The U.S. economy continues to churn under stormy skies, as inflation grows, credit markets remain sluggish, and the number of companies filing for bankruptcy rises. Many experts predict that during the next couple of years, we will see a significant increase in the number of firms that will seek to reorganize under Chapter 11.
This means some hard work ahead for the management teams who will need to develop and implement reorganization plans. It also means that reorganizing companies will most likely reflect new asset and liability values on their "emergence" balance sheets. Given changes in law that limit the time to file a plan of reorganization ("Plan") (generally, up to 18 months to avoid the loss of exclusivity in filing a Plan) and the appetite to achieve prepackaged or prenegotiated plans (which are negotiated before the actual filing), companies must plan early in the restructuring process to address the accounting requirements upon emergence from bankruptcy. These accounting requirements are a part of Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code ("SOP 90-7").
Issued by the AICPA in 1990, SOP 90-7, provides financial reporting guidance for businesses that have filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code and expect to reorganize as going concerns. This guidance covers financial reporting both for the period in bankruptcy and upon emergence from Chapter 11. As practice has demonstrated over the years, SOP 90-7 has resulted in a significant improvement in the consistency and quality of reporting for emerging companies. The most significant impact of SOP 90-7 has resulted from requirements regarding Fresh Start reporting. Upon emergence, the reporting entity must determine whether or not it must adopt Fresh Start reporting.
A company (whether a parent or subsidiary) must adopt Fresh Start reporting if it meets two conditions:
1. Immediately prior to confirmation of its plan of reorganization, it is "balance sheet insolvent" -- that is, the reorganization value of its assets is less than the sum of its post-petition liabilities and allowed claims.
2. Holders of voting shares before the court confirms the bankruptcy plan receive less than 50 percent of the emerging company's voting shares.
What is clear from SOP 90-7 and from the experience of the many companies that have come out of bankruptcy in the intervening years is that the managers of companies in Chapter 11 have some difficult, complex matters to orchestrate over a short time frame. Before dealing with the accounting issues, the first and most obvious is to develop, negotiate, and confirm a Plan. Then, the accounting effort can be divided into two main categories: (1) recording the effects of the bankruptcy plan and, if Fresh Start applies, (2) reporting on a new successor entity for accounting purposes, including a revaluation of the consolidated balance sheet.
At first blush, this may not seem much more onerous than accounting for any other acquisition. However, those who have been through the process have learned otherwise. As with any transaction, each case is based on a unique set of facts and is negotiated or litigated to a unique conclusion. Bankruptcy law and the resulting accounting implications, however, add complexities not seen in an acquisition or out-of-court restructuring.
Many of the bankruptcy concepts impacting financial reporting are not well understood, or at times misunderstood, by financial executives unfamiliar with bankruptcy. In addition, the Fresh Start revaluation is not applied just to an acquired business, but to the entire corporate enterprise (including subsidiaries that are not part of the bankruptcy filing).
The following are a number of steps that management must take when preparing for the emergence accounting requirements. We could have included many more, but for the purposes of this article we have boiled our approach down to five key steps.
1. Closing "old" books properly, with all liabilities subject to compromise finalized. Typically, this means recording estimates for those claims that remain contingent, unliquidated, or disputed. While accruals for claim estimates will be recorded throughout the proceeding, we typically see more emphasis on resolving matters toward the end of a case as part of the plan. Having a well-vetted claims reconciliation process integrated with the accounting function will provide the basis for recording the proper estimates.
Too often we see a lack of communication between various functions resulting in a significant last minute effort to reconcile the books. These estimates should be fine-tuned to minimize future earnings impacts for subsequent changes in estimates that would otherwise have to be recorded as part of the current operations of the successor company.
2. Recording the reorganization plan effects. Calculating recoveries to creditors is done on a plan class basis and at the legal entity level. This can be a challenge for a company given that liabilities are rarely recorded in the ledger on a plan class basis. Often, classes are commingled within certain general ledger accounts, and balances will need to be segregated to determine the proper recoveries and resulting gains from the extinguishment of debt. These transactions can result in hundreds or even thousands of entries in the ledgers and subledgers.
A thorough evaluation of the plan will help to identify the full population of entries to be recorded. In addition, a comprehensive plan to calculate the estimated recoveries to claimants and to address related systems issues to record these entries is critical. Capturing additional information needed for other financial disclosures should also be an important consideration in the planning process.
3. Valuing all assets and liabilities as of the proper date. Fresh Start accounting requires that all assets and liabilities be restated at their "fair value." This can be a significant challenge for companies, as this requirement will impact all entities in the organization whether domestic/foreign or a debtor/nondebtor. For each entity, companies will need to perform a detailed review of each line item in the balance sheet and identify accounts where balances will be revalued. In addition, since some intangibles such as intellectual property, goodwill, or favorable leases may never have been valued, the company will need to evaluate the need for creating new assets categories in accordance with SFAS 141.
Proper attention to segments and reporting units is also critical in allocating value, to minimize future impairment impacts that could result in conjunction with a company's annual assessments under SFAS 142 and Statement of Financial Accounting Standard 144, Accounting for the Impairment or Disposal of Long-Lived Assets.
In addition to paying close attention to the allocation of value to various assets (and liabilities) and entities within the organization, management should also focus on how future net income will be impacted by changes in depreciable basis and useful lives resulting from Fresh Start accounting. In addition, assets may also be moved between entities as a result of merger activity or the reorganization of new stand-alone reporting groups, adding to the complexity of the process.
4. Back-office systems. Companies emerging from Chapter 11 will need to address the impacts of this event on their accounting systems. Capturing stub period information, recording transactions to the subledgers, and establishing new reporting entities are a few of the challenges. The IT department will need to understand how the accounting entries related to the plan effects and Fresh Start will be recorded to determine what modifications will be required. Examples might be, How will pre-petitions vouchers in the accounts payable subledger be extinguished for recoveries? Or, Will the asset revaluation adjustments be recorded at the asset record level or ledger account level? Fixed assets that depreciate over time versus goodwill adjustments will have different requirements. The answers will often depend on the type of adjustments and needs of the company.
There are also considerations related to statutory reporting in foreign jurisdictions and tax books. Legacy accounting systems may lack the flexibility to include more than one value (tax, new book, historical) or values as of more than one date (purchase date vs. "Fresh Start" date). How will transactions be recorded to capture necessary information for reporting purposes?
5. Reporting. Internal accounting and external reporting should closely coordinate how to close the books as of the Fresh Start reporting date. While SOP 90-7 states that the reporting date is as of the confirmation date (subject to satisfaction of outstanding material conditions), most companies look to establish a convenience date for accounting purposes. A convenience date will typically fall at the beginning or end of an accounting period between the confirmation and emergence dates (plus, all material condition must be satisfied). This allows for a natural cutoff process to occur and will minimize some of the burden related to system modifications to establish a new reporting entity.
This issue can be managed through consultation with counsel and the external auditors and proper planning. It must be addressed early enough in the process to allow counsel to plan for court hearings and advantageous dates. Obviously, a debtor will be subject to the court's calendar, but proper management can make a big difference.
A reporting date occurring during a fiscal year (as opposed to a company's year-end) will require historical basis financial information to be presented for a stub period (from the beginning of the fiscal year to the date of adoption of Fresh Start accounting and separately on a new basis of accounting for the post--Fresh Start period). From the Fresh Start date forward, the event will result in a loss of comparability between "predecessor" and "successor" reporting periods. This means additional disclosure requirements for pre- and post-emergence activity as well as capturing plan effects and Fresh Start information.
The accounting for the plan treatments and revaluation adjustments is typically reflected in the financial statement footnotes in a columnar balance sheet presentation. This footnote reflects the final closing balances of the old entity in the first column followed by separate plan effects and Fresh Start adjustment columns to result in the opening balance sheet for the reorganized entity in a final column. All adjustments in the presentation are supported by accompanying explanatory notes.
In addition to external reporting impacts, other reporting considerations may include internal management reports where it is desirable to continue to capture cumulative results for the full year. A loss of continuity in the reporting structure (due to a restructuring and a Fresh Start revaluation, creating a new reporting entity in the middle of the year) will make it difficult to manage budgets and measure performance. In addition, incentive compensation programs could be impacted. Again, planning in advance can allow for the maintenance of necessary full-year data for management use, thereby avoiding the loss of continuity and allowing management to obtain needed internal reports to manage the business.
A bankrupt company will look much different from the emerging company. Obviously, the biggest change is in the amount of debt a company will carry upon emerging. But there will be other effects as well:
• Its depreciation and amortization pre- and post-bankruptcy will no longer be comparable due to the revaluation to fair value as of the effective date and the establishment of new accounting lives over which these revalued assets will be amortized.
• Adjustments including those to deferred revenue accounts and lease valuations can have unanticipated impacts on revenue and earnings.
Fresh Start accounting gives companies coming out of a Chapter 11 bankruptcy a chance to continue business with a newly valued balance sheet and less debt.
Coordinating all the elements that need to come together as of the Fresh Start reporting date is far more complex than even the most seasoned CFOs and other senior managers would imagine if they have not gone through a Chapter 11 bankruptcy before. Time frames are extremely tight, and hidden valuation, accounting, systems, tax, and reporting issues can make the process tortuous. Help from an advisor with broad, deep experience in emergence accounting can significantly improve an emerging company's ability to issue accurate, timely, financial reports.
Note: The AICPA and the FASB have provided little guidance on Fresh Start accounting since the issuance of SOP 90-7. However, some relevant additions or changes include the following:
• In March 2004, the AICPA issued Practice Bulletin 11: Accounting for Pre-confirmation Contingencies in Fresh Start Accounting, which, in addition to defining pre-confirmation contingencies, provides that, for periods after emergence from Chapter 11, post-bankruptcy companies need to include (and separately disclose) preconfirmation contingencies in the determination of net income from continuing operations in the period in which the adjustment is determined.
• References to other accounting literature have been updated as new pronouncements have been issued. For example, references to Accounting for Business Combinations have been updated from APB 11 to SFAS 141. In addition, in December 2007, the FASB issued SFAS 141R, Business Combinations, which will apply for fiscal years beginning after December 15, 2008. This revision to SFAS 141 was a joint project by the FASB and the IASB in an attempt to produce one worldwide standard for business combination accounting. It will also affect Fresh Start accounting. The specific consequences of SFAS 141R, along with recently issued SFAS 157, Fair Value Measurements, will need to be addressed in the near future as it will impact most companies emerging in 2009.
• On April 24, 2008, the FASB issued FSP 90-7-1, An Amendment of AICPA Statement of Position 90-7 (effective upon issuance). By amending paragraph 38 of AICPA Statement of Position No. 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code, the FASB Staff Position (FSP) removes the requirement that an entity emerging from bankruptcy must apply accounting principles that will be in effect within 12 months from the emergence date in its Fresh Start reporting. Going forward, entities emerging from bankruptcy should only apply those accounting principles that are in effect at the date of emergence, including those principles that may be early-adopted, if the entity chooses to make such an election.