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Chapter 18

CORPORATE LIQUIDATIONS and REORGANIZATIONS

Answers to Questions

1 Equity insolvency occurs when a debtor is unable to pay its debts as they come due. Bankruptcy insolvency
occurs when a debtors liabilities exceed the fair value of all assets.

2 A bankruptcy proceeding is designated voluntary if the debtor corporation files the petition to place itself
under the protection of the bankruptcy court and involuntary if creditors file the petition to bring the debtor
into bankruptcy court. An involuntary petition may be filed by a single creditor with an unsecured claim of
$12,300 or more if there are fewer than twelve unsecured creditors. Otherwise, three or more entities with
unsecured claims totaling at least $12,300 must file in order to commence an involuntary case. The
requirements are the same for Chapter 7 and Chapter 11 cases.

3 The duties of the U.S. trustee are to maintain and supervise a panel of private trustees eligible to serve in
Chapter 7 cases, to serve as trustee or interim trustee in some bankruptcy cases, to supervise the
administration of bankruptcy cases, and to preside over creditor meetings. Bankruptcy judges still
supervise cases in districts without U.S. trustees.

4 The debtor corporation in a bankruptcy case has the following duties: (1) to file a list of creditors, a
schedule of assets and liabilities, and a statement of the debtors financial affairs; (2) to cooperate with the
trustee so that the trustee may perform his duties; (3) To surrender all property, including books,
documents, records, and so on, to the trustee; and (4) to appear at hearings of the bankruptcy court as
required.

5 A trustee is not appointed in all Title 11 cases. In Chapter 7 cases, a trustee will be elected by unsecured
creditors if a majority of creditors vote for the trustee, and those creditors hold at least 20 percent of the
claims. Otherwise, an appointed interim trustee serves as trustee. In Chapter 11 cases a trustee is appointed
only if deemed necessary by the court, but otherwise, the debtor remains in possession of the estate and
performs the duties of a trustee. Within 30 days from the time the court orders the appointment of a trustee
in a Chapter 11 case, a party in interest may request the election of a trustee.

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18-2 Corporate Liquidations and Reorganizations

6 The trustee in a liquidation case takes possession of the debtors estate, converts estate assets into cash, and
distributes the proceeds as directed by the court. They also performs other duties such as investigating the
financial affairs of the debtor, providing information about the estate to parties of interest, examining
creditor claims and objecting to those that appear improper, operating the debtors business if authorized to
do so by the court, providing financial reports and summaries about the estate to the court, and filing
reports on trusteeship as directed by the court.

7 The priority rankings in a Chapter 7 liquidation case are summarized in Exhibit 182 of the text. The
priorities recognized for unsecured claims (Rank II) are: (1) administrative expenses, (2) claims incurred
between an involuntary filing and appointment of a trustee, (3) salary claims up to $10,000 per individual
earned within 90 days of filing, (4) employee benefit plan contribution claims up to $10,000 per individual
earned within 180 days of filing, (5) individual claims up to $1,800 for goods and services purchased from,
but not provided by the debtor, and (6) claims of governmental units for taxes owed by the debtor (subject
to time restrictions), including taxes collected and withheld for which the debtor is liable.

8 Four ranks within the unsecured nonpriority claim category (general unsecured claims) are: (1) claims
allowed that were timely filed, (2) claims allowed where proof was filed late, (3) claims allowed for fines,
penalties or forfeitures, or damages, and arising before the court order for relief or appointment of a
trustee, and (4) claims for interest on unsecured claims.

9 The accountants statement of affairs is a financial statement that is designed to provide information about
liquidation values and priority rankings for use by the trustee, the court, creditors, and other interested
parties in the debtors estate. Assets are measured at expected net realizable values in the statement, but
book values are also included for reference purposes.
10 A debtor corporations estate may be liquidated even though the filing is under Chapter 11. This can occur
when the case is transferred to Chapter 7 for liquidation. It can also be carried out in accordance with an
approved Chapter 11 plan of reorganization that calls for sale and distribution of the proceeds from the
debtor corporations estate.

11 A debtor in possession reorganization case is a Chapter 11 case in which the bankruptcy court does not
appoint a trustee, but instead, allows the debtor corporation to carry out the duties that otherwise would be
performed by a trustee.

12 A creditor committee can file a plan of reorganization under a Chapter 11 case after 120 days from the date
the court order for relief is granted. The order for relief occurs when the debtor or creditors filing petition
is approved by the court.

13 The approval of a plan of reorganization requires acceptance of the plan by at least two-thirds in dollar
amount and over half in number of claims in each class of claims. Further, each class of claims must accept
the plan or not be impaired under it. A class of claims that would receive nothing if the corporation were
liquidated is not impaired if it receives nothing under a plan and, accordingly, acceptance by that class of
claims is not required.

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Chapter 18 18-3

14 Prepetition liabilities are the liabilities of an enterprise that were incurred prior to a Chapter 11 filing. They
are reported at the amounts allowed by the bankruptcy court. Prepetition liabilities subject to compromise
are those liabilities that may be impaired by a plan and that are eligible for compromise because they are
either unsecured or undersecured.

15 Reorganization value is an estimate of the value of the reconstituted entity that will emerge from
reorganization, plus the expected net realizable value of the assets that will be disposed of before
reconstitution occurs. It is also described as the fair value of the entity before considering liabilities.
Reorganization value approximates the amount a willing buyer would pay for the assets of the entity
immediately after the restructuring.

16 Fresh start reporting should be used by a company emerging from Chapter 11 if the following two
conditions are met: (1) the reorganization value of the assets of the emerging entity immediately before the
date of confirmation is less than the total of all postpetition liabilities and allowed claims and (2) holders of
existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of
the emerging entity.

17 Entities not qualifying for fresh start reporting report liabilities compromised by a confirmed
reorganization plan in a manner similar to that of a note issued in a noncash transaction under FASB ASC
835. Forgiveness of debt should be reported as an extraordinary item.

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18-4 Corporate Liquidations and Reorganizations

SOLUTIONS TO EXERCISES

Solution E18-1 Solution 18-2

1 b 1 a
2 d 2 d
3 c 3 c
4 d 4 d

Solution E18-3

Note receivable from Pat $200,000

Amount secured by inventory items at expected recoverable value (50,000)

Unsecured portion of note receivable from Pat 150,000

Expected recovery on the dollar for unsecured claims .35

Expected recovery on unsecured portion of note 52,500

Add: Secured portion 50,000

Total expected recovery on note from Pat $102,500

Solution E18-4

1 On the basis of the reorganization value, Bax qualifies for fresh start
reporting because the estimated reorganization value of $2,000,000 is
less than the postpetition liabilities and allowed claims.

Estimated reorganization value $2,000,000

Liabilities:
Postpetition liabilities $1,200,000
Prepetition liabilities 1,500,000
Fully secured debt 900,000 3,600,000
Excess liabilities over reorganization value $1,600,000

2 Old stockholders must retain less than a 50% interest in the new
entity.

Reorganization value $2,000,000

Less: Payment to prepetition claimants 150,000
1,850,000
Reorganized capital structure:
Postpetition liabilities $1,200,000
Notes payable 300,000
Fully secured debt 900,000
New common stock to prepetition claimants 375,000 2,775,000
New common stock to old stockholders $ (925,000)

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Chapter 18 18-5
Solution E18-5

Cash available for distribution $200,000

Mortgage payable (secured portion) (100,000)
100,000
Priority claims (administrative expenses and salaries) (20,000)
Available for unsecured, nonpriority claims $ 80,000

Unsecured, nonpriority claims:

Balance of mortgage payable $ 60,000
Accounts payable 100,000
Unsecured, nonpriority claims $160,000

$80,000 available cash/$160,000 claims = $.50 on the dollar

Schedule of Distribution of Available Cash

Mortgage payable secured portion $100,000

Unsecured, priority claims 20,000
Mortgage payable unsecured portion ($60,000 $.50) 30,000
Accounts payable ($100,000 $.50) 50,000
Total cash distributed $200,000

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18-6 Corporate Liquidations and Reorganizations

SOLUTIONS TO PROBLEMS

Solution P18-1

1 Entries on trustees books:

March 1, 2011
Cash $ 4,000
Accounts receivable net 8,000
Inventories 36,000
Land 20,000
Buildings net 100,000
Intangible assets 26,000
Accounts payable $50,000
Note payable unsecured 40,000
Revenue received in advance 1,000
Wages payable 3,000
Mortgage payable 80,000
Estate equity 20,000
To record custody of Sco in liquidation.

March 2011
Cash $ 7,200
Estate equity 800
Accounts receivable net $ 8,000
To record collection of receivables and recognize loss.

Cash $ 19,400
Estate equity 16,600
Inventories $36,000
To record sale of inventories at a loss.

Cash $ 90,000
Estate equity 30,000
Land $ 20,000
Buildings net 100,000
To record sale of land and buildings at a loss.

Estate equity $ 26,000

Intangible assets $ 26,000
To write off intangible assets at a loss.

Estate equity $ 8,200

Administrative expenses
payable new $ 8,200
To accrue trustee expenses.

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Chapter 18 18-7
Solution P18-1 (continued)

2 Sco in Trusteeship
Balance Sheet
at March 31, 2011

Assets
Cash $120,600

Liabilities And Deficit

Accounts payable $ 50,000
Note payable unsecured 40,000
Revenue received in advance 1,000
Wages payable 3,000
Mortgage payable 80,000
Administrative expenses payable new 8,200
Total liabilities 182,200
Less: Estate deficit (61,600)

Total liabilities less deficit $120,600

Statement of Cash Receipts and Disbursements

from March 1 to March 31, 2011

Cash balance, March 1, 2011 $ 4,000

Add: Cash receipts

Collections of receivables $ 7,200
Sale of inventories 19,400
Sale of land and buildings 90,000 116,600
120,600
Less: Cash disbursements (none) 0

Cash balance, March 31, 2011 $120,600

Statement of Changes in Estate Equity

from March 1 to March 31, 2011

Estate equity, March 1, 2011 $20,000

Less:
Loss on uncollectible receivables $ 800
Loss on sale of inventories 16,600
Loss on sale of land and buildings 30,000
Loss on write-off of intangibles 26,000
Administrative expenses 8,200 81,600

Estate deficit, March 31, 2011 $61,600

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18-8 Corporate Liquidations and Reorganizations

Solution P18-1 (continued)

3 Entries on trustees books:

April 2011
Mortgage payable $80,000
Cash $80,000
To record payment of secured creditors from proceeds from sale of
land and buildings.

Administrative expenses payable new $ 8,200

Revenue received in advance 1,000
Wages payable 3,000
Cash $12,200
To record payment of priority liabilities.

Accounts payable $15,800

Note payable unsecured 12,600
Cash $28,400
To record payment of $.32 per dollar to unsecured creditors
(available cash of $28,400 divided by unsecured claims of
$90,000).

Accounts payable $34,200

Note payable unsecured 27,400
Estate equity $61,600
To write off remaining liabilities and close trustees records.

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Chapter 18 18-9
Solution P18-2

1 Amount expected to be available for unsecured claims:

Total amount expected to be available for all

claims $445,000

Less: Payments to secured and priority claims

Mortgage payable $220,000
Note payable 75,000
Priority claims 80,000 375,000

Expected to be available for unsecured

nonpriority claims $ 70,000

2 Expected recovery per dollar of unsecured claims:

Expected to be available (from 1) = $70,000

Unsecured claims ($550,000 - $375,000) = $175,000

Expected recovery on the dollar: $70,000/$175,000 = $.40

3 Expected recovery by class of creditors:

Fully secured mortgage payable $220,000

Partially secured note payable $75,000 + ($25,000 $.40) 85,000
Priority unsecured liabilities to priority creditors 80,000
Unsecured nonpriority creditors accounts
payable ($150,000 $.40) 60,000

Total $445,000

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18-10 Corporate Liquidations and Reorganizations

Solution P18-3

1 Ranking of claims:

Fully secured:
8. Holders of first mortgage and
related
interest $228,500

Unsecured priority:
1. Administrative expenses $ 12,500
6. Wages payable up to $4,000 per 47,000
employee
7. Customer claims for merchandise paid 1,500
for and not delivered (maximum
$1,800 per individual)
5. State government for gross $ 3,000
receipts taxes
3. Local government for property
taxes 4,000 7,000
Total unsecured priority claims 68,000

Unsecured nonpriority:
2. Merchandise creditors $99,000
4. Local bank for principal of loan 30,000
6. President for salary due over $4,000 1,000 130,000
4. Interest on unsecured bank loan 4,500
Total unsecured nonpriority claims 134,500

Total all claims $431,000

2 Distribution of available cash:

1st Mortgage holders (100%) $228,500

2nd Administrative expenses (100%) 12,500

3rd Employees (up to $4,000 each) (100%) 47,000

4th Customers for merchandise not delivered

(100%) 1,500

5th State government (100%) $ 3,000

Local government (100%) 4,000 7,000

[Remaining cash ($374,500 - $296,500) of $78,000/$130,000 claim of next

rank = $.60 return on dollar]

6th Merchandise creditors ($99,000 .60) $59,400

Local bank for loan principal
($30,000 .60) 18,000
Company president ($1,000 .60) 600 78,000
Total distributed (equal to available cash) $374,500

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Chapter 18 18-11
Solution P18-4

1 Hanna Corporation
Statement of Affairs
on June 30, 2011

Assets
Realizable
Values- Realizable
Liability Value
Offsets Available for
Book for Secured Unsecured
Value Creditors Creditors
Pledged for partially
secured creditors
$55,000 Equipment net $28,000
Less: Mortgage note payable
and accrued interest (31,000) $ 0

Available for priority

and unsecured creditors
2,200 Cash 2,200
15,000 Accounts receivable net 13,500
20,000 Inventories 22,500

Total available for priority and unsecured

creditors 38,200
Less: Priority liabilities 12,000

Total available for unsecured creditors 26,200

Estimated deficiency 10,800
$92,200 $37,000

Liabilities And Stockholders Equity

Book Secured and Unsecured Non-

Value Priority Claims priority Claims
Priority liabilities
$12,000 Wages payable (assumed under
$4,000 per employee) $12,000

Partially secured creditors

31,000 Note payable and accrued
interest $31,000
Less: Equipment pledged
as security (28,000) $ 3,000

Unsecured creditors
26,400 Accounts payable 26,400
7,600 Rent payable 7,600

Stockholders equity
55,000 Capital stock
(39,800) Retained earnings (deficit)
$92,200 $37,000

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18-12 Corporate Liquidations and Reorganizations

Solution P18-4 (continued)

2 Estimated payments per dollar for unsecured creditors

Cash available $66,200

Distribution to partially secured and unsecured

priority creditors:

Note payable and interest $28,000

Administrative expenses 4,000
Wages payable 12,000 44,000

Available to unsecured nonpriority

creditors = A $22,200

Note payable and interest (unsecured portion) $ 3,000

Accounts payable 26,400
Rent payable 7,600

Unsecured nonpriority claims = B $37,000

A/B = $22,200/$37,000 = $.60 per dollar

Expected recovery for each class of claims

Partially secured

Note payable and interest

Secured portion $28,000
Unsecured portion ($3,000 $.60) 1,800 $29,800

Unsecured priority

Administrative expenses $ 4,000

Wages payable 12,000 16,000

Unsecured nonpriority

Accounts payable ($26,400 $.60) $15,840

Rent payable ($7,600 $.60) 4,560 20,400

Total payments $66,200

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Chapter 18 18-13
Solution P18-5

1 Dawn Corporation in Chapter 7

Statement of Affairs at July 10, 2011

Assets
Realizable Realizable
Value- Value
Book Liability Available for
Value Offsets Unsecured
Fully secured
$210,000 Accounts receivable net $160,000
Less: Notes payable 100,000 $ 60,000
Partially secured
250,000 Land and buildings net $140,000
Less: Mortgage and interest
payable 205,000 0
Unsecured
80,000 Cash 80,000
200,000 Inventories 210,000
150,000 Equipment net 60,000
10,000 Intangible assets 0
Available for priority and
unsecured 410,000
Priority liabilities 150,000
Available for nonpriority
unsecured 260,000
Estimated deficiency 155,000
$900,000 $415,000

Equities
Secured and Unsecured-
Book Priority Nonpriority
Value Claims Claims
Priority liabilities
$ 50,000 Accounts payable $ 50,000
24,000 Wages payable 24,000
76,000 Taxes payable 76,000
150,000
Fully secured
100,000 Note payable $100,000
Less: Accounts receivable net 160,000
(60,000)
Partially secured
205,000 Mortgage and interest payable $205,000
Less: Land and buildings net 140,000
65,000 $ 65,000
Unsecured
350,000 Accounts payable 350,000
300,000 Capital stock
(205,000) Retained earnings deficit
$900,000 $415,000

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18-14 Corporate Liquidations and Reorganizations

Solution P18-5 (continued)

2 Claims by Amounts to Amounts to Be

Priority Ranks Be Paid Written Off
Priority claims
Administrative expenses $ 11,000 $ 11,000
Accounts payable 50,000 50,000
Wages payable 24,000 24,000
Taxes payable 76,000 76,000
Fully secured claims
Note payable 100,000 100,000
Partially secured claims
Mortgage and interest payable 205,000 140,000 $ 26,000
39,000
Unsecured
Accounts payable 350,000 210,000 140,000
$816,000 $650,000 $166,000

Calculation of recovery for unsecured nonpriority claims

Cash available $650,000

Less: Paid to priority claims (161,000)
Less: Paid to fully secured claims (100,000)
Less: Paid to partially secured creditors secured portion (140,000)

A Cash available for unsecured $249,000

Unsecured claims:
Partially secured ($205,000 - $140,000 secured) $ 65,000
Accounts payable nonpriority 350,000

B Total unsecured claims $415,000

A B = $249,000/$415,000 = $.60 recovery on the dollar

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Chapter 18 18-15
Solution P18-6

1 Everlast Window Corporation

Statement of Affairs on June 30, 2011

Assets
Realizable
Values- Realizable
Liability Value
Offsets for Available for
Book Secured Unsecured
Value Creditors Creditors
Pledged for fully
secured creditors
$230,000 Land and building $170,000
Less: Mortgage payable
and accrued interest (165,000) $ 5,000
Available for priority
and unsecured creditors
40,000 Cash 40,000
70,000 Accounts receivable net 63,000
50,000 Inventories 42,000
60,000 Machinery net 20,000
50,000 Goodwill 0
Total available for priority and unsecured
Creditors 170,000
Less: Priority liabilities 70,000
Total available for unsecured creditors 100,000
Estimated deficiency 65,000
$500,000 $165,000

Liabilities and Stockholders Equity

Secured and Unsecured
Book Priority Non-priority
Value Claims Claims
Priority liabilities
$ 60,000 Wages payable $ 60,000
10,000 Property taxes payable 10,000
70,000
Fully secured creditors
150,000 Mortgage payable $150,000
15,000 Interest on mortgage payable 15,000
165,000
Unsecured creditors
110,000 Accounts payable $110,000
50,000 Note payable unsecured 50,000
5,000 Interest payable unsecured 5,000
Stockholders equity
200,000 Capital stock
(100,000) Retained earnings (deficit)
$500,000 $165,000

2 Settlement per dollar of rank 1 unsecured creditors is $.6250 ($100,000

available for unsecured/$160,000 accounts and notes payable). No payment
is made for the $5,000 unsecured interest claim.

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18-16 Corporate Liquidations and Reorganizations

Solution P18-7

1 The reorganization is eligible for fresh start accounting because the

liabilities on June 30, 2011 of $16,500 exceed the reorganization value
of $16,000 by $500. Also, the common stock of the new entity is
allocated $5,000 to prepetition creditors and $2,000 to Lowsteps old
stockholders, so that the old stockholders have less than a 50 percent
interest in the new entity.

2 Entries to adjust Lowsteps accounts for the reorganization plan:

Prepetition liabilities $12,500

Accounts payable (old) $ 800
Wages payable (old) 400
Note payable (new) 3,800
Common stock (new) 5,000
Gain on debt restructuring 2,500
To adjust prepetition liabilities to conform with the plan.

Loss on asset adjustments to fair values $ 4,000

Inventories 400
Land 1,000
Buildings net $1,400
Patent 4,000
To adjust assets to their fair values.

Common stock (old) $ 7,000

Common stock (new) $2,000
Additional paid-in capital 5,000
To record exchange of common stock.

Gain on debt discharge $ 2,500

Additional paid-in capital 5,000
Reorganization value in excess of fair value 1,000
Loss on asset adjustments to fair
values $4,000
Deficit 4,500
To eliminate deficit and record adoption of fresh start reporting.

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Chapter 18 18-17
Solution P18-7 (continued)

3 Lowstep Corporation
Final Balance Sheet
as of July 8, 2011

Assets
Cash $ 6,700
Trade receivables net 1,000
Inventories 2,000
Land 2,000
Buildings net 1,500
Equipment net 1,800
Reorganization value in excess of fair values 1,000
Total assets $16,000

Liabilities and Stockholders Equity

Accounts payable $ 3,000

Accounts payable (old) 800
Wages payable 1,000
Wages payable (old) 400
Notes payable (new) 3,800
Total liabilities 9,000
Common stock (new) 7,000
Total liabilities and stockholders equity $16,000

Note: The final balance sheet of Lowstep Corporation will be the same as
the beginning balance sheet of Highstep Corporation.

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