Centuries ago in Italy the bankrupt merchant would be forced into an odd form of pillory. He would have the table he did business at in the town square broken. At least one source says the word bankruptcyderives from the Italian words for this practice, which translate to broken bench.2 A basic assumption of accounting is that a business is considered a going concernunless evi- dence to the contrary is discovered. As a result, assets such as inventory, land, buildings, and equipment are traditionally reported based on historical cost rather than net realizable value.
Unfortunately, not all companies prove to be going concerns.
When the recession began last December, businesses nationwide were filing an average of 206 bankruptcy petitions a day. That average has increased steadily since June, reaching 318 per day in November. Commercial bankruptcy filings are up 111 percent in Oregon, 91 percent in Utah, and 83 percent in California.3
Not only is the number of bankruptcies rising but also the size of many bankruptcies is be- coming astronomical. Notice how many of the 10 largest U.S. bankruptcies have occurred in the last few years:
• Lehman Brothers Holdings Inc., July 15, 2008, $691.1 billion in assets.
• Washington Mutual Inc., September 26, 2008, $327.9 billion.
• WorldCom Inc., July 21, 2002, $103.9 billion.
• General Motors Corp., June 1, 2009, $91.1 billion.
• Enron Corp., December 2, 2001, $65.5 billion.
• Conseco Inc., December 17, 2002, $61.4 billion.
• Chrysler LLC, April 30, 2009, $39.3 billion.
• Thornburg Mortgage Inc., May 1, 2009, $36.5 billion.
• Pacific Gas and Electric Co., April 6, 2001, $36.2 billion.
• Texaco Inc., April 12, 1987, $35.0 billion.4
What happens to these businesses after they fail? Is bankruptcy the equivalent of a death sen- tence? Who gets the assets? Are the creditors protected? How does the accountant reflect the economic plight of the company?
Virtually all businesses undergo financial difficulties at various times. Economic down- turns, poor product performance, and litigation losses can create cash flow difficulties for even the best-managed organizations. Most companies take remedial actions and work to return their operations to normal profitability. However, as the preceding list indicates, not all com- panies are able to solve their monetary difficulties. If problems persist, a company can even- tually become insolvent,unable to pay debts as the obligations come due. When creditors are not paid, they obviously attempt to protect their financial interests in hope of reducing the possibility of loss. They may seek recovery from the distressed company in several ways:
repossessing assets, filing lawsuits, foreclosing on loans, and so on. An insolvent company can literally become besieged by its creditors.
If left unchecked, pandemonium would be the possible outcome of a company’s insolvency.
As a result, some of the creditors and stockholders as well as the company itself could find themselves treated unfairly. One party might be able to collect in full while another is left with a
LO1
Describe the history and current status of bankruptcy and bank- ruptcy laws.
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Accounting for Legal Reorganizations and Liquidations 559
total loss. Not surprisingly, bankruptcy laws have been established in the United States to struc- ture this process, provide protection for all parties, and ensure fair and equitable treatment.
Although a complete coverage of bankruptcy statutes is more appropriate for a business law textbook, significant aspects of this process directly involve accountants.
In many small business situations, the company accountant is the sole outside financial adviser and the first to recognize that the deteriorating financial picture mandates consideration of bank- ruptcy in one form or another. In many such situations, the accountant’s role in convincing man- agement that a timely reorganization under the bankruptcy law is the sole means of salvaging any part of the business may be critical.5
Bankruptcy Reform Act of 1978
Over the ages debtors who found themselves unable to meet obligations were dealt with harshly.
Not only were all their assets taken from them, but they were given little or no relief through legal forgiveness of debts. Many of them ended up in debtors’ prisons with all means of rehabili- tation removed. A large number of the early settlers in this country left their homelands to escape such a fate.6
Based on an original provision of the U.S. Constitution, Congress is responsible for creating bankruptcy laws. However, virtually no federal bankruptcy laws were actually passed until the Bankruptcy Act of 1898 (subsequently revised in 1938 by the Chandler Act). Later, following a decade of study and debate by Congress, the Bankruptcy Reform Act of 1978 replaced these laws. Congress has amended this act several times since 1978.7
Consequently, the Bankruptcy Reform Act of 1978 as amended continues to provide the le- gal structure for most bankruptcy proceedings. It strives to achieve two goals in connection with insolvency cases: (1) the fair distribution of assets to creditors and (2) the discharge of an honest debtor from debt.
Voluntary and Involuntary Petitions
When insolvency occurs, any interested party has the right to seek protection under the Bank- ruptcy Reform Act.8Thus, the company itself can file a petition with the court to begin bank- ruptcy proceedings.9If the company is the initiator, the process is referred to as a voluntary bankruptcy. In such cases, the company’s petition must be accompanied by exhibits listing all debts and assets (reported at fair value). Company officials also must respond to questions concerning various aspects of the business’s affairs. Such questions include:
• When did the business commence?
• In whose possession are the books of account and records?
• When was the last inventory of property taken?
Creditors also can seek to force a debtor into bankruptcy (known as an involuntarybank- ruptcy) in hope of reducing their potential losses. To avoid nuisance actions, bankruptcy laws
5John K. Pearson, “The Role of the Accountant in Business Bankruptcies,” The National Public Accountant, November 1982, p. 22.
6Homer A. Bonhiver, The Expanded Role of the Accountant under the 1978 Bankruptcy Code(New York:
Deloitte Haskins & Sells, 1980), p. 7.
7An excellent overview of the bankruptcy process from a legal perspective can be downloaded at www.
uscourts.gov/bankruptcycourts/bankbasics.pdf. It is titled “Bankruptcy Basics” and is produced by the Adminis- trative Office of the United States Courts, James C. Duff, Director. Bankruptcy can be viewed in an entirely different light in the book Comic Warswritten by Dan Raviv and published in 2002 by Broadway Books in New York. Comic Warsfollows the battle between several financial icons as they seek to gain control over Marvel Entertainment as it struggles to avoid liquidation.
8As is discussed later in this chapter, insolvency (not being able to pay debts as they come due) is not neces- sary for filing a bankruptcy petition. During the 1980s, such companies as Manville Corporation, Texaco, and A. H. Robins originally filed for protection under the Bankruptcy Reform Act in hope of settling massive litiga- tion claims.
9The bankruptcy petition filed by Circuit City on November 10, 2008, can be found at http://www.creditslips.
org/creditslips/CircuitCity.pdf. This document shows that the company owed Hewlett-Packard, the biggest unsecured creditor, $118,797,964. The petition was originally for a reorganization but that quickly became a liquidation in January 2009 after an unsuccessful attempt to cash in on Christmas sales.
LO2
Explain the difference between a voluntary and involuntary bankruptcy.
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regulate the filing of involuntary petitions. If a company has 12 or more unsecured creditors, at least 3 must sign the petition. In addition, under current rules, the creditors that sign must have unsecured debts of at least $13,475.10If fewer than 12 unsecured creditors exist, only a single signer is required, but the $13,475 minimum debt limit remains.
While owners of the recently built Webster Holiday Inn Express Hotel & Suites battle each other in the state Supreme Court, creditors seeking payment of long overdue bills have intervened with a petition seeking to force the business into Chapter 11 bankruptcy. Opened in late October 2007, the 104-room hotel on Holt Road is the newest Rochester-area addition to Intercontinental Hotels Group’s Holiday Inn chain. Three Rochester-based companies—Concord Electric Corp., Billone Mechanical Contractors Inc., and Image City Interiors Inc.—filed a petition March 27 in U.S.
Bankruptcy Court in Rochester, seeking to force the Webster hotel’s owner, Webster Hospitality Development LLC, into an involuntary Chapter 11 proceeding. The filing lists amounts owed as
$31,060 to Concord Electric, $24,020 to Billone Mechanical, and $34,899 to Image City.11
Neither a voluntary nor an involuntary petition automatically creates a bankruptcy case.
The court rejects voluntary petitions if the action is considered detrimental to the creditors. In- voluntary petitions also can be rejected unless evidence exists to indicate that the debtor is not actually able to meet obligations as they come due. Merely being slow to pay is not sufficient.
The debtor may well fight an involuntary petition fearing that its reputation will be tainted in the business community.
If the court accepts the petition, an order for relief is granted. This order halts all actions against the debtor, thus providing time for the various parties involved to develop a course of action. In addition, the company comes under the authority of the bankruptcy court so that any distributions must be made in a fair manner.
To prevent creditors from seizing whatever is handy once the bankruptcy is filed, the Bankruptcy Code provides for an automatic stay or injunction that prohibits actions by creditors to collect debts from the debtor or the debtor’s property without the court’s permission. The automatic stay bars any creditor (including governmental creditors such as the Internal Revenue Service) from taking any action against the debtor or the debtor’s property.12
Classification of Creditors
Following the issuance of an order for relief, the possible risk of loss obviously influences each creditor’s view of a bankruptcy case. However, many creditors may have already obtained some measure of security for themselves. When a debt is created, the parties can agree to attach a mortgage lien or security interest to specified assets (known as collateral) owned by the debtor. Such action is most likely when the amounts involved are great or the debtor is experiencing financial difficulty. In the event that the liability is not paid when due, the creditor has the right to force the sale (or, in some cases, the return) of the pledged property with the proceeds being used to satisfy all or part of the obligation. Thus, in bankruptcy proceedings, a secured creditor holds a much less vulnerable position than an unsecured creditor.
Because of the possible presence of liens, all loans and other liabilities are reported to the court according to their degree of protection against loss. Some debts are identified as fully securedto indicate that the net realizable value of the collateral exceeds the amount of the obligation. Despite the debtor’s insolvency, these creditors will not suffer loss; they are com- pletely protected by the pledged property. Any money received from the asset that is in excess of the balance of the debt is then used to pay unsecured creditors.
Conversely, a liability is partially securedif the value of the collateral covers only a portion of the obligation. The remainder is considered unsecured;the creditor risks losing some or all of this additional amount. For example, a bank might have a $90,000 loan due from an insolvent party that is protected by a lien attached to land valued at $64,000. This debt is only partially secured; the asset would not satisfy $26,000 of the balance. This residual portion is reported to the court as unsecured.
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10Throughout the bankruptcy laws, a number of monetary standards such as this exist. Such dollar amounts were last adjusted for inflation on April 1, 2007. These balances are to be adjusted every three years based on the Consumer Price Index for All Urban Consumers.
11Will Astor, “Hotel Tussle Sparks Move by Creditors,” Rochester Business Journal, April 3, 2009, p. 3.
12Pearson, “The Role of the Accountant,” p. 24.
LO3
Identify the various types of creditors as they are labeled during a bankruptcy.
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Accounting for Legal Reorganizations and Liquidations 561
All other liabilities are unsecured; these creditors have no legal right to any of the debtor’s specific assets. They are entitled to share only in any funds that remain after all secured claims have been settled. Obviously, unsecured creditors are in a precarious position. Unless a debtor’s assets greatly exceed secured liabilities (which is unlikely in most insolvency cases), these creditors can expect significant losses if liquidation proves to be necessary. Hence, one of the most important aspects of the bankruptcy laws is the ranking of unsecured claims.
The Bankruptcy Reform Act identifies several types of unsecured liabilities that have priority and must be paid before other unsecured debts are settled. These obligations are ranked with each level having to be satisfied in full before any payment is made to the next.
Only in this manner is a systematic distribution of any remaining assets possible.
Unsecured Liabilities Having Priority The following liabilities have priority:13
1. Claims for administrative expenses such as the costs of preserving and liquidating the es- tate. All trustee expenses and the costs of outside attorneys, accountants, or other consul- tants are included in this category. Without this high-priority ranking, insolvent companies would have difficulty convincing qualified individuals to serve in these essential positions.
In recent years, the amounts assessed for such services have come under fire from many critics: “The protests follow a recent court filing by Enron, the fallen energy company, pro- jecting that professional fees for the first 13 months of the bankruptcy will total $306 mil- lion. All told, according to the projections, administrative costs during the period will be
$773 million, or nearly $60 million a month.”14
2. Obligations arising between the date that a petition is filed with the bankruptcy court and the appointment of a trustee or the issuance of an order for relief. In voluntary cases, such claims are quite rare because an order for relief is usually entered when the petition is filed.
This provision is important, however, in helping the debtor continue operations if an invol- untary petition is presented but no legal action is immediately taken. Without this ranking, suppliers would stop providing merchandise to the debtor until the matter was resolved.
With this high ranking, the debtor can hope to continue to buy goods and stay in business while resisting an involuntary petition.
3. Employee claims for wages earned during the 180 days preceding the filing of a petition.
The amount of this priority is limited, though, to $10,950 per individual. This priority rank- ing does not include officers’ salaries. It is designed to prevent employees from being too heavily penalized by the company’s problems and encourages them to continue working until the bankruptcy issue is settled. In addition, employees are not company creditors in the traditional sense of that term. They did not enter employment to serve as lenders to the corporation. However, employees can still be financially damaged by bankruptcy.
The $32 million claim filed on behalf of former Heller employees, represented by Garfield Granett, Carl Goodman, and Anna Scarpa, asks for at least $10,950 for each of the firm’s 861 former employees. Called a priority claim, that amount is guaranteed to employees of a company in bankruptcy, after secured creditors are paid.15
4. Employee claims for contributions to benefit plans earned during the 180 days preceding the filing of a petition. Again, a $10,950 limit per individual (reduced by certain specified payments) is enforced.
5. Claims for the return of deposits made by customers to acquire property or services that the debtor never delivered or provided. The priority figure, in this case, is limited to $2,425.
These claimants did not intend to be creditors; they were merely trying to make a purchase.
6. Government claims for unpaid taxes.
All other obligations of an insolvent company are classified as general unsecured claims that can be repaid only after the creditors with priority have been satisfied. If the funds that remain for the general unsecured debts are not sufficient to settle all claims, the available money must
13Only the most significant unsecured liabilities given priority are included here. For a complete list, check a current business law textbook.
14Michael Orey, “Group of Enron Creditors Say Court Costs Grow Unwieldly,” The Wall Street Journal, November 4, 2002, p. B3.
15Amanda Royal, “Thelen, Heller Face Huge Wage Claims,” The Recorder, April 2, 2009.
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be divided proportionally.Periodic changes in this priority listing are made and can impact the amounts various types of creditors will receive. For example, in 2005, Congress reclassified prior rent still due as an administrative expense rather than as an unsecured claim as it had been previously classified. Consequently, such rental debts are now more likely to be paid in full, leaving less for the remaining unsecured creditors.
Liquidation versus Reorganization
The most important decision in any bankruptcy filing (either voluntary or involuntary) is the method by which the debtor will be discharged from its obligations. One obvious option is to liquidate the company’s assets with the proceeds distributed to creditors based on their secured positions and the priority ranking system just outlined. However, a very important alternative to liquidation does exist. The debtor company may survive insolvency and continue opera- tions if the parties involved accept a proposal for reorganization. Not everyone agrees with the wisdom of allowing reorganization. This argument holds that keeping inefficient orga- nizations alive and competing does not serve the industry or the economy well.
There are many reasons why a business gets sick, but they don’t necessarily mean it should be de- stroyed. Hundreds of thousands of businesses that at one time or another had financial difficulties
Discussion Question
WHAT DO WE DO NOW?
The Toledo Shirt Company manufactures men’s shirts sold to department stores and other outlets throughout Ohio, Illinois, and Indiana. For the past 14 years, one of Toledo’s ma- jor customers has been Abraham and Sons, a chain of nine stores selling men’s clothing.
Mr. Abraham retired 18 months ago and his two sons took complete control of the orga- nization. Since that time, they have invested enormous sums of money in an attempt to expand each store by also selling women’s clothing. Success in this new market has been difficult. Abraham and Sons is not known for selling women’s clothing, and no one in the company has much expertise in the area.
Approximately seven months ago, James Thurber, Toledo’s chief financial officer, be- gan to notice that it was taking longer than usual to collect payments from Abraham and Sons. Instead of the normal 30 days, the retailer was taking 45 days—and frequently longer—to pay each invoice. Because of the amount of money involved, Thurber began to monitor the balance daily. When the age of the receivable ($243,000) hit 65 days, he called Abraham and Sons. The treasurer assured him that the company was merely having seasonal cash flow issues but that payments would soon be back on a normal schedule.
Thurber was still concerned and shortly thereafter placed Abraham and Sons on a
“cash and carry” basis. No new sales were to be made unless cash was collected in advance.
The company’s treasurer immediately called Thurber to complain bitterly. “We have been one of your best customers for well over a decade, but now that we have gotten into a bit of trouble you stab us in the back. When we straighten things out here, we will re- member this. We can get our shirts from someone else. Our expansions are now com- plete; we have hired an expert to help us market women’s clothing. We can see the light at the end of the tunnel. Abraham and Sons will soon be more profitable than ever.” In hope of appeasing the customer while still protecting his own position, Thurber agreed to sell merchandise to Abraham and Sons on a very limited credit basis.
A few days later, Thurber received a disturbing phone call from a vice president with another clothing manufacturer. “We’ve got to force Abraham and Sons into bankruptcy immediately to protect ourselves. Those guys are running the company straight into the ground. They owe me $160,000, and I can only hope to collect a small portion of it now. I need two other creditors to sign the petition and I want Toledo Shirt to be one of them.
Abraham and Sons has already mortgaged all of its buildings and equipment so we can’t get anything from those assets. Inventory stocks are dwindling and sales have disap- peared since they’ve tried to change the image of their stores. We can still get some of our money but if we wait much longer nothing will be left but the bones.”
Should the Toledo Shirt Company be loyal to a good customer or start the bankruptcy process to protect itself? What actions should Thurber take?
LO4
Describe the difference between a Chapter 7 bankruptcy and a Chapter 11 bankruptcy.
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