Business failures are a common occurrence in the U.S. economy. The situation that precedes the typical business failure is inability to pay liabilities at maturity. A business enterprise may be unable to pay its liabilities at maturity even though the current fair value of its assets exceeds its liabilities. However, insolvency is a more typical state of a failing enterprise. Insolvency is defined as an excess of liabilities over current fair value of assets.
The present U.S. Bankruptcy Code was enacted in 1978 and amended in 1994 to replace the Bankruptcy Act, which with numerous amendments had remained in effect for 80 years. In 1980, the Bankruptcy Tax Act established income tax rules for bankruptcy and insolvency. Important interpretations of the Bankruptcy Code are in the Federal Rules of Bankruptcy Procedure established by the Supreme Court.
Liquidation under Chapter 7 of the Bankruptcy Code involves the realization (sale) of the assets of an individual or business enterprise and the distribution of the cash proceeds to the creditors. Creditors are ranked in bankruptcy according to whether they have a security interest in assets of the debtor or are unsecured. The claims of certain unsecured creditors have priority over other unsecured creditors' claims under provisions of the Bankruptcy Code.
With certain exceptions, any individual or business enterprise may initiate liquidation proceedings by filing in a federal bankruptcy court a debtor's petition for liquidation. Alternatively, under specified conditions creditors of a debtor enterprise may file in a federal bankruptcy court a creditors' petition to have the debtor enterprise liquidated. Both types of petitions must be accompanied by extensive supporting data. In addition, a creditors' petition must include a claim that the debtor was not paying debts as they came due, or that recently a custodian had assumed responsibility for the debtor's property.
The federal bankruptcy court in which a debtor's or creditors' bankruptcy petition is filed oversees all aspects of the bankruptcy proceedings. One of the court's first acts is to dismiss the petition or to grant an order for relief under the Bankruptcy Code. An order for relief acts to stay any suits pending against the debtor until the question of the debtor's discharge is determined by the court.
Either the creditors or the court may appoint a trustee for the debtor's estate. The trustee realizes the assets of the estate and pays cash to unsecured creditors.
Once the debtor's assets have been realized and all possible amounts have been paid to creditors, the debtor may receive from the court a discharge, which is a release from all unliquidated debts except those specified in the Bankruptcy Code.
The accountant's role in liquidation proceedings is concerned with proper reporting of the financial condition of the debtor and adequate accounting and reporting for the trustee of the debtor's estate. A statement of affairs is a financial statement that presents the financial condition of a quitting concern entering bankruptcy proceedings. The statement of affairs displays the assets and liabilities of the debtor enterprise from a liquidation viewpoint, because liquidation is the outcome of Chapter 7 bankruptcy proceedings. Thus, assets in the statement of affairs are valued at current fair value, and assets and liabilities in the statement are classified according to the rankings and priorities set forth in the Bankruptcy Code. A contra (offset) technique is used in the statement of affairs when the legal right of setoff exists.
Maintenance of the accounting records of a debtor should be continued during the period that a trustee carries on the operations of the debtor's business. An accountability technique is used once the trustee begins realization of the debtor's assets. In the accountability method of accounting, the assets and liabilities for which the trustee is responsible are entered in the trustee's accounting records at their statement-of-affairs valuations. The offset is to a ledger account with a title such as Estate Deficit. Differences between cash receipts and payments and the carrying amounts of assets realized and liabilities paid by the trustee are debited or credited directly to the Estate Deficit ledger account.
The periodic and final reports of the trustee to the bankruptcy court are a statement of cash receipts and payments, a statement of realization and liquidation, and for interim reports a supporting exhibit of assets not yet realized and liabilities not yet paid.
A reorganization under Chapter 11 of the Bankruptcy Code involves such features as reductions of amounts payable to some creditors, issuance of the debtor's equity securities to settle other creditors' claims, and a reduction of the par or stated value of the debtor's common stock.
During the process of reorganization, management or owners of the debtor enterprise may continue to operate the enterprise, or the bankruptcy court may appoint a trustee to manage it. The trustee identifies the enterprise's creditors and stockholders and formulates a plan for continuing the enterprise's operations, if management of the enterprise has not done so.
The plan of reorganization developed by the trustee or by management is submitted to the bankruptcy court and distributed to other interested parties, including the Secretary of the Treasury and perhaps the Securities and Exchange Commission. The plan must contain a number of provisions, including modifications of the interests and rights of the corporation's creditors and stockholders. The SEC may review, and be heard by the bankruptcy court on, many reorganization plans.
In order for a reorganization plan to be confirmed by the court, two-thirds of all stockholders, and a majority of creditors whose claims account for two-thirds of the total liabilities, must accept the plan. Confirmation of a reorganization plan by the court makes it binding on the debtor enterprise and all its creditors and stockholders.
Journal entries to record a reorganization typically include (a) exchange of newly authorized common stock for old outstanding common stock and for some liabilities; (b) extension of due dates of other liabilities; (c) payments to other creditors at less than 100 cents for each $1 of debt; and (d) elimination of a retained earnings deficit. Extensive disclosure in a note to the financial statement is essential for the complex provisions of a reorganization.
