Filing for Chapter 11 bankruptcy can bring a new lease on life for a struggling company. During bankruptcy, business leaders may confront the reasons for reorganization in a way that empowers the company to surmount its challenges and uncover opportunities to reassess operations. It’s even possible to emerge from bankruptcy stronger than before.
From the pre-bankruptcy planning to the post-bankruptcy reality, companies will encounter technical accounting and financial reporting complexities that further complicate their decision making. But business leaders also stand to take advantage of new options that arise. In this article, we will explore the dual nature of bankruptcy and offer insights into the roles that accounting professionals can play.
The Accounting Hurdles of Bankruptcy
Bankruptcy can complicate critical accounting functions that already require meticulous attention to detail and compliance with a multitude of reporting requirements pursuant to the federal bankruptcy code, tax laws and regulations. Key accounting challenges for a company that is considering bankruptcy or has already filed for Chapter 11 include the following:
Pre-Bankruptcy
Before deciding to file for bankruptcy, companies often face internal and external challenges, such as inventory disruption, skyrocketing prices, and unfavorable contracts (e.g., revenue, supply, leasing). Management must tackle myriad complex accounting issues, even before filing for bankruptcy, including:
- Valuation and accounting issues related to:
- Accounts receivable and contract assets
- Inventory
- Long-lived assets
- Intangible assets and goodwill
- Contingent liabilities (not recorded on the books and records of the company),
- Tax liabilities
- Ownership interests pre-filing and potentially post-filing
- Debt covenant compliance and debt modification
- Contract modifications (revenue and supply contracts and lease agreements)
- Restructuring considerations (exit and disposal activities, potential discontinued operations, change in ownership, net operating losses)
- Operating segment results
- Cash-flow and liquidity projections
- Going concern
During Bankruptcy
Even after companies file for bankruptcy, they often continue to report financial results. Companies that file for a reorganization under Chapter 11 apply Accounting Standards Codification (ASC) 852 – Reorganizations for guidance on financial reporting. The guidance in ASC 852 applies to companies that have filed petitions with the Bankruptcy Court and expect to reorganize as going concerns under Chapter 11 of Title 11 of the United States Code. Companies that liquidate under Chapter 11, or adopt plans of liquidation and restructure outside of Chapter 11, are outside the scope of ASC 852 and would instead generally apply ASC 205-30, Presentation of Financial Statements — Liquidation Basis of Accounting.
The provisions within ASC 852 generally are incremental to the requirements in other U.S. GAAP, rather than a replacement, and are intended to address the change in the needs of the financial statement users. It is important to note that ASC 852 applies only after the Chapter 11 filing. If a filing occurs after year end but before the issuance of a company’s financial statements (or before the financial statements are available to be issued), consideration must be given related to the requirements to evaluate, account for, and disclose subsequent events.
Companies operating under Chapter 11 distinguish liabilities within their balance sheets as prepetition liabilities subject to compromise from those that are not subject to compromise and post-petition liabilities. Careful evaluation of the classification is required in each reporting period, and that classification must be revised to reflect the then current expectations and the decisions of the court as the bankruptcy proceeds.
Accounting and presentation for debt while in bankruptcy requires careful consideration of the facts and circumstances for the appropriate presentation in accordance with ASC 852.
While in Chapter 11, a company continues to present the results of its operations. However, revenues, expenses (including professional fees), realized gains and losses, and provisions for losses resulting from the reorganization and restructuring of the business are reported separately as reorganization items. Similarly, reorganization items are presented separately within the operating, investing, and financing categories of the statement of cash flows. The determination as to whether an item qualifies as reorganization items requires careful evaluation and often judgment is required. Further complexities can arise when the reorganization plan involves discontinued operations, or when some but not all companies within a consolidated group are subject to the reorganization under a Chapter 11 bankruptcy. A company must also consider the presentation and disclosure requirements in ASC 852 to comply with reporting standards.
The accounting considerations noted in the Pre-Bankruptcy section above (as well as all other U.S. GAAP) also generally apply during bankruptcy.
After Bankruptcy
ASC 852 provides further reporting principles for a company whose plans have been confirmed by the court and have thereby emerged from Chapter 11 when all material conditions precedent to the plan’s becoming binding are resolved. The company generally accounts for the plan’s effects in its financial statements as of the date the plan is confirmed.
If the reorganization value of the assets of the emerging company immediately before the date of confirmation is less than the total of all post-petition liabilities and allowable claims, and if holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging company, it must adopt fresh-start reporting upon emergence from Chapter 11, assuming the loss of control is substantive and not temporary.
Careful consideration must be given to the determination of the reorganization value of the assets and the determination of whether a loss of (collective) control has occurred. If either of the aforementioned conditions is not met, the company would not qualify for fresh-start accounting, and a new reporting entity would not be created for accounting purposes.
Fresh-start accounting requires the company to present its assets and liabilities at fair value, with some exceptions, with the adjustments to such values from the pre-emergence carrying amounts being reflected within the predecessor statement of operations. This typically requires obtaining a third-party valuation.
Charting a Course for the Future
Before, during, and after bankruptcy, business leaders must work hard to confront and resolve their company’s financial difficulties.
However, a company’s accounting team may be stretched to the limit or not well versed in bankruptcy laws or the accounting required under U.S. GAAP. This is where an outside accounting firm can supplement the accounting function as it shoulders new, and sometimes competing, priorities. Additionally, some of the accounting issues that arise before, during, and after emerging from bankruptcy can be complex. External accounting professionals can help.
With a global network covering more than 160 counties and well-trained professionals, we are prepared to guide companies before, during and after bankruptcy. Learn more by contacting our Accounting & Reporting Advisory Services, Turnaround and Restructuring Services, and Valuation & Capital Market Analysis teams.