After a wild spring, the financial disruptions created by COVID-19 are leading to some concerning outcomes for businesses. Even with the assistance of state and federal funding for businesses — and whether or not companies have highly leveraged capital structures — more restructurings and bankruptcies to avoid default are on the horizon for companies in many of the hardest hit sectors. Those could include travel, transportation, energy, and discretionary retail and manufacturing.
While there are many balls to juggle during these challenging times, accounting and financial reporting still remains very relevant given the environment in which all of us are operating. Below explains some of the general accounting principles of bankruptcy and restructuring accounting — pre, during and post — for companies that prepare financial statements under U.S. GAAP.
Financial Reporting Prior to Bankruptcy
A company may file for bankruptcy because of a single negative event, such as an unfavorable litigation outcome or severe adverse financial hit. In other cases, a bankruptcy is led by a slow decline in financial condition and will typically give rise to certain accounting treatment that might not be easily observable when a company is profitable. Some of those considerations are outlined below.
Generally, a bankruptcy filing is not the first triggering event for an impairment assessment. Asset impairments and triggering events usually come well before a bankruptcy filing given the financial decline that a company typically faces, which may also be occurring throughout the broader industry in which it operates. Impairments are usually associated with declines in the company's cash flows from operations and a corresponding decline in the fair values of underlying assets.
Disposal Activities, Exit Costs and Restructuring
Companies may decide to exit or restructure existing businesses, including terminating employees, to improve profitability and liquidity. The recognition of costs for employee terminations, for example, is affected by the type of termination as well as any future service requirements associated with termination benefits to be paid. Because different types of termination arrangements may fall within the scope of various sections of the accounting standards with differing measurement and reporting criteria, it is important to understand the guidance that applies in the specific situation.
Given the negative financial conditions usually associated with companies moving toward bankruptcy, companies might violate covenants (financial and nonfinancial) in existing debt arrangements. For example, when a covenant violation is triggered, the debt may become technically due on demand. Under accounting guidance for debt, these obligations may need to be classified as current unless the lender has waived or subsequently lost the right to demand repayment for more than a year from the balance sheet date. Also, companies that have violated a covenant but obtained a waiver at period-end should consider whether they will continue to meet the covenant in future periods. If a future violation is probable, the debt would be classified as a current obligation. Companies should be aware of the disclosure requirements associated with debt covenant violations and waivers. This would include disclosure in the notes of the financial statements about the circumstances and amounts regarding any default of principal, interest, sinking fund or redemption provisions, or breach of contract that has not been subsequently cured.
The financial difficulties a company may experience prior to a bankruptcy filing may have certain income tax accounting consequences, particularly with respect to management’s assertions regarding indefinite reinvestment of foreign subsidiaries, long-term investment nature of intercompany loans, recoverability of investments in domestic subsidiaries and valuation of deferred tax assets.
Disclosures of Risks and Uncertainties
ASC 275 requires entities to disclose information about risks and uncertainties in their financial statements in the following areas:
- Nature of operations
- Use of estimates in the preparation of financial statements
- Certain significant estimates
- Current vulnerability resulting from certain concentrations
An estimate should be disclosed when known information available before the financial statements are issued (or are available to be issued for private companies), indicating that the following criteria are met:
- It is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events.
- The effect of the change would be material to the financial statements.
Companies considering a bankruptcy filing face unique challenges from an operational and financial perspective. Entities should consider disclosure of these difficulties and the potential for a bankruptcy filing under ASC 275. This could include the state of the operations and any restructuring or exit activities initiated to increase liquidity.
Financial Reporting During Bankruptcy
Once a company has filed a petition for bankruptcy under Chapter 11, for example, of the Bankruptcy Code, its accounting and financial reporting falls under the scope of ASC 852-10, Reorganizations. ASC 852-10 applies only to Chapter 11 proceedings, and it excludes governmental organizations and entities that are in liquidation under Chapter 7 of the Bankruptcy Code or for other reasons. The main purpose of financial reporting by entities in bankruptcy is to reflect the financial progress of the bankruptcy process.
The guidance requires that transactions and events directly associated with the reorganization be separated from the ongoing operations of the business. Also, ASC 852-10 provides for changes in the accounting and presentation of significant items on the balance sheet, particularly liabilities. The primary financial statements for a company reporting under ASC 852-10 are generally similar to the presentation prior to a bankruptcy filing. The company will continue to present a balance sheet and statements of operations, cash flows and changes in stockholders' equity after the bankruptcy filing. One change, however, is the labeling of the statements. A debtor-in-possession title should clearly label each financial statement.
The guidance in ASC 852-10-45-1 provides the general concept that financial reporting during a bankruptcy proceeding does not necessarily affect the accounting for most items on the balance sheet and in the statement of operations. In most cases, other areas of U.S. GAAP would continue to apply in the recognition and measurement of assets and liabilities as if a company was not involved in a bankruptcy proceeding. For example, the literature applicable to the various accounting matters, such as asset impairments, other asset valuation matters and income tax considerations, would generally still apply after a bankruptcy filing. However, because an entity in bankruptcy is clearly in circumstances different from those in periods before the filing, some changes in the financial statements are needed to reflect the unique aspects of the bankruptcy proceeding. The most significant impact of ASC 852-10 on the financial reporting of balance sheet items involves the classification and presentation of liabilities of a company in reorganization.
Presentation of Liabilities
Liabilities under ASC 852-10 are separated into obligations that were incurred prior to the filing of the bankruptcy petition — pre-petition liabilities — and those incurred after the filing — post-petition liabilities. Pre-petition liabilities are further segregated into those that are subject to compromise and those that are not subject to compromise, as described in ASC 852-10.
Obligations (or liabilities) subject to compromise are pre-petition obligations that are not fully secured and that have at least a possibility of not being repaid at the full claim amount. These liabilities, which generally make up the majority of liabilities in a bankruptcy filing, can include any type of obligation of the company, such as trade payables, contract obligations or unsecured debt. The determination of which liabilities are subject to compromise is initially made at the date of the bankruptcy filing based on whether the liability is adequately secured. If unsecured, or if there is doubt as to the adequacy of the value of security related to a given liability, the entire liability should be included in liabilities subject to compromise.
Liabilities subject to compromise are presented as a group on one line on the balance sheet and are classified outside of current liabilities.
As stated in ASC 852-10-45-5, liabilities subject to compromise, including claims that become known after the bankruptcy petition is filed, should be reported on the basis of the expected amount of the total allowed claims, even if the claims will be settled at lesser amounts.
Statement of Operations
The statement of operations of a company while in bankruptcy will reflect changes due to the evolution of the bankruptcy process according to ASC 852-10-45-9. Items related to the bankruptcy should be presented separately in the financial statements.
The method of differentiating transactions and events associated with the reorganization on the statement of operations is through the use of a separate line for reorganization items. The company uses this line to reflect the revenues, expenses, gains and losses that are the result of the reorganization of the business during the bankruptcy. However, it would be rare to report revenues as a reorganization item. Changes relating to pre-petition estimates of liabilities, or the correction of errors, would not typically be recorded to reorganization items. Judgment is required in determining which statement of operations items should be reported as reorganization items. Generally, only incremental costs directly related to the company’s bankruptcy filing, such as professional fees related to the bankruptcy, would be presented as a reorganization item. Recurring internal costs of normal operations should not be presented as reorganization items. Related tax effects from reorganization items should be reflected in income tax expense. In addition, changes in the balance sheet accounts from the application of the principles of ASC 852-10, such as adjustments to the expected amount of the allowed claims for liabilities subject to compromise discussed earlier, should be recorded as reorganization items. Impairment charges and restructuring activities would not usually be considered reorganization items because these costs are associated with the ongoing operations of the business. Only those costs initiated directly as a result of the bankruptcy filing and which would not have otherwise been incurred by the company may be presented as reorganization items.
Financial Reporting Upon Emergence (Post Bankruptcy)
A company emerging from bankruptcy must record the effects of its reorganization plan. Generally, the company will also qualify for fresh start reporting, whereby balance sheet items are adjusted to fair values to denote a “fresh start” upon emergence from bankruptcy. If the criteria to apply fresh start reporting are met, the company should apply fresh start reporting once the court has confirmed the company’s reorganization plan and it has emerged from Chapter 11. References are then made to the “predecessor” and “successor” company when applying fresh start reporting. The separate references are the result of the predecessor company exiting the bankruptcy process and becoming the successor company as a result of applying fresh start reporting. This successor company is considered to be a new company, separate from the predecessor for accounting and financial reporting purposes. As result of its emergence from bankruptcy and the adoption of fresh start reporting, the company has a new beginning, which should be reflected in its financial statements.
Adopting Fresh Start Accounting
An entity should apply fresh start reporting at the later of either the date that the court has confirmed its reorganization plan, or the date that all material, unresolved conditions precedent to the plan’s becoming binding are resolved.
A company must apply fresh start reporting upon emergence from bankruptcy if it meets both of the following criteria:
- The reorganization value of the emerging entity immediately before the date of confirmation is less than the total of all post-petition liabilities and allowed claims, and
- The holders of existing voting shares immediately before confirmation receive less than 50% of the voting shares of the emerging entity.
What is Reorganization Value?
The reorganization value of the company is determined through the plan of reorganization in the Chapter 11 process and generally approximates the fair value of the company before considering liabilities. The reorganization value approximates the amount a willing buyer would pay for the assets of the company immediately after the restructuring. The reorganization value is the basis for determining the value received by the company's creditors and equity holders determined after extensive arm’s-length negotiations between the interested parties as overseen and approved by the court. The reorganization value is usually determined as a range of value rather than a single point estimate; however, the company will choose a value within the range to use to apply fresh start reporting. Though several methods can be used to determine the reorganization value, it is generally derived using a discounted cash flow approach.
Applying Fresh Start Reporting
According to ASC 852-10, adjustments are made in the predecessor accounts upon emerging from bankruptcy and adopting fresh start reporting. The emergence from bankruptcy and adoption of fresh start reporting are generally displayed in the footnotes using a four-column format that presents:
- The balance sheet just prior to confirmation of the plan,
- Reorganization adjustments,
- Fresh start adjustments, and
- The closing balance of the predecessor company, which becomes the opening balance sheet of the successor entity.
The predecessor's final statement of operations should reflect the impact of adopting fresh start reporting and the recognition of reorganization items. The statement will include the effects of adjustments to individual assets and liabilities, forgiveness of debt, and, separately, any related tax effects. While ASC 852-10 explicitly requires the effects of adjustments of assets and liabilities resulting from the application of fresh start reporting to be reflected in the statement of operations, it does not provide guidance on how adjustments to equity should be recorded. Typically as part of its emergence from bankruptcy, the predecessor company’s equity will be cancelled and new equity of the successor company will be issued.
These are just a handful of the main considerations that companies and their accountants must consider with regard to financial reporting for restructurings and bankruptcy. Within the applicable financial reporting rules and guidance there is still a myriad of additional nuances and transactions to consider and fully prepare for. It’s imperative to understand all of the rules to ensure the accuracy and completeness of your financial statements.
Contact Gino Scipione at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.