtor and the creditors' committee in trying to reach a settlement. Bargaining can be both vigorous and delicate. The debtor bargains, perhaps, for a settlement that consists of a small percentage of the debt, demanding only a small immediate cash outlay, with payments to be made in the future. The debtor may want the debts outstanding to be subordinated to new credit or may ask that the agreement call for partial payment in preferred stock. The creditors want a settlement that represents a high percentage of the debt and consists of a larger cash down payment with the balance to be paid as soon as possible. In cases where there is very little cash available for debt repayment on confirmation, unsecured creditors may be interested in obtaining most of the outstanding stock of the company. In the past 20 years, the creditors of public companies have received an increasing interest in the ownership of the debtor. It is not unusual for the creditors to own all of the outstanding stock of the emerging entity. The shareholders of failed LBOs and other highly leveraged firms often receive no equity interest in the reorganized entity.
The services that the accountant may render for the creditors' committee in the negotiations with the debtor vary significantly depending on several factors, including the size of the debtor, the experience of the members of the creditors' committee, the nature of the debtor's operations, and the creditors' committee confidence in the debtor and in the professionals—especially attorneys and accountants—who are helping the debtor. In most cases, to varying degrees, the committee depends on the accountant to help evaluate the debtor's operations, the information provided about those operations, and the terms of a proposed plan. Often accountants may be engaged to investigate selected aspects of the debtor's operations and to obtain an overall understanding of the debtor's problems and possible solutions.
Of primary significance to a creditors' committee is determining whether the projections and forecasts submitted by the debtor are realistic. The representatives of the largest unsecured creditors on the committee typically are not accountants and thus may need assistance in evaluating the financial data prepared by the debtor. The accountant for the creditors' committee may be in a strong position to evaluate the debtor's projections and to make recommendations. The intention is not to perform an audit of such data but rather to review the information to determine whether the projections can be supported to some extent by hard evidence. The level of involvement by the accountant for the creditors' committee will vary, depending on the sophistication of the company or of the financial people who prepared the data. In some cases, the review could be limited to a discussion of the data with those who prepared the projections, to determine whether the forecasts seem to make sense. In other situations, however, the accountant may find that the preparation of this information has been somewhat loose or vague. In these circumstances, the accountant for the committee may need to get involved in the preparation or to perform a review of the appropriate accounting records to see whether the basic underlying data have some foundation in fact.
In some cases, accountants for the creditors' committee develop their own models of the debtor's operations. Cash flow projections can then be prepared for determining the reorganized entity's value. Operational changes made by the debtor are entered in the model as are proposed sales or other major actions, providing a basis for the committee's response to the debtor's proposals. Evaluation by the creditors' committee focuses on the impact these actions will have on the value of the reorganized entity and on the amount of potential settlement.
As noted earlier, the accountant for the debtor provides advice and assistance in the formulation of a plan of reorganization in a Chapter 11 proceeding and a plan of settlement in an agreement out of court. An important function of an accountant employed by the creditors is to help evaluate the proposed plan of action. In a Chapter 11 case where the debtor has not proposed a plan within 120 days, a proposed plan has not been accepted within 180 days after the petition was filed, or where the trustee has been appointed, the accountant may assist the creditors in developing a plan to submit to the court. The accountant is able to provide valuable assistance to the committee because of familiarity with the financial background, nature of operations, and management of the company gained during the audit. In committee meetings, a great deal of discussion goes on between the committee members and the accountant concerning the best settlement they can expect and how it compares with the amount they would receive if the business were liquidated.
The creditors are interested in receiving as much as possible under any reorganization plan. The accountant may work with the creditors' committee to see that the amount proposed under the plan is reasonable and fair based on the nature of the debtor's business. First, it must be determined that the plan provides for at least as much as would be received in Chapter 7 liquidation. Second, the creditors must leave for the debtor enough assets to operate the business after reorganization. If a reasonable basis does not exist for future operations, the judge may not confirm the plan because it is not feasible.
If an audit has not been performed, the accountant for the creditors' committee must rely on the information contained in the disclosure statement and in other reports that have been issued. Thus, the content of the disclosure statement may be most important. Also, since the disclosure statement serves as the basic report used by the creditors to evaluate the plan, it is critical that it be properly prepared and contain the type of information that allows the creditors to effectively evaluate the proposed plan.
The accountant for the creditors' committee may be asked to evaluate the disclosure statement. If, in the accountant's opinion, it does not contain adequate information, the deficiencies may be conveyed to the debtor informally (normally through creditors' committee counsel) prior to submission of the plan to the court, or an objection to the content of the statement may be raised at the disclosure hearing.
In evaluating the information in the disclosure statement, the accountant for the creditors' committee may be asked to review the financial statements contained in the disclosure statement or others that were issued by the debtor. Special consideration must be made in reviewing pro forma and liquidation statements of financial condition. The pro forma statement provides the creditors with an indication of the debtor's likely financial condition if the plan is accepted. This statement should show that the creditors will receive more if they accept the plan than they would receive if the debtor were liquidated. The pro forma statement also should demonstrate that the plan is feasible in that, after satisfying the provisions of the plan, the debtor retains an asset base with which to operate. In reviewing the pro forma statement prepared by the debtor, special consideration must be given to the analysis of the assumptions used to prepare it and to the evaluation of the value of the assets (which may differ from book values). If the pro forma statements are based on historical costs, the accountant for the creditors' committee may want to restate them to reflect the reorganized values of the entity. The creditors' committee will be able to evaluate the terms of the plan more effectively if it can compare the terms to pro forma statements containing the reorganized value of the entity rather than historical values.
Liquidation statements show what the unsecured creditors would receive if the business were liquidated. The assumptions used in the adjustments to book values must be evaluated carefully. The accountant for the creditors' committee may be asked to review statements of this nature and to provide advice as to the reasonableness of the analysis. There may be a tendency for the debtor to understate liquidation values in order to make the terms of the plan more appealing to the unsecured creditors.
SOP 90-7 (ASC 852) explains how the debtor emerging from Chapter 11 should account for the reorganization both when fresh start reporting should be adopted and when it is not allowed. Fresh start reporting requires the debtor to use current values (going-concern or reorganization values) in its balance sheet for both assets and liabilities and to eliminate all prior earnings or deficits.
The two conditions that must be satisfied before fresh start reporting can be used are:
Paragraph 36 of SOP 90-7 (ASC 852-10-45-19) indicates that the loss of control contemplated by the plan must be substantive and not temporary. Thus, the new controlling interest must not revert to the shareholders existing immediately before the plan was confirmed. For example, a plan that provides for shareholders existing prior to the confirmation to reacquire control of the company at a subsequent date may prevent the debtor from adopting fresh start reporting.
Debtors that meet both of the preceding conditions will report the assets and liabilities at their going-concern (reorganization) values. Reorganization value is defined as the “fair value of the entity before considering liabilities and approximates the amount that a willing buyer would pay for the assets of the entity immediately after the restructuring.” The focus in determining the reorganization value is on the value of the assets. Normally the value is determined by discounted future cash flows. However, the value from the discounting of cash flows is defined as enterprise value. To get from enterprise value to reorganization value, current liabilities (ignoring current portion of funded debt) are added to the enterprise value.8 The reorganization value of the entity may be determined by several approaches depending on the circumstances.9 In most cases, it is not the responsibility of the accountant to determine the reorganization value of the debtor but to report in the financial statements the value that is determined through the negotiations by the debtor, creditors' and stockholders' committees, and other interested parties.
Professionals involved in bankruptcy cases have been aware of the limited usefulness of book values for some time. For example, market values are required in the schedules that are filed with the bankruptcy court, and fair market values of assets are determined under Section 506 of the Bankruptcy Code for assets pledged.
Reorganization values will be used only when both conditions for a fresh start are satisfied. For example, fresh start reporting will not be used by most nonpublic companies because in most cases there is no change of ownership. Thus, the provisions of SOP 90-7 (ASC 852) will apply primarily to public companies.
For entities meeting the criteria just discussed (reorganization value less than liabilities and old shareholders own less than 50 percent of voting stock of the emerging entity), fresh start reporting will be implemented in these three ways:
SOP 90-7 (ASC 852) indicates that three basic entries are needed to record the adoption of fresh start reporting in the accounts:
Paragraph 39 of SOP 90-7 (ASC 852-10-50-7) indicates that when fresh start reporting is adopted, the notes to the initial financial statement should disclose:
According to SOP 90-7 (ASC 852), some of the other significant matters that should be disclosed include:
Debtors that do not meet both of the conditions for adopting fresh start reporting should state any debt issued or liabilities compromised by confirmed plans at the present values of amounts to be paid. Thus, the debtor will no longer have the option to elect to discount or not to discount debt issued in a Chapter 11 case.
These provisions apply only to Chapter 11 cases. However, in out-of-court workouts where liabilities are generally restated, it will be difficult to justify accounting for issuance of new debt in a manner different from the discounting procedure described in SOP 90-7 (ASC 852).
Companies that qualify for fresh start reporting will value all of the assets at their fair value. If a company does not qualify for fresh start reporting, the provisions of FASB Statement No. 144 (ASC 360) must be followed. FASB Statement No. 142 (ASC 350), as described, provides guidance for the reporting of the impairment of goodwill.
The accounting for impairment of assets follows a three-step approach for financial statement recognition and valuation:
The loss from impairment of the assets will be the difference between the carrying amount and the fair value of the assets. For example, assume that a manufacturing facility is potentially impaired by use of the plant to manufacture a product different from the original design for plant use. This change in the nature of the product was caused by technological advancements in the industry. The company reviews for impairment by estimating the expected future net cash flows for the asset undiscounted and without interest. For example, if the carrying value of the plant is $3 million and the further cash flows are less than $3 million, then the asset is impaired. For example, if the future cash flows were expected to be $2.5 million and the fair value of the plant was determined to be $1.7 million, a loss of $1.3 million would be reflected even though the difference between the cash flows and the carrying value of the plant is only $.5 million. This process is viewed as one only of cost allocation; as a result, subsequent increases in the value of the asset may not be reflected in the accounts.
The rules described here also apply to assets that will be disposed of. Prior practice allowed the entity to reflect these assets to be disposed of at their net realizable value; if there was an increase in their value, a gain was reflected in the accounts to the extent of a previous write-down. This practice will no longer be allowed, except in a case in which FASB Statement No. 144 (ASC 360). In the case of disposition of assets associated with discontinued operations, under FASB Statement No. 144 (ASC 360) the assets will continue to be measured at their realizable value. At the time a bankruptcy petition is filed, it may appear that assets are impaired and carrying value should be materially reduced. However, with the filing of the petition, there will be a complete analysis of the viability of the business and of the various segments of the business. Until the assessment is complete, the company should avoid the impulse to materially reduce the carrying value of assets.
Accountants often issue various types of reports and schedules as part of services rendered in the bankruptcy and insolvency area. These services include the preparation of operating reports, evaluation or development of a business plan, valuation of the business, and search for preferences. Many of the reports or schedules produced would generally be classified as financial statements. Because financial statements are issued, the accountant must determine if a compilation, review, or audit report must be issued, or if the service that generated the statements is exempted from professional standards related to compilation of financial statements from the records and the attestation standards. This issue has involved considerable controversy among accountants who practice in the bankruptcy and insolvency area.
When the accountant begins an engagement involving bankruptcy or insolvency issues, a decision needs to be made as to application of the attestation standards. Section 9100.48 of Attestation Engagements Interpretation, “Applicability of Attestation Standards to Litigation Services,” excludes litigation services that “involve pending or potential formal legal or regulatory proceedings before a trier of fact in connection with the resolution of a dispute between two or more parties.” Guidance in this area is provided by the AICPA's Management Consulting Division, in Consulting Services Special Report 03-1, “Litigation Services and Applicable Professional Standards” (CSSR 03-1). This report concludes in paragraph 76/105.03 that “[b]ankruptcy, forensic accounting, reorganization, or insolvency services, as practiced by certified public accountants (CPA's), generally are acceptable as forms of litigation services.”
CSSR 03-1 notes that the role of the accountant in a litigation engagement is different from the role in an attestation services engagement. When involved in an attestation engagement, the CPA firm expresses “a conclusion about the reliability of a written assertion of another party.” In the performance of litigation services, the accountant helps to “gather and interpret facts and must support or defend the conclusions reached against challenges in cross-examination or regulatory examination and in the work product of others.”
Appendix G of CSSR 03-1 describes the delivery of reorganization services to include items such as these:
CSSR 03-1 then concludes that bankruptcy services similar to those listed above that are provided by CPAs generally are accepted as a form of litigation services. Appendix G of CSSR 03-1 provides that:
This acceptance is due to many fundamental and practical similarities between bankruptcy services and the consulting services associated with other forms of litigation. Bankruptcy law, as promulgated by the Bankruptcy Code and case law, is applied by bankruptcy judges and lawyers to resolve disputes between a debtor and its creditors (for example, distribution of the debtor's assets). Bankruptcy cases frequently include actions related to claims for preferential payments and fraudulent conveyances; negligence of officers, directors, or professionals engaged by the debtors; or other allegations common to commercial litigation. The bankruptcy court has the power and authority to value legal claims and resolve such common litigation as product liability, patent infringement, and breach of contract. The decisions of bankruptcy judges can be appealed as can the decisions of other courts.
According to CSSR 03-1, these guidelines should also apply to services rendered in an out-of-court workout, as described in the following paragraph from Appendix G:
Out-of-court restructuring holds the potential for litigation. Therefore, the settlement process is generally conducted with the same scrutiny, due diligence, and intense challenge as that of a formal court-administered process. Furthermore, bankruptcy services provided by CPAs are typically not three-party attest services (the three parties in attest services are the asserter, the attester, and the third party). Instead, affected parties have the opportunity to question, challenge, and provide input to the bankruptcy findings and process.
For services to be exempted, they must be rendered in connection with the litigation, and the parties to the proceeding must have an opportunity to analyze and challenge the work of the accountant. For example, when the CPA expresses a written conclusion about the reliability of a written assertion by another party, and the conclusions and assertions are for the use of others who will not have the opportunity to analyze and challenge the work, the professional standards would apply. Also, when the CPA is specifically engaged to perform a service in accordance with the attestation standards or accounting services standards (SAARS), professional standards are applicable.
If it is determined that the analysis or report that will be issued comes under the guidelines as a form of litigation services, it is advisable to explain both the association and the responsibility, if any, through a transmittal letter or a statement affixed to documents distributed to third parties. Appendix 71/B of CSSR 93-1 suggests this format for a statement that would explain the association of the CPAs and their responsibility, if any:
The accompanying schedules (projected financial information; debt capacity analysis; liquidation analysis) were assembled for your analysis of the proposed restructuring and recapitalization of ABC Company. The aforementioned schedules were not examined or reviewed by independent accountants in accordance with standards promulgated by the AICPA. This information is limited to the sole use of the parties involved (management; creditors' committee; bank syndicate) and is not to be provided to other parties.
If it is determined that the service does not qualify as litigation service, any financial statements that might be issued from the services rendered should be accompanied with an accountant's report based on the compilation of the financial statements. Prior to the issuance of a compilation report, the format and nature of the report must be cleared with the firm administrator.
Another area where there is considerable uncertainty is in the issuance of operating reports. All regions of the U.S. trustee require monthly operating reports be submitted to the court as well as annual operating reports. Among those items that were listed in CSSR 03-1 that might fall under litigation services was the preparation or review of the monthly operating reports required by the bankruptcy court. These reports, especially for larger public companies, are often prepared in accordance with generally accepted accounting principles, including SOP 90-7 (ASC 852). For example, in the region of New York, Connecticut, and Vermont, the U.S. trustee has issued guidelines that require the statements to conform to SOP 90-7 (ASC 852). Other U.S. trustees have on request by the accountant allowed the statements to be prepared in the format that conforms to the manner in which the accountant normally prepares monthly financial statements. Additionally, the accountant is asked to prepare supplemental data not generally presented in monthly financial statements such as an aging schedule of postpetition payables and a schedule of postpetition taxes paid and accrued.
As noted in CSSR 03-1, the professional standards would apply under two conditions:
In most situations, the second requirement—specifically engaged to perform attestation or compilation services—is not satisfied. Thus, based on this condition, the professional standards would not apply. Certified public accountants are generally engaged to prepare the operating reports that the U.S. trustee and the bankruptcy court require and not specifically to perform an audit or review of the financial records or even compile the financial statements in accordance with the professional standards.
It is the first requirement—expressing a written conclusion about the reliability of a written assertion by another party who will not have the opportunity to analyze and challenge the work—that needs further consideration by the profession. While no specific hearing is scheduled to review the reports, creditors or other parties in interest might raise objections to the content of the reports. Objections to the operating reports have been raised, but rarely. The preparation or the review of monthly operating reports that are required by the court is one of the items listed in the services that are rendered by accountants in the performance of reorganization services. CSSR 03-1 notes that “[b]ankruptcy services provided by CPAs generally are accepted as a form of litigation services.”
Since operating reports are considered a form of litigation services, a compilation report should not be issued on the reports. Rather, the following statement should be included in a transmittal letter or affixed to the operating reports:
The accompanying operating reports for the month of were assembled for your analysis of the proposed restructuring of the ABC Company under Chapter 11 of the Bankruptcy Code. The aforementioned operating reports were not examined or reviewed by independent accountants in accordance with the standards promulgated by the AICPA. This information is limited to the sole use of the parties in interest in this Chapter 11 case and is not to be provided to other parties.
If, however, it is determined in a particular engagement that professional standards are applicable and the CPA is associated with the financial statements, then a compilation report should be issued based on the prescribed form as set forth in SAARS No. 3. As noted, prior to the issuance of a compilation report the format and nature of the report must be reviewed for conformity to applicable standards.
Preference analysis or other special investigative services performed in a bankruptcy proceeding, receivership or out-of-court settlement, are considered litigation services. As a result, the accountant is not required to issue an agreed-on procedures report. This would not preclude the professional from issuing a report that described the procedures performed and the results ascertained from the performance of the stated procedures. For example, using the preceding format, a report issued to a trustee based on an analysis of preferences might be worded:
The accompanying analysis of preferential payments was assembled (or prepared) for your analysis (or consideration) in conjunction with the proposed reorganization under Chapter 11 of the Bankruptcy Code. The aforementioned analysis of preferential payments was not examined or reviewed by independent accountants in accordance with standards promulgated by the AICPA. This information is limited to the sole use of the trustee in this Chapter 11 case and is not to be provided to other parties.
Section 200.3 of the AICPA Statements on Standards for Attestation Engagements states that the standards for prospective financial statements do not apply for engagements involving prospective financial statements used solely in connection with litigation support services. CSSR 03-1 clearly indicates that prospective financial information qualifies as a litigation service. CSSR 03-1 states that parties-in-interest can challenge prospective financial information during negotiations or during bankruptcy court hearings often dealing with the plan's feasibility and adequacy of disclosure. Projections that are included in a disclosure statement would not be subject to the attestation standards since there is a hearing on the disclosure statement and the court must approve the disclosure statement before votes for the plan can be solicited. Parties-in-interest have an opportunity to challenge the prospective information included. Any projections provided for the debtor or for the creditors' committee that is used in the negotiations of the plan would also not fall under the attestation standards.
CSSR 03-1 does, however, indicate that in situations where the users of the prospective financial information cannot challenge the CPA's work, the attestation standards apply. CSSR 03-1 suggests that the attestation standard might apply in situations where exchange offers are made to creditors and stockholders with whom the company has not negotiated or who are not members of a creditor group represented by a committee. Section 200.3 of the AICPA Statements on Standards for Attestation Engagements indicates that if the prospective financial statements are used by third parties that do not have the opportunity to analyze and challenge the statements, the litigation exception does not apply.
Section 200.2 of the AICPA Statements on Standards for Attestation Engagements indicates that when an accountant submits, to the client or to others, prospective financial statements that he or she has assembled (or assisted in assembling) or reports on prospective financial statements that might be expected to be used by third parties, a compilation, examination, or agreed-on procedures engagement should be performed. Thus, for prospective financial statements that do not qualify for the litigation exception, the engagement must be in the form of a compilation, examination, or agreed-on procedures if the accountant is associated with the financial statements.
The determination of the reorganization or liquidation values to be included in the disclosure statement or to be used by the debtor or creditors' committee in the negotiations of the terms of a plan, as well as other services that involve financial projections, would fall under the litigation exception. If it is determined that the report regarding the issuance of financial projections would not fall under litigation services, the format and nature of the report must be reviewed for conformity to applicable standards.
This wording might be in the transmittal letter or in a statement affixed to the documents:
The accompanying projected financial statements (or information) were assembled for your analysis of the proposed restructuring and reorganization of under Chapter 11 of the Bankruptcy Code. The aforementioned statements were not examined or reviewed by independent accountants in accordance with standards promulgated by the AICPA. This information is limited to the sole use of and is not to be provided to other parties.
American Institute of Certified Public Accountants. Accounting Standards Executive Committee, Statement of Position (SOP) No. 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code (ASC 852, Reorganization). New York: Author, 1990.
Behrenfield, W. H., and A. R. Biebl. “Bankruptcy/Insolvency.” In The Accountant's Business Manual., New York: AICPA, 1989.
Countryman, V. “Executory Contracts in Bankruptcy,” Minnesota Law Review 57 (1973): 439, 460.
Financial Accounting Standards Board.Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (ASC 450). Stamford, CT: Author, 1975 (ASC 450 Contingencies).
_____. Statement of Financial Accounting Standards No. 141F, Business Combinations (SC 805). Norwalk, CT: Author, 2001 (ASC 805 Business Combinations).
_____. Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (ASC 360). Norwalk, CT: Author, 2001 (ASC 360 Property, Plant, and Equipment).
_____. Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (ASC 350). Norwalk, CT: Author, 2001 (ASC 350 Intangibles - Goodwill and Other).
_____. Statement of Financial Accounting Standards No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings (ASC 310 and 470). Stamford, CT: Author, 1977 (ASC 310 Receivables and ASC 470 Debt).
King, L. P., ed. Collier Bankruptcy Manual. New York: Matthew Bender, 1994.
Newton, G. W. Bankruptcy and Insolvency Accounting, 7th ed. Hoboken, NJ: John Wiley & Sons, 2010.
_____. Corporate Bankruptcy: Tools, Strategizing, and Alternatives. Hoboken, NJ: John Wiley & Sons, 2002.
Patterson, G. F., Jr., and G. Newton. “Accounting for Bankruptcies: Implementation SOP 90-97 (ASC 852),” Journal of Accountancy 46 (April 1993).
Securities and Exchange Commission. Staff Accounting Bulletin No. 73, “‘Push Down’ Basis of Accounting for Parent Company Debt Related to Subsidiary Acquisitions.” Washington, DC: Author, 1987.
_____. Staff Accounting Bulletin No. 78, “Views Regarding Certain Matters Relating to Quasi-Reorganizations, Including Deficit Eliminations.” Washington, DC: Author, 1988. (See ASC 852.)
1 119.1 2006-48 I.R.B. 995.
2 See Vern Countryman, “Executive Contracts in Bankruptcy,” Minnesota Law Review 57 (1973): 439, 460.
3 See S. Rep. No. 95–989, 95th Cong., 2nd Sess. (1977).
4 Grant W. Newton, Bankruptcy and Insolvency Accounting, 7th ed. (Hoboken, NJ: John Wiley & Sons, 2010).
5 The dollar amounts for priority claims will be adjusted every three years to reflect the changes in the Consumer Price Index for All Urban Consumers. The next adjustment will be made on April 1, 2013.
6 This ASC was issued by the FASB codifying the Statements of Financial Accounting Standards, Accounting Principles Board Opinions, Statements of Positions, and other previously issued statements of principles and concepts.
7 A discussion of the cram down provision is found in Section 5.33 of Newton's Bankruptcy and Insolvency Accounting.
8 If the appraiser reduced the enterprise by the amount of cash or excess cash, this amount should also be added with current liabilities to determine reorganization value.
9 Newton, Bankruptcy and Insolvency Accounting.
10 CSSR 03-1 notes that the words review and reviewing are not intended to have the same meaning as they do in the AICPA Statements on Standards for Accounting and Review Services.
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