Bankrupty Liquidation and Reor

Larsen: Modern Advanced
Accounting, Tenth Edition
IV. Accounting for

Fiduciaries
14. Bankruptcy: Liquidation

and Reorganization
The McGrawHill
Companies, 2005
Chapter Fourteen
Bankruptcy:
Liquidation and
Reorganization
Scope of Chapter
Business failures are a common occurrence in the U.S. economy. Poor management, excessive debt, and inadequate accounting are the most commonly cited causes of business
failures. The situation that precedes the typical business failure is inability of a business
enterprise to pay liabilities as they become due. Unsecured creditors often resort to lawsuits to satisfy their unpaid claims against a business enterprise. Secured creditors may
force foreclosure proceedings for real property or may repossess personal property that
collateralizes a security agreement. The Internal Revenue Service may seize the assets
of a business enterprise that has failed to pay FICA and income taxes withheld from its
employees.
A business enterprise may be unable to pay its liabilities as they become due even
though the current fair values of its assets exceed its liabilities. For example, an enterprise
may experience a severe cash shortage in times of price ination because of the lag between
the purchase or production of goods at inated costs and the recovery of the inated costs
through increased selling prices.
More typical of the failing business enterprise than the conditions described in the foregoing paragraph is the state of insolvency. Insolvent is dened in the Bankruptcy Code as
follows:
insolvent means
(A) with reference to an entity other than a partnership and a municipality, nancial condition such that the sum of such entitys debts is greater than all of such entitys property, at a
fair valuation, exclusive of
(i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such
entitys creditors; and
(ii) property that may be exempted from property of the estate under . . . this title; and
(B) with reference to a partnership, nancial condition such that the sum of such partnerships debts is greater than the aggregate of, at a fair valuation
(i) all of such partnerships property, exclusive of property of the kind specied in subparagraph (A) (i) of this paragraph; and
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Part Four Accounting for Fiduciaries
(ii) the sum of the excess of the value of each general partners nonpartnership property, exclusive of property of the kind specied in subparagraph (A) (ii) of this paragraph, over
such partners nonpartnership debts;1
The terms insolvent and bankrupt often are used as interchangeable adjectives. Such
usage is technically incorrect; insolvent refers to the nancial condition of a person or
business enterprise, and bankrupt refers to a legal state. In this chapter, various legal and
accounting issues associated with bankruptcy liquidations and reorganizations are discussed and illustrated.
THE BANKRUPTCY CODE

The U.S. Constitution (Article 1, Section 8) authorizes Congress to establish uniform laws
on the subject of bankruptcies throughout the United States. For the rst 89 years under the
Constitution, the United States had a national bankruptcy law for a total of only 16 years.
During the periods in which national bankruptcy laws were not in effect, state laws on insolvency prevailed. In 1898 a Bankruptcy Act was enacted that, as amended, remained in
effect for 80 years. Enactment of the Bankruptcy Act caused state laws on insolvency to be
relatively dormant. In 1978 the Bankruptcy Reform Act established the present Bankruptcy
Code; in 1980 the Bankruptcy Tax Act established a uniform group of income tax rules for
bankruptcy and insolvency; and in 1994 the Bankruptcy Code was amended by the Bankruptcy Reform Act of 1994.
The U.S. Supreme Court may prescribe by general rules the various legal practices and
procedures under the Bankruptcy Code. Thus, the Federal Rules of Bankruptcy Procedure
established by the Supreme Court constitute important interpretations of provisions of the
Bankruptcy Code.
BANKRUPTCY LIQUIDATION
The process of bankruptcy liquidation under Chapter 7 of the Bankruptcy Code involves
the realization (sale) of the assets of an individual or a business enterprise and the distribution of the cash proceeds to the creditors of the individual or enterprise. Creditors having
security interests collateralized by specic assets of the debtor generally are entitled to obtain satisfaction of all or part of their claims from the assets pledged as collateral. The
Bankruptcy Code provides for priority treatment for certain unsecured creditors; their
claims are satised in full, if possible, from proceeds of realization of the debtors noncollateralized assets. Unsecured creditors without priority receive cash, in proportion to the
amounts of their claims, from proceeds available from the realization of the debtors assets.
Thus, there are four classes of creditors in a bankruptcy liquidation: fully secured creditors,
partially secured creditors, unsecured creditors with priority, and unsecured creditors
without priority.
Debtors (Voluntary) Petition

The Bankruptcy Code provides that any person, except certain entities such as a railroad, an insurance company, a bank, a credit union, or a savings and loan association,
Bankruptcy Code, sec. 101 (32).

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Chapter 14 Bankruptcy: Liquidation and Reorganization 609
may le a petition in a federal bankruptcy court for voluntary liquidation under Chapter 7
of the Code. The ofcial form for a debtors bankruptcy petition, also known as a voluntary petition, must be accompanied by supporting exhibits of the petitioners debts and
property. The debts are classied as follows: (1) creditors having priority; (2) creditors
holding security; and (3) creditors having unsecured claims without priority. The debtors
property is reported as follows: real property, personal property, and property claimed as
exempt. Valuations of property are at market or current fair values. Also accompanying
the debtors bankruptcy petition is a statement of nancial affairs (not to be confused
with the accounting statement of affairs illustrated on page 614 of this chapter), which
contains a series of questions concerning all aspects of the debtors nancial condition
and operations.
Creditors (Involuntary) Petition

If a debtor other than a farmer, a nonprot organization, or one of the types precluded
from ling voluntary petitions owes unpaid amounts to 12 or more unsecured creditors
who are not employees, relatives, stockholders, or other insiders, three or more of the
creditors having unsecured claims totaling $10,000 or more may le in a federal bankruptcy court a creditors petition for bankruptcy, also known as an involuntary petition.
If fewer than 12 creditors are involved, one or more creditors having unsecured claims of
$10,000 or more may le the petition. The creditors petition for bankruptcy must claim
either (1) the debtor is not paying debts as they come due or (2) within 120 days prior to
the date of the petition, a custodian was appointed for or had taken possession of the
debtors property.
Unsecured Creditors with Priority

The Bankruptcy Code provides that the following unsecured debts are to be paid in full, in
the order specied if adequate cash is not available for all, out of a debtors estate before
any cash is paid to other unsecured creditors:
1. Administrative costs.
2. Claims arising in the course of the debtors business or nancial affairs after the commencement of a creditors bankruptcy proceeding but before appointment of a trustee or
order for relief.
3. Claims for wages, salaries, and commissions, including vacation, severance, and sick
leave pay not in excess of $4,000 per claimant, earned within 90 days before the date of
ling the petition for bankruptcy or cessation of the debtors business.
4. Claims for contributions to employee benefit plans arising within 180 days
before the date of ling the petition for bankruptcy or cessation of the debtors business. The limit of such claims is $4,000 times the number of employees covered by
the plans, less the aggregate amount paid to the covered employees under priority
3 above.
5. Claims by producers of grain against a grain storage facility or by shermen against a
sh storage or processing facility, not in excess of $4,000 per claimant.
6. Claims for cash deposited for goods or services for the personal, family, or household
use of the depositor, not in excess of $1,800 per claimant.
7. Claims for alimony, maintenance, or support of a spouse, former spouse, or child of the
debtor, under a separation agreement, divorce decree, or court order.
8. Claims of governmental entities for various taxes or duties, subject to varying time
limitations.

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Property Claimed as Exempt

Certain property of a bankruptcy petitioner is not includable in the debtors estate. The
Bankruptcy Code excludes from coverage of the Code the various allowances provided in
the laws of either the United States or the state of the debtors residence, whichever is more
benecial to the debtor. Typical of these allowances are residential property exemptions
provided by homestead laws and exemptions for life insurance policies payable on death to
the spouse or a relative of the debtor. (Bills introduced in Congress in 2001 would modify
these allowances.)
Role of Court in Liquidation

The federal bankruptcy court in which a debtors or creditors petition for bankruptcy liquidation is led oversees all aspects of the bankruptcy proceedings.
One of the first acts of the court is either to dismiss the debtors or creditors bankruptcy petition or to grant an order for relief under the Bankruptcy Code. The filing
of a debtors petition in bankruptcy is in effect an order for relief; in a creditors petition,
order for relief is made by the court after a hearing at which the debtor may attempt
to refute the creditors allegations that the debtor was not paying debts as they came
due. Any suits that are pending against a debtor for whom a debtors or creditors bankruptcy petition is filed generally are stayed until order for relief or dismissal of the
petition; after order for relief such suits are further stayed until the question of the
debtors discharge is determined by the court. Further, the court appoints an interim
trustee after the order for relief, to serve permanently or until a trustee is elected by
the creditors.
Role of Creditors
Within a period of 10 to 30 days after an order for relief, the bankruptcy court must call a
meeting of the creditors. At the meeting, the outsider creditors appoint a trustee to manage the debtors estate. A majority vote in number and amount of claims of all unsecured
and nonpriority creditors present is required for actions by creditors.
Role of Trustee
The trustee elected by the creditors or appointed by the court assumes custody of the debtors
nonexempt property. The principal duties of the trustee are to continue operating the debtors
business if directed by the court, realize the free assets of the debtors estate, and pay cash to
unsecured creditors. The trustee is responsible for keeping accounting records to enable the
ling of a nal report with the bankruptcy court.
The Bankruptcy Code empowers the trustee to invalidate a preference, dened as the
transfer of cash or property to an outsider creditor for an existing debt, made while the
debtor was insolvent and within 90 days of ling of the bankruptcy petition, provided
the transfer caused the creditor to receive more cash or property than would be received in
the bankruptcy liquidation. The trustee may recover from the creditor the cash or property
constituting the preference and include it in the debtors estate.
Discharge of Debtor
Once the debtors property has been liquidated, all secured and priority creditor claims have
been paid, and all remaining cash has been paid to unsecured, nonpriority creditors, the

IV. Accounting for

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debtor may receive a discharge, dened as the release of the debtor from all unliquidated
debts except debts such as the following:
1. Taxes payable by the debtor to the United States or to any state or subdivision, including
taxes attributable to improper preparation of tax returns by the debtor.
2. Debts resulting from the debtors obtaining money or property under false pretenses or
representations, or willful conversion of the property of others.
3. Debts not scheduled by the debtor in support of the bankruptcy petition, such creditors
not being informed of the bankruptcy proceedings.
4. Debts arising from embezzlement or other fraudulent acts by the debtor acting in a duciary capacity.
5. Amounts payable for alimony, maintenance, or child support.
6. Debts for willful and malicious injuries to the persons or property of others.
7. Debts for nes, penalties, or forfeitures payable to governmental entities, other than for
tax penalties.
8. With certain exceptions, debts for educational loans made, insured, or guaranteed by
governmental entities or by nonprot universities or colleges. (In 1997, a National Bankruptcy Review Commission recommended discharge of educational loans other than for
medical schools.)
A debtor will not be discharged if any crimes, misstatements, or other malicious acts
were committed by the debtor in connection with the court proceedings. In addition, a
debtor will not be discharged if the current bankruptcy petition was led within six years
of a previous bankruptcy discharge to the same debtor.
Role of Accountant in Bankruptcy Liquidation

The accountants role in liquidation proceedings is concerned with proper reporting of the
nancial condition of the debtor and adequate accounting and reporting for the trustee for
the debtors estate, as described in the following sections.
Financial Condition of Debtor Enterprise:

The Statement of Affairs
A business enterprise that enters bankruptcy liquidation proceedings is a quitting concern,
not a going concern. Consequently, a balance sheet, which reports the nancial position of
a going concern, is inappropriate for an enterprise in liquidation.
The nancial statement designed for a business enterprise entering liquidation is the
statement of affairs (not to be confused with the legal bankruptcy form with a similar title
described on page 609). The purpose of the statement of affairs is to display the assets and
liabilities of the debtor enterprise from a liquidation viewpoint, because liquidation is the
outcome of the Chapter 7 bankruptcy proceedings. Thus, assets displayed in the statement
of affairs are valued at current fair values; carrying amounts of the assets are presented on
a memorandum basis. In addition, assets and liabilities in the statement of affairs are classied according to the rankings and priorities set forth in the Bankruptcy Code; the current/noncurrent classication used in a balance sheet for a going concern is not appropriate
for the statement of affairs.
Illustration of Statement of Affairs

The balance sheet of Sanders Company on June 30, 2006, the date that Sanders led a
debtors (voluntary) bankruptcy petition, is as follows:

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Companies, 2005
SANDERS COMPANY
Balance Sheet
(prior to ling of debtors bankruptcy petition)
June 30, 2006
Assets
Current assets:
Cash
Notes receivable and accrued interest, less allowance
for doubtful notes, $6,000
Trade accounts receivable, less allowance for
doubtful accounts, $23,240
Inventories, at rst-in, rst-out cost:
Finished goods
Goods in process
Material
Factory supplies
Short-term prepayments
Total current assets
Plant assets, at cost:
Land
Buildings (net)
Machinery (net)
Tools (net)
Net plant assets
Total assets
Liabilities and Stockholders Equity
Current liabilities:
Notes payable:
Pacic National Bank, including accrued interest
(due June 30, 2007)
Suppliers, including accrued interest
(due May 31, 2007)
Trade accounts payable
Salaries and wages payable
Property taxes payable
Interest payable on rst mortgage bonds
FICA and income taxes withheld and accrued
Total current liabilities
First mortgage bonds payable
Total liabilities
Stockholders equity:
Common stock, $100 par; 750 shares
authorized, issued, and outstanding
Decit
Total liabilities and stockholders equity
2,700
13,300
16,110
12,000
35,100
19,600
6,450
950
$106,210
$ 20,000
41,250
48,800
14,700
124,750
$230,960
$ 15,300
51,250
52,000
8,850
2,900
1,800
1,750
$133,850
90,000
$223,850
$ 75,000
(67,890)
7,110
$230,960

IV. Accounting for

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and Reorganization
The McGrawHill
Companies, 2005
Other information available from notes to nancial statements and from estimates of
current fair values of assets follows:
1. Notes receivable with a face amount plus accrued interest totaling $15,300, and a current fair value of $13,300, collateralize the notes payable to Pacic National Bank.
2. Finished goods are expected to be sold at a markup of 3313% over cost, with disposal
costs estimated at 20% of selling prices. Estimated cost to complete goods in process
is $15,400, of which $3,700 would be cost of material and factory supplies used. The
estimated selling price of goods in process when completed is $40,000, with disposal
costs estimated at 20% of selling prices. Estimated current fair values for material and
factory supplies not required to complete goods in process are $8,000 and $1,000, respectively. All short-term prepayments are expected to be consumed in the course of
liquidation.
3. Land and buildings, which collateralize the rst mortgage bonds payable, have a current
fair value of $95,000. Machinery with a carrying amount of $18,200 and current fair
value of $10,000 collateralizes notes payable to suppliers in the amount of $12,000, including accrued interest. The current fair value of the remaining machinery is $9,000,
net of disposal costs of $1,000, and the current fair value of tools after the amounts used
to complete the goods in process inventory is $3,255.
4. Salaries and wages payable are debts having priority under the Bankruptcy Code.
5. Costs of administering the bankruptcy liquidation are estimated at $1,905.
The statement of affairs for Sanders Company on June 30, 2006, is as shown on
page 614.
The following points should be stressed in the review of the June 30, 2006, statement of
affairs for Sanders Company:
1. The Carrying Amount columns in the statement of affairs serve as a tie-in to the balance sheet of Sanders on June 30, 2006, as well as a basis for estimating expected losses
or gains on realization of assets.
2. Assets are assigned to one of three groups: pledged for fully secured liabilities, pledged
for partially secured liabilities, and free. This grouping of assets facilitates the computation of estimated amounts available for unsecured creditorsthose with priority and
those without priority.
3. Liabilities are grouped in the categories reported by a debtor in the exhibits supporting
a debtors bankruptcy petition (see pages 608609): unsecured with priority, fully secured, partially secured, and unsecured without priority.
4. An offset technique used where the legal right of setoff exists. For example, amounts
due to fully secured creditors are deducted from the estimated current fair value of
the assets serving as collateral; and unsecured liabilities with priority are deducted
from estimated amounts available to unsecured creditors from the proceeds of free asset
realization.
5. An estimated settlement per dollar of unsecured liabilities without priority is computed
by dividing the estimated amount available for unsecured, nonpriority creditors by the
total unsecured liabilities, thus:
$60,960
64 cents on the dollar
$95,250
This computation enables the bankruptcy trustee to estimate the amount of cash that will
be available to unsecured, nonpriority creditors in a liquidation proceeding.
Assets
Net realizable value
Estimated disposal costs ($40,000 0.20)
Less: Estimated out-of-pocket completion costs ($15,400 $3,700)
*Estimated selling price
$ 20,300
(8,000)
(11,700)
$ 40,000
12,800
20,300*
8,000
1,000
-09,000
3,255
$ 2,700
16,110
8,200
34,290
$95,250
$60,960
12,800
(800)
20,300*
14,800
8,000
11,600
1,000
5,450
-0950
9,000
21,600
3,255
11,445
$76,365 $ 39,495
15,405
2,700
16,110
$ 3,200
$(33,750)
39,250
52,000
7,110
12,000
15,300
90,000
1,800
8,850
2,900
1,750
$ 230,960
1,800
$91,800
$90,000
Unsecured Liabilities without Priority:

Notes payable to suppliers
Stockholders equity
Partially Secured Liabilities:

Notes and accrued interest payable to Pacic
National Bank
$15,300
Less: Net realizable value of notes receivable
pledged as collateral (contra)
13,300
Notes and accrued interest payable to
suppliers
$12,000
Less: Estimated realizable value of machinery
pledged as collateral (contra)
10,000
Fully Secured Liabilities:

First mortgage bonds payable
Accrued interest on rst mortgage bonds
payable
Total (deducted contra)
Unsecured Liabilities with Priority:

Estimated administrative costs
$ 1,905
8,850
2,900
FICA and income taxes withheld and accrued 1,750
$15,405
$95,250
39,250
52,000
2,000
$ 2,000
Amount
Unsecured

and Reorganization
$230,960
12,000
35,100
19,600
6,450
950
30,600
14,700
Free Assets:
Cash
Trade accounts receivable
Inventories:
Finished goods
Goods in process
Material
Factory supplies
Machinery
Tools
Total estimated amount available
Less: Unsecured liabilities with priority (contra)
Estimated amount available for unsecured,
nonpriority creditors (64 on the dollar)
Estimated deciency to unsecured, nonpriority
creditors (36 on the dollar)
$ 13,300
$ 10,000
91,800
f$ 95,000
Current Estimated
Loss or
Fair
Amount (Gain) on Carrying
Values Available Realization Amounts
IV. Accounting for

Fiduciaries
2,700
16,110
Assets Pledged for Partially

Secured Liabilities:
13,300
Notes and interest receivable
(deducted contra)
18,200
Machinery (deducted contra)
Assets Pledged for Fully

Secured Liabilities:
$ 20,000
Land
41,250
Buildings
Less: Fully secured liabilities
(contra)
Carrying
Amounts
Statement of Affairs
June 30, 2006
614
SANDERS COMPANY

The McGrawHill
Companies, 2005

IV. Accounting for

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Estimated Amounts to Be Recovered by Each

Class of Creditors
By reference to the statement of affairs on page 614, the accountant for the trustee in bankruptcy for Sanders Company may prepare the summary of estimated amounts to be recovered by each class of Sanderss creditors shown below:
SANDERS COMPANY
Estimated Amounts to Be Recovered by Creditors
June 30, 2006
Class of Creditors
Unsecured with priority
Fully secured
Partially secured
Unsecured without priority
Totals
Total Claims
$ 15,405
91,800
27,300
91,250
$225,755*
Computation
100%
100%
$23,300 ($4,000 0.64)
64%
Estimated
Recovery
$ 15,405
91,800
25,860
58,400
$191,465
*$15,405 $91,800 $15,300 $12,000 $39,250 $52,000 $225,755.

$95,000 $13,300 $10,000 ($76,365 $3,200) $191,465.
Accounting and Reporting for Trustee

Traditionally, the accounting records and reports for trustees have been extremely detailed
and elaborate. However, the provisions of the applicable Federal Rule of Bankruptcy Procedure are general. Therefore, simple accounting records and reports such as the following
should be adequate.
1. The accounting records of the debtor should be used during the period that a trustee carries on the operations of the debtors business.
2. An accountability technique should be used once the trustee begins realization of the
debtors assets. In the accountability method of accounting, the assets and liabilities for
which the trustee is responsible are entered in the accounting records of the trustee at
their statement of affairs valuations, with a balancing debit to a memorandum-type
ledger account with a title such as Estate Decit. The amount of the debit to Estate
Decit is equal to the estimated deciency to unsecured creditors reported in the statement of affairs. Appropriate cash receipts and cash payments journal entries are made
for the trustees realization of assets and payment of liabilities. No gain or loss
ledger account is necessary because a business enterprise in liquidation does not require
an income statement. Differences between cash amounts realized or paid and carrying
amounts of the related assets or liabilities are debited or credited to the Estate Decit
ledger account.
3. The interim and nal reports of the trustee to the bankruptcy court are a statement of
cash receipts and cash payments, a statement of realization and liquidation, and, for
interim reports, supporting exhibits of assets not yet realized and liabilities not yet
liquidated.
Illustration of Accountability Technique

Assume that Arline Wells, the trustee in the voluntary bankruptcy liquidation proceedings for Sanders Company (see page 612), took custody of the assets of Sanders on

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IV. Accounting for

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Companies, 2005
June 30, 2006. The accountant for the trustee prepared the following journal entry on
June 30, 2006.
Journal Entry for

Bankruptcy Trustee
SANDERS COMPANY, IN BANKRUPTCY

Arline Wells, Trustee
Journal Entry
June 30, 2006
Cash
Notes and Interest Receivable
Trade Accounts Receivable
Finished Goods Inventory
Goods in Process Inventory
Material Inventory
Factory Supplies
Land and Buildings
Machinery ($10,000 $9,000)
Tools
Estate Decit
Estimated Administrative Costs
Notes and Interest Payable ($15,300 $12,000 $39,250)
Trade Accounts Payable
Salaries and Wages Payable
Property Taxes Payable
FICA and Income Taxes Withheld and Accrued
Interest Payable on First Mortgage Bonds
First Mortgage Bonds Payable
To record current fair values of assets and liabilities of Sanders Company,
in bankruptcy liquidation proceedings.
2,700
13,300
16,110
12,800
20,300
8,000
1,000
95,000
19,000
3,255
34,290 (1)
1,905
66,550
52,000
8,850
2,900
1,750
1,800
90,000
(1) Equal to estimated deciency to unsecured, nonpriority creditors in the statement of affairs on page 614.
When the trustee realizes assets of Sanders, the appropriate journal entry is a debit
to Cash, credits to the asset ledger accounts, and a debit or credit to the Estate Decit account for a loss or gain on realization, respectively. Costs of administering the estate that
exceed the $1,905 liability also are debited to the Estate Decit ledger account.
Statement of Realization and Liquidation

The traditional statement of realization and liquidation was a complex and not too readable
accounting presentation. A form of realization and liquidation statement that should be
more useful to the bankruptcy court than the traditional statement is as follows. This nancial statement is based on the assumed activities of the trustee for the estate of Sanders
Company during the month of July 2006, including operating the business long enough to
complete and sell the goods in process inventory.

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Interim Statement of
Realization and
Liquidation for Trustee
in Bankruptcy
Liquidation
SANDERS COMPANY, IN BANKRUPTCY

Arline Wells, Trustee
For Month Ended July 31, 2006
Estate decit, June 30, 2006

Assets realized:

Finished goods inventory
Goods in process inventory
Totals
Liabilities with priority liquidated
at carrying amounts:
FICA and income taxes
withheld and accrued
Total liabilities with priority
liquidated
Administrative costs paid, $1,867
($1,905 had been estimated)
Estate decit, July 31, 2006
$34,290
Current Fair
Values,
June 30, 2006
Realization
Proceeds
Loss or
(Gain)
$14,620
12,800
14,820
$42,240
$12,807
11,772
15,075
$39,654
$ 1,813
1,028
(255)
2,586
$ 8,850
2,900
1,750
$13,500
(38)
$36,838
An accompanying statement of cash receipts and cash payments for the month ended
July 31, 2006, would show the sources of the $39,654 total realization proceeds, and the
dates, check numbers, payees, and amounts of the $13,500 paid for liabilities with priority
and the $1,867 paid for administrative costs. Supporting exhibits would summarize assets
not yet realized and liabilities not yet paid.
Liquidation involves realization of the assets of the debtors estate. In many cases, an insolvent debtor may be restored to a sound nancial footing if it can defer payment of its
debts. Chapter 11 of the Bankruptcy Code, dealing with reorganization, enables a debtor to
continue operations under court protection from creditor lawsuits while it formulates a plan
to pay its debts. Reorganization is discussed in the next section.
BANKRUPTCY REORGANIZATION
Chapter 11 of the Bankruptcy Code provides for the court-supervised reorganization of a
debtor business enterprise. Typically, a reorganization involves the reduction of amounts
payable to some creditors, other creditors acceptance of equity securities of the debtor for
their claims, and a revision of the par or stated value of the common stock of the debtor.
A debtors (voluntary) petition for reorganization may be led by a railroad or by any
person eligible to petition for liquidation (see pages 608609) except a stockbroker or a
commodity broker. Requirements for a creditors (involuntary) petition for reorganization
are the same as the requirements for a liquidation petition (see page 609).

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Appointment of Trustee or Examiner

During the process of reorganization, management or owners of the business enterprise
may continue to operate the enterprise as debtor in possession. Alternatively, the bankruptcy court may appoint a trustee to manage the enterprise. A trustee is appointed because
of fraud, dishonesty, incompetence, or gross mismanagement by current owners or managers, or to protect the interests of creditors or stockholders of the enterprise. In some reorganization cases not involving a trustee, the court may appoint an examiner to investigate
possible fraud or mismanagement by the current managers or owners of the enterprise; the
appointment of an examiner is limited to enterprises having unsecured liabilities, other than
payables for goods, services, or taxes, exceeding $5 million.
Among the powers and duties of the trustee are the following:
1. Prepare and le in court a list of creditors of each class and their claims and a list of
stockholders of each class.
2. Investigate the acts, conduct, property, liabilities, and business operations of the enterprise, consider the desirability of continuing operations, and formulate a plan for such
continuance for submission to the bankruptcy judge if management of the debtor has not
done so.
3. Report to the bankruptcy judge any facts ascertained as to fraud against or mismanagement of the debtor enterprise.
Plan of Reorganization
The plan of reorganization submitted by the management or the trustee to the bankruptcy court is given to the debtor enterprises creditors and stockholders, to the U.S.
Secretary of the Treasury, and possibly to the SEC. The plan must include provisions
altering or modifying the interests and rights of the creditors and stockholders of the
debtor enterprise, as well as a number of additional provisions. The SEC may review
the plan and may be heard in the bankruptcy courts consideration of the plan. Before
a plan of reorganization is confirmed by the bankruptcy court, the plan must be accepted by a majority of the creditors, whose claims must account for two-thirds of the
total liabilities, and by stockholders owning at least two-thirds of the outstanding capital stock of each class. If one or more classes of stockholders or creditors has not
accepted a plan, the bankruptcy court may confirm the plan if the plan is fair and
equitable to the nonacceptors. Conrmation of the plan of reorganization by the bankruptcy court makes the plan binding on the debtor enterprise, on all creditors and owners of the enterprise, and on any other enterprise issuing securities or acquiring property
under the plan.
Accounting for a Reorganization

The accounting for a reorganization typically requires journal entries for adjustments
of carrying amounts of assets; reductions of par or stated value of capital stock (with
recognition of resultant paid-in capital in excess of par or stated value); extensions of due
dates and revisions of interest rates of notes payable; exchanges of equity securities for
debt securities; and the elimination of a retained earnings decit. The latter entry is associated with fresh start reporting for a reorganized enterprise whose liabilities exceed
the reorganization value (essentially current fair value) of its assets.2 Because of
Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy
Code (New York: AICPA, 1990), par. 36.

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changes in the ownership of common stock of such an enterprise as a result of the reorganization, it is no longer controlled by its former stockholder group, and it essentially is
a new reporting enterprise whose assets and liabilities should be valued at current fair
values and whose stockholders equity consists only of paid-in capital.3
It is important for accountants to be thoroughly familiar with the plan of reorganization, in order to account properly for its implementation. Accountants must be careful
to avoid charging post-reorganization operations with losses that arose before the reorganization.
To illustrate the accounting for a reorganization, assume that Sanders Company (see
pages 611615) led a petition for reorganization, rather than for liquidation, on June 30,
2006, with Sanders management as debtor in possession. The plan of reorganization, which
was approved by stockholders and all unsecured creditors and conrmed by the bankruptcy
court, included the following:
1. Deposit $25,000 with escrow agent, as soon as cash becomes available, to cover liabilities with priority and costs of reorganization proceedings.
2. Amend articles of incorporation to provide for 10,000 shares of authorized common
stock of $1 par. The new common stock is to be exchanged on a share-for-share basis for
the 750 shares of outstanding $100 par common stock.
3. Extend due date of unsecured notes payable to suppliers totaling $15,250 for four years,
until May 31, 2011. Increase the interest rate on the notes from the stated rate of 14% to
18%, the current fair rate of interest.
4. Exchange 1,600 shares of new $1 par common stock (at current fair value of $15 a
share) for unsecured notes payable to suppliers totaling $24,000.
5. Pay suppliers 70 cents per dollar of trade accounts payable owed.
The journal entries below and on page 620, numbered to correspond with the provisions
of the reorganization plan outlined above, were recorded by Sanders Company as cash became available from operations. Assuming that fresh start reporting is appropriate for
Sanders Company after the plan of reorganization has been carried out, the last journal
entry on page 620 is appropriate for eliminating the $67,890 retained earnings decit of
Sanders on June 30, 2006.
SANDERS COMPANY
Journal Entries for

Bankruptcy
Reorganization
Journal Entries
(1) Cash with Escrow Agent
Cash
To record deposit of cash with escrow agent under terms of bankruptcy
reorganization.
Salaries and Wages Payable
Property Taxes Payable
FICA and Income Taxes Withheld and Accrued
Cash with Escrow Agent
To record escrow agents payment of liabilities with priority.
25,000
25,000
8,850
2,900
1,750
13,500
(continued)
Ibid., par. 39.

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SANDERS COMPANY
Journal Entries (concluded)
Journal Entry to
Eliminate Decit
Costs of Bankruptcy Proceedings

To record escrow agents payment of costs of bankruptcy proceedings.
11,000
(2) Common Stock, $100 par

Common Stock, $1 par
Paid-in Capital in Excess of Par
To record issuance of 750 shares of $1 par common stock in exchange
for 750 shares of $100 par common stock.
75,000
(3) 14% Notes Payable to Suppliers, due May 31, 2007

18% Notes Payable to Suppliers, due May 31, 2011
To record extension of due dates of notes payable to suppliers and
increase of interest rate to 18% from 14%.
15,250
(4) Notes Payable to Suppliers

To record exchange of 1,600 shares of $1 par common stock
for $24,000 face amount of notes payable, at current fair value
of $15 a share.
24,000
(5) Trade Accounts Payable

Cash
Gain from Discharge of Indebtedness in Bankruptcy
To record payment of $0.70 per dollar of accounts payable to suppliers.
52,000

Gain from Discharge of Indebtedness in Bankruptcy
Retained Earnings
To eliminate decit on June 30, 2006, and close bankruptcy
gain and costs to Paid-in Capital in Excess of Par ledger account.
63,290
15,600
11,000
750
74,250
15,250
1,600
22,400
36,400
15,600
11,000
67,890
The effect of the foregoing journal entries is to show a clean slate for Sanders Company as a result of the approved bankruptcy reorganization and the write-off of the retained
earnings decit existing on the date of the petition for reorganization. The extension of due
dates of some liabilities, conversion of other liabilities to common stock, and liquidation of
trade accounts payable at less than their face amount should enable Sanders to resume operations as a going concern. For a reasonable number of years following the reorganization,
Sanders might date the retained earnings in its balance sheets to disclose that the earnings were accumulated after the reorganization.
Disclosure of Reorganization
The elaborate and often complex issues involved in a bankruptcy reorganization are disclosed in a note to the nancial statements for the period in which the plan of reorganization was carried out. Examples of recent such disclosures are included in the AICPAs 1994
publication Illustrations of Financial Reporting by Entities in Reorganization under the

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Bankruptcy Code. In addition, the Summary of Signicant Accounting Policies note to nancial statements of a reorganized enterprise might include disclosures such as the following for Wang Laboratories, Inc., a publicly owned enterprise:
Bankruptcy-Related Accounting
The Company has accounted for all transactions related to the Chapter 11 case in accordance
with Statement of Position 90-7 (SOP 90-7), Financial Reporting by Entities in Reorganization under the Bankruptcy Code, which was issued by the American Institute of Certied
Public Accountants in November 1990. Accordingly, liabilities subject to compromise under
the Chapter 11 case have been segregated on the Consolidated Balance Sheet and are recorded
for the amounts that have been or are expected to be allowed on known claims rather than estimates of the amounts those claims are to receive under the Reorganization Plan. In addition,
the Consolidated Statements of Operations and Consolidated Statements of Cash Flows for
the year ended June 30, 1993 separately disclose expenses and cash transactions, respectively,
related to the Chapter 11 case (see Note C, Reorganization and Restructuring). In accordance
with SOP 90-7, no interest has been accrued on pre-petition, unsecured debt. Additionally, interest income earned by WLI subsequent to the ling of Chapter 11 is reported as a reduction
of reorganization items. The reorganized Company will account for the Reorganization Plan
utilizing the Fresh-Start reporting principles contained in SOP 90-7.4
Review
Questions
1. Dene insolvency as that term is used in the Bankruptcy Code for an entity other than
a partnership.
2. What are Federal Rules of Bankruptcy Procedure?
3. Identify the various classes of creditors whose claims are dealt with in bankruptcy
liquidations.
4. Describe the process of liquidation under Chapter 7 of the Bankruptcy Code.
5. Differentiate between a debtors petition and a creditors petition.
6. May any business enterprise le a debtors bankruptcy petition for liquidation?
Explain.
7. Who may le a creditors petition for bankruptcy liquidation?
8. What is a statement of nancial affairs under the Bankruptcy Code?
9. List the unsecured debts having priority over other unsecured debts under the provisions of the Bankruptcy Code.
10. Describe the priority of claims for wages and salaries under the Bankruptcy Code.
11. Describe the authority of a bankruptcy trustee with respect to a preference.
12. What are the effects of a discharge in bankruptcy liquidation proceedings? Explain.
13. What use is made of the accounting nancial statement known as a statement of
affairs? Explain.
14. Describe the accountability method of accounting used by a trustee in a bankruptcy
liquidation.
15. For what types of bankruptcy reorganizations might an examiner be appointed by the
bankruptcy court?
16. What is the role of the Securities and Exchange Commission in a bankruptcy reorganization?
4
AICPA, Accounting Trends & Techniques, 48th ed. (New York: 1994), p. 35.

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17. Must all classes of creditors accept a reorganization plan before the plan may be conrmed by the bankruptcy court? Explain.
18. What is fresh-start reporting for a business enterprise reorganized under Chapter 11
of the Bankruptcy Code, and under what circumstances is it appropriate?
Exercises
(Exercise 14.1)
Select the best answer for each of the following multiple-choice questions:
1. A category of assets that typically has zero in the Estimated Amount Available column
of a statement of affairs is:
a. Factory supplies inventory
b. Tools
c. Short-term prepayments
d. None of the foregoing
2. In a bankruptcy proceeding, the term statement of affairs refers to:
a. A document containing a series of questions concerning all aspects of the debtors
nancial condition and operations.
b. A nancial statement prepared in lieu of a balance sheet.
c. Both a and b.
d. Neither a nor b.
3. The number of classes of creditors in a bankruptcy liquidation is:
a. Two
b. Three
c. Four
d. Five
4. The Paid-in Capital in Excess of Par ledger account of a debtor corporation undergoing bankruptcy reorganization typically is debited or credited for:
a. Costs of bankruptcy proceedings.
b. Gain from discharge of indebtedness in bankruptcy.
c. Retained earnings decit.
d. All the foregoing items.
e. None of the foregoing items.
5. The bankruptcy trustee for Insolvent Company sold assets having a carrying amount
of $10,000 for $8,500 cash. The journal entry (explanation omitted) to record the
sale is:
a. Cash
8,500
Loss on Realization of Assets
1,500
Assets
10,000
b. Cash
8,500
Estate Administration Expenses
1,500
Assets
10,000
c. Cash
8,500
Cost of Goods Sold
10,000
Sales
8,500
Assets
10,000

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6.
7.
8.
9.
10.
11.
d. Cash
8,500
Estate Decit
1,500
Assets
10,000
In a statement of affairs (nancial statement), assets pledged for partially secured liabilities are:
a. Included with assets pledged for fully secured liabilities.
b. Offset against partially secured liabilities.
c. Included with free assets.
d. Disregarded.
Regis Company is being liquidated in bankruptcy. Unsecured creditors without priority are expected to be paid 50 cents on the dollar. Sardo Company is the payee of a note
receivable from Regis in the amount of $50,000 (including accrued interest), which is
collateralized by machinery with a current fair value of $10,000. The total amount expected to be realized by Sardo on its note receivable from Regis is:
a. $35,000
b. $30,000
c. $25,000
d. $10,000
e. Some other amount
In journal entries for a bankruptcy reorganization, the difference between the carrying
amount of a liability of the debtor and the amount accepted by the creditor in full settlement of the liability is credited to:
a. Retained Earnings (Decit).
b. Paid-in Capital in Excess of Par or Stated Value.
c. Paid-in Capital from Reorganization.
d. Cash with Escrow Agent.
e. Some other ledger account.
With respect to the terms bankrupt and insolvent as adjectives:
a. Bankrupt refers to a legal state; insolvent refers to the nancial condition of a person or a business enterprise.
b. Bankrupt refers to the nancial condition of a person or a business enterprise;
insolvent refers to a legal state.
c. Both bankrupt and insolvent refer to the nancial condition of a person or a business enterprise.
d. Bankrupt and insolvent properly may be used as interchangeable adjectives.
The accounting records of a trustee in a bankruptcy liquidation are maintained:
a. Under the accrual basis of accounting.
b. Under the cost basis of accounting.
c. Under an accountability technique.
d. In accordance with the bankruptcy courts instructions.
Under the Bankruptcy Code, are creditors having priority:
a.
b.
c.
d.
Secured Creditors?
Unsecured Creditors?
Yes
Yes
No
No
Yes
No
Yes
No

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12. The period of time that must elapse before a debtor that has had a previous bankruptcy
discharge may again be discharged is:
a. Four years
b. Five years
c. Six years
d. Seven years
13. The sequence of listing (1) fully secured liabilities, (2) partially secured liabilities,
(3) unsecured liabilities with priority, and (4) unsecured liabilities without priority in
the liabilities and stockholders equity section of a statement of affairs is:
a. (1), (2), (3), (4)
b. (3), (1), (2), (4)
c. (1), (3), (2), (4)
d. (1), (3), (4), (2)
14. The following journal entry (explanation omitted) was prepared by an enterprise that
had led a debtors petition in bankruptcy:
Cash
100,000
100,000
Such a journal entry generally is related to:

a. A liquidation only.
b. A reorganization only.
c. Either a liquidation or a reorganization.
d. Neither a liquidation nor a reorganization.
15. The estimated amount available for free assets in a statement of affairs for a business
enterprise undergoing bankruptcy liquidation is equal to the assets:
a. Carrying amounts less current fair values.
b. Carrying amounts plus gain or less loss on realization.
c. Carrying amounts plus loss or less gain on realization.
d. Current fair values less carrying amounts.
16. A retained earnings decit of a business enterprise undergoing bankruptcy reorganization typically is eliminated by its:
a. Offset against gain from discharge of indebtedness in bankruptcy.
b. Inclusion with costs of bankruptcy proceedings.
c. Offset against legal capital.
d. Offset against additional paid-in capital.
17. On April 30, 2006, Carson Welles, trustee in bankruptcy liquidation for Lyle Company,
paid $12,140 in full settlement of Lyles liability under product warranty, which had
been carried in Welless accounting records at $10,000. The appropriate journal entry
for Welles (explanation omitted) is:
a. Liability under Product Warranty
12,140
Cash
12,140
b. Liability under Product Warranty
10,000
Estate Decit
2,140
Cash
12,140
c. Liability under Product Warranty
10,000
Product Warranty Expense
2,140
Cash
12,140

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d. Liability under Product Warranty

Retained Earnings (Prior Period Adjustment)
Cash
(Exercise 14.2)
CHECK FIGURE
To partially secured
liabilities, $48,000.
10,000
2,140
12,140
The December 18, 2006, statement of affairs of Downside Company, which is in bankruptcy
liquidation, included the following:
Assets pledged for fully secured liabilities

Assets pledged for partially secured liabilities
Free assets
Fully secured liabilities
Partially secured liabilities
Unsecured liabilities with priority
Unsecured liabilities without priority
$100,000
40,000
120,000
80,000
50,000
60,000
90,000
Prepare a working paper to show the estimated amount of assets expected to be received
by each of the four classes of creditors of Downside Company in its bankruptcy liquidation.
(Exercise 14.3)
CHECK FIGURE
Estimated deciency,
$100,000.
Amounts related to the statement of affairs of Foldup Company, in bankruptcy liquidation

on April 30, 2006, were as follows:

Free assets
$ 80,000
50,000
280,000
60,000
80,000
40,000
330,000
Prepare a working paper to compute the total estimated deciency to unsecured, nonpriority creditors, and the cents per dollar that such creditors may expect to receive from
Foldup Company.
(Exercise 14.4)
CHECK FIGURE
Data from the April 30, 2006, statement of affairs of Windup Company, which was undergoing bankruptcy liquidation, included the following:

Free assets
$70,000
30,000
50,000
60,000
40,000
30,000
50,000
Prepare a working paper to show how Windup Companys assets on April 30, 2006, are
expected to be apportioned to Windups creditors claims on that date.

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(Exercise 14.5)
CHECK FIGURE
Components of the December 17, 2006, statement of affairs of Liquo Company, which was
undergoing liquidation under Chapter 7 of the Bankruptcy Code, included the following:
Assets pledged for fully secured liabilities, at current fair value

Assets pledged for partially secured liabilities, at current fair value
Free assets, at current fair value
$150,000
104,000
80,000
60,000
120,000
14,000
224,000
Prepare a working paper dated December 17, 2006, to compute the amount expected to
be paid to each class of creditors of Liquo Company. The following column headings are
suggested: Class of Creditor, Total Claims, Computation, Estimated Amount. The total of
the Estimated Amount column should equal total assets, $334,000.
(Exercise 14.6)
Scott Company led a debtors bankruptcy petition on June 25, 2006, and its statement of
affairs included the following amounts:
CHECK FIGURE
Cash received by
partially secured
creditors, $84,000.
Carrying
Amounts
Current
Fair Values
Assets
Free assets
Totals
$160,000
90,000
200,000
$450,000
$190,000
60,000
140,000
$390,000
Liabilities
Total
$ 20,000
130,000
100,000
260,000
$510,000
Assuming that Scott Companys assets realized cash at the current fair values and the
business was liquidated by the bankruptcy trustee, prepare a working paper to compute
the amount of cash that the partially secured creditors should receive.
(Exercise 14.7)
CHECK FIGURE
Amount to Stark
Company, $22,897.
The statement of affairs for Wick Corporation shows that approximately 78 cents on the
dollar probably will be paid to unsecured creditors without priority. Wick owes Stark Company $23,000 on a promissory note, plus accrued interest of $940. Inventories with a current fair value of $19,200 collateralize the note payable.
Prepare a working paper to compute the amount that Stark Company should receive
from the trustee of Wick Corporation, assuming that actual payments to unsecured creditors without priority amount to 78 cents on the dollar. Round all amounts to the nearest
dollar.

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(Exercise 14.8)
Decker Company led a debtors bankruptcy petition on August 15, 2006, and its statement
of affairs included the following amounts:
CHECK FIGURE
Carrying
Amounts
Current
Fair Values
Assets
Free assets
Totals
$150,000
90,000
210,000
$450,000
$185,000
60,000
160,000
$405,000
Liabilities
Total
$ 35,000
130,000
100,000
270,000
$535,000
Cash available,
$180,000.
Assuming that Decker Companys assets realized cash at the current fair values and the
business was liquidated by the bankruptcy trustee, prepare a working paper to compute
the amount of cash available to pay unsecured liabilities without priority.
(Exercise 14.9)
CHECK FIGURE
creditors, $57,200.
(Exercise 14.10)
Prepare a working paper to compute the estimated amount expected to be paid to each
class of creditors, using the following data taken from the statement of affairs for Kent
Corporation:
Assets pledged for fully secured liabilities (current fair value, $75,000)
Assets pledged for partially secured liabilities (current fair value, $52,000)
Free assets (current fair value, $40,000)
$ 90,000
74,000
70,000
7,000
30,000
60,000
112,000
The following information for Progress Book Company on May 31, 2006, was obtained by
an accountant retained by Progress Books creditors:
1. Furniture and xtures: Carrying amount, $70,000; current fair value, $60,500; pledged
on a note payable of $42,000 on which unpaid interest of $800 has accrued.
2. Book manuscripts owned: Carrying amount, $15,000; current fair value, $7,200; pledged
on a note payable of $9,000; interest on the note is paid to date.
3. Books in process of production: Accumulated cost (direct material, direct labor, and
factory overhead), $37,500; estimated sales value on completion, $60,000; additional
out-of-pocket costs of $14,200 will be required to complete the books in process.
Prepare the headings for the asset side of a statement of affairs for Progress Book Company on May 31, 2006, and illustrate how each of the three items described is displayed in
the statement.

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(Exercise 14.11)
Edward Ross, the trustee in bankruptcy for Winslow Company, set up accounting records
based on the April 30, 2006, statement of affairs for Winslow. The trustee completed the
following transactions and events early in May 2006:
May 2 Sold for $10,000 cash the nished goods inventory with a statement of affairs
valuation of $10,500.
3 Paid wages with a statement of affairs valuation of $8,000.
4 Collected $6,000 on trade accounts receivable with a statement of affairs valuation of $6,200. The remainder was considered to be uncollectible.
7 Paid trustee fee for one week, $500. (Debit Estimated Administrative Costs.)
Prepare journal entries (omit explanations) for Edward Ross, trustee in bankruptcy for
Winslow Company, for the transactions and events described above.
(Exercise14.12)
From the following traditional form of statement of realization and liquidation, prepare
a more concise statement of realization and liquidation similar to the one illustrated on
page 617.
CHECK FIGURE
Estate decit, Jan. 31,
$7,150.
REED COMPANY, IN BANKRUPTCY

Selma Ross, Trustee
For Month of January 2006
Assets to be realized:
Inventories
Equipment
Subtotal
Supplementary charges:
Administrative costs
Interest expense
Liabilities liquidated:
Liabilities not liquidated:
Notes payable
Interest payable
Total
(Exercise 14.13)
$ 7,500
12,500
10,000
$30,000
2,950
50
6,000
5,000
24,000
200
$68,200
Liabilities to be liquidated:
Notes payable
Interest payable
Subtotal
Liabilities assumed:
Interest payable
Assets realized:
Inventories
Assets not realized:
Equipment
Net loss
Total
$ 5,000
30,000
150
$35,150
50
6,500
14,500
10,000
2,000
$68,200
Following are selected provisions of the plan of reorganization for Kolb Company, which is
emerging from Bankruptcy Code Chapter 11 reorganization on July 27, 2006:
(1) Amended articles of incorporation to provide for 100,000 shares of authorized common stock, $5 par, to be exchanged on a share-for-share basis for 50,000 shares of outstanding no-par, no-stated-value common stock with a carrying amount of $600,000.
(2) Exchanged 10,000 shares of the new $5 par common stock for trade accounts payable
totaling $70,000.
(3) Paid 80 cents per dollar for full settlement of other trade accounts payable totaling
$60,000.

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Prepare journal entries (omit explanations) for Kolb Company on July 27, 2006, to reect the foregoing elements of its plan of reorganization.
(Exercise 14.14)
Among the provisions of the reorganization of Hayward Company under Chapter 11 of the
Bankruptcy Code were the following:
(1) Issued 1,000 shares of $5 par common stock in exchange for 1,000 shares of $100 par
common stock outstanding.
(2) Issued 200 shares of $5 par common stock (current fair value $10 a share) for notes
payable to suppliers with unpaid principal of $2,500 and accrued interest of $500.
(3) Paid $8,000 to suppliers in full settlement of trade accounts payable of $10,000.
Prepare journal entries (omit explanations) for Hayward Company for the foregoing provisions, all of which were completed on January 20, 2006.
Cases
(Case 14.1)
The January 29, 1994, balance sheet of Hills Stores Company, a publicly owned enterprise,
included the following asset:
Reorganization value in excess of amounts

allocable to identiable assets, net
$176,718,000
The Intangible Assets section of Hillss Summary of Signicant Accounting Policies note
to nancial statements read in part as follows:
Reorganization value in excess of amounts allocable to identiable assets is being amortized
over 20 years on a straight-line basis. Accumulated amortization was $29,395,000 at January
29, 1994.
The reorganization value accounted for more than 19% of Hillss total assets of
$907,621,000 on January 29, 1994.
Instructions
What is your opinion of the foregoing balance sheet display and related note disclosures?
Explain, after researching the following:
AICPA Statement of Position 90-7, Financial Reporting by Entities in Reorganization
under the Bankruptcy Code, paragraphs 9, 38, 61, and 62.
FASB Statement of Financial Accounting Concepts No. 6, Elements of Financial
Statements, paragraphs 25 through 31 and 171 through 177.
FASB Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets, paragraphs 1, 5, and 10.
FASB Statement of Financial Accounting Standards No. 87, Employers Accounting
for Pensions, paragraphs 36, 37, and 38, and dissent of Robert T. Sprouse.

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(Case 14.2)
In auditing the nancial statements of Delbert Company for the six months ended December 31, 2006, you nd items a through e below had been debited or credited to the Retained
Earnings ledger account during the six months immediately following a bankruptcy reorganization, which was effective July 1, 2006:
a. Debit of $25,000 arising from an additional income tax assessment applicable to
2005.
b. Credit of $48,000 resulting from gain on disposal of equipment that was no longer
used in the business. This impaired equipment had been written down by a $50,000
increase in the Accumulated Depreciation ledger account on July 1, 2006.
c. Debit of $15,000 resulting from the loss on plant assets destroyed in a re on November
2, 2006.
d. Debit of $32,000 representing cash dividends declared on preferred stock.
e. Credit of $60,400, the net income for the six-month period ended December 31,
2006.
Instructions
For each of the foregoing items, state whether it is correctly debited or credited to the
Retained Earnings ledger account. Give a brief reason for your conclusion.
(Case 14.3)
You have been asked to conduct a training program explaining the preparation of a statement of affairs (nancial statement) for the staff of Bixby & Caneld, CPAs.
Instructions
Explain how each of the following is presented in a statement of affairs (nancial statement) for a corporation in bankruptcy liquidation proceedings:
a. Assets pledged for partially secured liabilities.
b. Unsecured liabilities with priority.
c. Stockholders equity.
Problems
(Problem 14.1)
On July 24, 2006, the date the plan of reorganization of Re-Org Company was approved by
the bankruptcy court, Re-Orgs stockholders equity was as follows:
Common stock, no par or stated value; authorized 100,000

shares, issued and outstanding 60,000 shares
Decit
Total stockholders equity
$ 580,000
(260,000)
$ 320,000
Included in Re-Orgs plan of reorganization were the following:

1. Authorize payment of $50,000 unrecorded bankruptcy administrative costs by escrow
agent holding special Re-Org cash account.
2. Amend articles of incorporation to change common stock to $1 par from no-par, nostated-value stock.

IV. Accounting for

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3. Exchange 10% unsecured $120,000 promissory note payable to supplier (interest unpaid
for three months) for a 12%, two-year promissory note in the total amount of unpaid principal and accrued interest on the 10% note.
4. Pay suppliers 80 cents on the dollar (from Re-Org cash account) for their claims totaling $100,000.
5. Eliminate decit against paid-in capital resulting from (2) and gain resulting from (4).
Instructions
Assuming the foregoing were completed on July 24, 2006, prepare journal entries (omit
explanations) for Re-Org Company on that date. Use the following ledger account titles:
Cash
Common Stock, no par
Gain from Discharge of Indebtedness in
Bankruptcy
(Problem 14.2)
Interest Payable
10% Note Payable
12% Note Payable
Retained Earnings (Decit)
Trade Accounts Payable
The following information was available on October 31, 2006, for Dodge Company, which
cannot pay its liabilities when they are due:
CHECK FIGURE
Carrying
Amounts
Estimated deciency,
$20,500.
Cash
Trade accounts receivable (net): Current fair value equal to carrying amount
Inventories: Net realizable value, $18,000; pledged on $21,000 of notes
payable
Plant assets: Current fair value, $67,400; pledged on mortgage note
payable
Accumulated depreciation of plant assets
Supplies: Current fair value, $1,500
Wages payable, all earned during October 2006
Notes payable, $21,000 secured by inventories
Mortgage note payable, including accrued interest of $400
Common stock, $5 par
Decit
$ 4,000
46,000
39,000
134,000
27,000
2,000
5,800
1,200
60,000
40,000
50,400
100,000
59,400
Instructions
a. Prepare a statement of affairs for Dodge Company on October 31, 2006, in the form
illustrated on page 614.
b. Prepare a working paper to compute the estimated percentage of claims each group
of creditors should expect to receive if Dodge Company petitions for liquidation in
bankruptcy.
(Problem 14.3)
Robaire Corporation was in nancial difculty because of declining sales and poor cost
controls. Its stockholders and principal creditors had asked for an estimate of the nancial

632
IV. Accounting for

Fiduciaries

and Reorganization
The McGrawHill
Companies, 2005
CHECK FIGURES
b. Estate decit, Jan.
31, $9,380; c. Trial
balance totals,
$31,850.
results of the realization of the assets, the payment of liabilities, and the liquidation of
Robaire. Thus, the accountant for Robaire prepared the statement of affairs shown on
page 633.
On January 2, 2007, Robaire led a debtors petition for liquidation under the Bankruptcy Code. Charles Stern was appointed as trustee by the bankruptcy court to take custody of the assets, make payments to creditors, and implement an orderly liquidation. The
trustee completed the following transactions and events during January, 2007:
Jan. 2 Recorded the assets and liabilities of Robaire Corporation in a separate set of
accounting records. The assets were recorded at current fair value, and all liabilities were recorded at the estimated amounts payable to the various groups
of creditors.
7 Disposed of the land and buildings at an auction for $52,000 cash and paid
$42,550 to the mortgagee. The payment included interest of $50 that accrued
in January.
10 Made cash payments as follows:
Wages payable
Completion of inventories
Administrative costs of liquidation
$1,500
800
400
600
31 Received cash from Jan. 8 to Jan. 31, 2007, as follows:
Collection of trade accounts receivable at carrying amount,

including $10,000 of assigned accounts
Sale of inventories
Disposal of Public Service Company bonds
$17,500
18,000
920
31 Made additional cash payments as follows:
Administrative costs of liquidation

Note payable to bank (from proceeds of collection of assigned
accounts receivable)
Fifty cents on the dollar to unsecured creditors
$ 1,250
10,000
30,500
Instructions
a. Prepare journal entries for the foregoing events and transactions of the trustee for
Robaire Corporation.
b. Prepare a statement of realization and liquidation for the trustee of Robaire Corporation
for the month of January 2007. Use the format illustrated on page 617.
c. Prepare a trial balance for the trustee of Robaire Corporation on January 31, 2007.
9,100
5,750
38,000
700
10,450
40,000
10,000
4,000
25,000
18,950
-0900
18,000
$56,500
18,950
-0900
18,000
10,000
$61,000
$51,000
5,500
700
10,450
$ 7,500
$ 700
10,450
$10,000
$20,000
30,000
$50,000
42,500
21,050
9,100
4,850
20,000
$ 34,000
$(16,000)
(5,000)
Estimated
Loss or
Amount
(Gain) on
Available Realization
20,000
26,000
27,200
25,000
42,000
500
1,500
800
$143,000
Carrying
Amounts

Stockholders equity
10,000
$25,000
$42,000
500
$42,500
800
$ 5,500
$ 3,200
1,500
Unsecured Liabilities without

Priority:
Notes payable to bank

Less: Assigned trade
accounts receivable
Partially Secured Liabilities:
Mortgage note payable

Interest payable
Fully Secured Liabilities:
Estimated administrative
costs
Wages payable
FICA and income taxes
withheld and accrued
Unsecured Liabilities with Priority:
Liabilities and
Stockholders Equity
$61,000
20,000
26,000
$ 15,000
Amount
Unsecured

and Reorganization
Estimated amount available for

unsecured, nonpriority creditors
Estimated deciency to unsecured,
nonpriority creditors
Cash
Inventories
$19,350
Less: Cost to complete
400
Factory supplies
Public Service Company bonds
Machinery and equipment
Total estimated amount available
Less: Unsecured liabilities with priority
(contra)
Free Assets:

(deducted contra)
Assets Pledged for Partially Secured

Liabilities:
Land
Buildings
Total
Less: Fully secured liabilities (contra)
Assets Pledged for Fully Secured

Liabilities:
Assets
Current
Fair
Values
IV. Accounting for

Fiduciaries
$143,000
Carrying
Amounts
Statement of Affairs
December 31, 2006
ROBAIRE COMPANY

The McGrawHill
Companies, 2005

634
IV. Accounting for

Fiduciaries

and Reorganization
The McGrawHill
Companies, 2005
(Problem 14.4)
CHECK FIGURE
b. Estimated
deciency, $22,500.
Javits Corporation advised you that it is facing bankruptcy proceedings. As the independent
auditor for Javits, you knew of its nancial condition.
The unaudited balance sheet of Javits on July 10, 2006, was as follows:
JAVITS CORPORATION
Balance Sheet
July 10, 2006
Assets
Cash
Short-term investments, at cost
Trade accounts receivable, less allowance for doubtful accounts
Finished goods inventory
Material inventory
Land
Buildings (net)
Machinery (net)
Goodwill (net)
Total assets
Notes payable to banks
Wages payable
Mortgage notes payable
Common stock
Retained earnings (decit)
Total liabilities and stockholders equity
$ 12,000
20,000
90,000
60,000
40,000
5,000
13,000
90,000
120,000
20,000
$470,000
$135,000
94,200
15,000
130,000
100,000
(4,200)
$470,000
Additional Information
1. Cash included a $500 travel advance that had been spent.
2. Trade accounts receivable of $40,000 had been pledged as collateral for notes payable
to banks in the amount of $30,000. Credit balances of $5,000 were netted in the accounts receivable total. All accounts were expected to be collected except those for
which an allowance had been established.
3. Short-term investments (all acquired in May 2006), classied as trading, consisted
of U.S. government bonds costing $10,000 and 500 shares of Owens Company
common stock. The current fair value of the bonds was $10,000; the current fair
value of the stock was $18 a share. The bonds had accrued interest receivable of
$200. The short-term investments had been pledged as collateral for a $20,000 note
payable to bank.
4. Estimated realizable value of nished goods was $50,000 and of material was $30,000.
For additional out-of-pocket costs of $10,000 the material would realize $59,900 as
nished goods.
5. Short-term prepayments were expected to be consumed during the liquidation period.
6. The current fair values of plant assets were as follows: land, $25,000; buildings,
$110,000; impaired machinery, $65,000.

IV. Accounting for

Fiduciaries

and Reorganization
The McGrawHill
Companies, 2005
7. Trade accounts payable included $15,000 withheld FICA and income taxes and $6,000
payable to creditors who had been reassured by the president of Javits that they would
be paid. There were unrecorded employers FICA taxes in the amount of $500.
8. Wages payable were not subject to any limitations under the Bankruptcy Code.
9. Mortgage notes payable consisted of $100,000 secured by land and buildings, and a
$30,000 installment contract secured by machinery. Total unrecorded accrued interest
for these liabilities amounted to $2,400.
10. Probable judgment on a pending suit against Javits was estimated at $50,000.
11. Costs other than accounting fees to be incurred in connection with the liquidation were
estimated at $10,000.
12. You had not submitted an invoice for $5,000 for the April 30, 2006, annual audit of
Javits, and you estimate a $1,000 fee for liquidation work.
Instructions
a. Prepare correcting journal entries for Javits Corporation on July 10, 2006.
b. Prepare a statement of affairs for Javits Corporation on July 10, 2006. Amounts in the
statement should reect the journal entries in a.
(Problem 14.5)
CHECK FIGURE
Estimated deciency,
$32,400.
The adjusted trial balance of Laurel Company on June 30, 2006, is as follows:
LAUREL COMPANY
Adjusted Trial Balance
June 30, 2006
Debit
Cash
Notes receivable
Interest receivable
Allowance for doubtful accounts
Inventories
Land
Building
Accumulated depreciation of building
Machinery and equipment
Accumulated depreciation of machinery and equipment
Furniture and xtures
Accumulated depreciation of furniture and xtures
Goodwill
Note payable to City Bank
Notes payable to Municipal Trust Company
Interest payable on notes
Wages payable
Mortgage bonds payable
Interest payable on mortgage bonds
Common stock
Retained earningsdecit
Totals
Credit
$ 14,135
29,000
615
24,500
$
800
48,000
10,000
50,000
15,000
33,000
19,000
21,000
9,500
9,600
18,000
6,000
24,000
1,280
80,520
1,400
430
32,000
1,820
70,000
39,900
$279,750
$279,750

636
IV. Accounting for

Fiduciaries

and Reorganization
The McGrawHill
Companies, 2005
Additional Information
1. Notes receivable of $25,000 were pledged to collateralize the $18,000 note payable to
City Bank. Interest of $500 was accrued on the pledged notes receivable, and interest of
$600 was accrued on the $18,000 note payable to the bank. All the pledged notes receivable were considered collectible. Of the remaining notes receivable, a $1,000 noninterest-bearing note was uncollectible. The note had been received for an unconditional
cash loan.
2. Trade accounts receivable included $7,000 from Boren Company, which currently was
being liquidated. Creditors were expected to realize 40 cents on the dollar. The allowance for doubtful accounts was adequate to cover any other uncollectible accounts.
A total of $3,200 of the remaining collectible trade accounts receivable was pledged as
collateral for the notes payable to Municipal Trust Company of $6,000 with accrued interest of $180 on June 30, 2006.
3. Inventories, valued at rst-in, rst-out cost, were expected to realize 25% of cost on a
forced liquidation sale after the write-off of $10,000 of obsolete stock.
4. Land and buildings, which had been appraised at 110% of their carrying amount, were
mortgaged as collateral for the bonds. Interest of $1,820 was accrued on the bonds on
June 30, 2006. Laurel expected to realize 20% of the cost of its impaired machinery and
equipment, and 50% of the cost of its impaired furniture and xtures after incurring renishing costs of $800.
5. Estimated costs of liquidation were $4,500. Depreciation and accruals had been adjusted
to June 30, 2006.
6. Laurel had net operating loss carryovers for income tax purposes of $22,000 for
the year ended June 30, 2005, and $28,000 for the year ended June 30, 2006. The
income tax rate expected to be in effect when the operating loss carryovers were used
was 40%.
Instructions
Prepare a statement of affairs for Laurel Company on June 30, 2006.
(Problem 14.6)
CHECK FIGURE
b. Total assets,
$1,137,530.
Bilbo Corporation, which is in bankruptcy reorganization, had $105,000 of dividends in arrears on its 7% cumulative preferred stock on March 31, 2006. While retained earnings were
adequate to permit the payment of accumulated dividends, Bilbos management did not
want to weaken its working capital position. It also realized that a portion of the plant assets was no longer used by Bilbo. Therefore, management proposed the following plan of
reorganization, which was accepted by stockholders and conrmed by the bankruptcy
court, to be effective on April 1, 2006:
1. The preferred stock was to be exchanged for $300,000 face amount and current fair
value of 15%, ten-year bonds. Dividends in arrears were to be settled by the issuance of
12,000 shares of $10 par, 15%, noncumulative preferred stock having a current fair
value equal to par.
2. Common stock was to be assigned a par of $50 a share.
3. Impaired goodwill was to be written off; impaired plant assets were to be written
down, based on appraisal and estimates of current fair value, by a total of $103,200,
consisting of a $85,400 increase in the Accumulated Depreciation ledger account balance and a $17,800 decrease in plant assets; other current assets were to be written
down by $10,460 to reduce trade accounts receivable and inventories to net realizable
values.

IV. Accounting for

Fiduciaries

and Reorganization
The McGrawHill
Companies, 2005
The balance sheet of Bilbo Corporation on March 31, 2006, follows:
BILBO CORPORATION
Balance Sheet
March 31, 2006
Assets
Cash
Other current assets
Plant assets
Less: Accumulated depreciation
Goodwill
Total assets
Current liabilities
7% cumulative preferred stock, $100 par ($105,000
dividends in arrears); 3,000 shares authorized, issued,
and outstanding
Common stock, no par or stated value; 9,000 shares
authorized, issued, and outstanding
Additional paid-in capital: preferred stock
Retained earnings
Total liabilities & stockholders equity
$
$1,458,250
512,000
30,000
252,890
946,250
50,000
$1,279,140
$ 132,170
300,000
648,430
22,470
176,070
$1,279,140
Instructions
a. Prepare journal entries for Bilbo Corporation to give effect to the plan of reorganization
on April 1, 2006.
b. Prepare a balance sheet for Bilbo Corporation on April 30, 2006, assuming that net
income for April was $15,000. The operations resulted in $11,970 increase in cash,
$18,700 increase in other current assets, $7,050 increase in current liabilities, and
$8,620 increase in the Accumulated Depreciation ledger account.

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Larsen: Modern Advanced

Accounting, Tenth Edition

IV. Accounting for

14. Bankruptcy: Liquidation

Larsen: Modern Advanced

IV. Accounting for

14. Bankruptcy: Liquidation

Part Four Accounting for Fiduciaries

THE BANKRUPTCY CODE

Debtors (Voluntary) Petition

Bankruptcy Code, sec. 101 (32).

Larsen: Modern Advanced

IV. Accounting for

14. Bankruptcy: Liquidation

Chapter 14 Bankruptcy: Liquidation and Reorganization 609

Creditors (Involuntary) Petition

Unsecured Creditors with Priority

Larsen: Modern Advanced

IV. Accounting for

14. Bankruptcy: Liquidation

Part Four Accounting for Fiduciaries

Property Claimed as Exempt

Role of Court in Liquidation

Larsen: Modern Advanced

IV. Accounting for

14. Bankruptcy: Liquidation

Chapter 14 Bankruptcy: Liquidation and Reorganization 611

Role of Accountant in Bankruptcy Liquidation

Financial Condition of Debtor Enterprise:

Illustration of Statement of Affairs

Larsen: Modern Advanced

IV. Accounting for

14. Bankruptcy: Liquidation

Part Four Accounting for Fiduciaries

Larsen: Modern Advanced

IV. Accounting for

14. Bankruptcy: Liquidation

Chapter 14 Bankruptcy: Liquidation and Reorganization 613

Net realizable value

Estimated disposal costs ($40,000 0.20)

Less: Estimated out-of-pocket completion costs ($15,400 $3,700)

*Estimated selling price

Unsecured Liabilities without Priority:

Partially Secured Liabilities:

Fully Secured Liabilities:

Unsecured Liabilities with Priority:

Liabilities and Stockholders Equity

14. Bankruptcy: Liquidation

IV. Accounting for

Assets Pledged for Partially

Assets Pledged for Fully

Larsen: Modern Advanced

Part Four Accounting for Fiduciaries

Larsen: Modern Advanced

IV. Accounting for

14. Bankruptcy: Liquidation

Chapter 14 Bankruptcy: Liquidation and Reorganization 615

Estimated Amounts to Be Recovered by Each

*$15,405 $91,800 $15,300 $12,000 $39,250 $52,000 $225,755.

Accounting and Reporting for Trustee

Illustration of Accountability Technique

Larsen: Modern Advanced

IV. Accounting for