Accounting for Bankruptcy

There are two forms of bankruptcy that a business entity can petition. These two forms are Chapter 7 and Chapter 11. "In Chapter 7 bankruptcy, the company ceases operations and the assets are generally sold by a trustee. In a chapter 11 bankruptcy, the business is reorganized and the creditors agree on a plan for payment of their claims" (Jeter, 2004 p. 506).

The realization and liquidation account is a form prepared by the trustee and used by the courts to monitor the fiduciary's changes in monetary items. The three main reporting sections, assets, liabilities, and revenues and expenses are described in more detail below. Assets section is composed of four subparts. Assets to be realized are assets the trustee has taken title from the debtor. Assets acquired are an itemized list of assets earned during the period's operating activities. Assets realized are the proceeds from conversion of assets. Lastly, assets not realized report the assets remaining at the end of the reporting period. Cash is not included in this report because it is already realized. The court is given a copy of the cash account with the realization and liquidation account. The liabilities section has four subparts, the first is liabilities liquidated, or liabilities the trustee has taken responsibility for. Liabilities incurred are the liabilities from the period's operating activities. Liabilities to be liquidated are paid by the trustee. Lastly, liabilities not liquidated are those that still need to be paid by the trustee. The revenues and expenses portion is comprised of only two parts, supplementary charges and supplementary credits. Supplementary charges are the period's revenues and the supplementary credits the expenses. A period gain or loss is the amount that balances the account (Jeter, 2004 p. 503-504).

Accounting by Debtors and Creditors for Troubled Debt Restructurings, FASB statement number 15 establishes standards by the debtor and by the creditor for a troubled debt restructuring it does not apply to bankruptcy cases that are a general restatement of liabilities. "This Statement requires adjustments in payment terms from a troubled debt restructuring generally to be considered adjustments of the yield (effective interest rate) of the loan. So long as the aggregate payments (both principal and interest) to be received by the creditor are not less than the creditor's carrying amount of the loan, the creditor recognizes no loss, only a lower yield over the term of the restructured debt. Similarly, the debtor recognizes no gain unless the aggregate future payments (including amounts contingently payable) are less than the debtor's recorded liability" (Financial, 1977).

A debtor can discuss with the creditor transferring an asset for full resolution of the debt but the debtor will need to recognize it as a gain. "The gain is measured by the excess of the carrying value of the payable over the fair value of the assets transferred" (Jeter, 2004 p. 506). The gain or loss of the transfer is reported in net income during the period that the transfer occurs. The gain of restructuring is included in net income under extraordinary item. A business can decide to offer an equity interest in exchange for full settlement of a debt. The gain will equal the fair value of equity interest deducted from the carrying amount of the debt. As with transferring an asset, the gain will be included as an extraordinary item in the net income. The debtor and creditor can decide to restructure the debt by modification of terms. Modification of terms of a debt is accounted for by the results of the restructuring potentially from the time of restructuring. "The effects of changes in the amounts or timing (or both) of future cash payments designated as either interest or face amount are reflected in future periods... This is the approach that is followed in the bankruptcy regardless of whether the total future payments exceed the existing carrying value of the debt plus accrued interest" (Jeter, 2001 p. 493). This should be recognized as a deduction to the carrying value of the debt and no interest t expense should be recognized after the restructuring begins until after the maturity.

The AICPA's statement of position 90-7 provides guidance for fresh-start accounting for firms emerging from bankruptcy. The organization emerging from bankruptcy is treated as though it is a new firm, thus assets and liabilities are recorded at fair value and retained earnings is zero (Jeter, 2004 p.491). There are two requirements to be met for fresh-start accounting "The fair value of assets must be less than the post liabilities and allowed claims, and the original owners must own less than 50% of the voting stock after reorganization" (Jeter, 2004 p.491). When implementing fresh-start accounting timing has a significant impact on the ease of the process. If the entity's fresh-start reporting date does not occur at year end, they will need to issue two income statements for the year, one up to the fresh-start reporting date (stub income statement) and one after. To accomplish this, the company needs to establish procedures to close the books out mid-year and use that as the starting point on the fresh-start accounting (Sasso, 2005).

Bibliography

Jeter, D.C. and Chaney, P.K. (2004) Advanced Accounting. New Baskerville: Hermitage Publishing Services.

Financial Accounting Standards Board. (1977). Summary of Statement No. 15. Accounting by Debtors and Creditors for Troubled Debt Restructurings. Retrieved April 27, 2006, from http://www.fasb.org/st/summary/stsum15.shtml

Sasso, T. (16 May 2005) Make it New: A Fresh-Start Accounting Primer: What Debtors Need to Know in Planning for Their Emergence From Bankruptcy. Retrieved May 5, 2006 from http://www.deloitte.com/dtt/cda/doc/content/us_deal_t02fl.pdf#search='fresh%20start%20accounting.