CH 10

Slide
10-1
10
10
Insolvency—
Insolvency Liquidation and
Reorganization
Advanced Accounting, Fifth Edition
Slide
10-2
Learning
Learning Objectives
Objectives
1. Distinguish between a Chapter 7 and a Chapter 11 bankruptcy.

2. Describe the five priority categories of unsecured claims and
list the order in which they are settled.
3. Distinguish between a voluntary and involuntary bankruptcy
petition.
4. Distinguish among fully secured, partially secured, and
unsecured claims of creditors.
5. Describe contractual agreements that the debtor and its
creditors may enter into outside of formal bankruptcy
proceedings to resolve the debtor’s insolvent position.
6. Describe the ways debt may be restructured in a
reorganization.
Slide
10-3
Insolvency
Insolvency
When a business becomes insolvent, it generally has three

possible courses of action:
1. Debtor and its creditors may enter into a contractual

agreement, outside bankruptcy;
2. Debtor or its creditors may file a bankruptcy petition, after

which the debtor is liquidated under Chapter 7 of the
Bankruptcy Reform Act; or
3. Debtor or its creditors may file a petition for reorganization

under Chapter 11 of the Bankruptcy Reform Act.
Slide
10-4
Insolvency
Insolvency
Review:
True/False: Insolvency means that a debtor has
more current liabilities than current assets.
False
Slide
10-5
Contractual
Contractual Agreements
Agreements
A business that is unable to pay its obligations may reach
an accommodation with its creditors. Possibilities generally
include:
1. An extension of payment periods.

2. Composition agreements.
3. Formation of a creditors’ committee.
4. Voluntary assignment of assets.
Slide
10-6
LO 5 Contractual agreements.
Contractual
Agreements
Extension of Payment Periods
FASB ASC paragraph 470-50-40-6

Provides that where a debt restructuring involves only a
modification of terms of payment, the debtor should
account for the restructuring prospectively and not change
the carrying amount of the payable, unless the carrying
amount exceeds the total future cash payments of principal
and interest specified by the new terms.
No gain is recognized when the restructuring involves an

extension of the payment period only.
Slide
10-7
Contractual
Agreements
Composition Agreements
(Creditors Accept Less Than Full Amount)
Creditors are often given some immediate cash payment,

and the amount of the remaining debts and their interest
rates are renegotiated.
Formation of a Creditors’ Committee

Committee is responsible for managing the debtor’s
business affairs for the period during which plans are
developed to rehabilitate, reorganize, or liquidate the
business.
Slide
10-8
Contractual
Agreements
Voluntary Assignment of Assets

A debtor may elect to place its property under the control
of a trustee for the benefit of its creditors.
Any proceeds remaining after payment of the creditors,

are returned to the debtor.
Slide
10-9
Bankruptcy
Bankruptcy
Provisions of the Bankruptcy Reform Act apply to
individuals, corporations, and partnerships, as well as to
municipalities seeking voluntary relief from their creditors.
A business unable to pay its obligations, may attempt to

negotiate with its creditors. If an agreement cannot be
reached, a legal petition for bankruptcy will be initiated by
either the
 debtor (a voluntary petition) or its
 creditors (an involuntary petition).
Slide
10-10
LO 3 Voluntary vs. involuntary petitions.
Bankruptcy
Bankruptcy
Voluntary Petitions
A debtor may file a voluntary petition with a bankruptcy
court for;
 liquidation under Chapter 7 or for
 reorganization under Chapter 11.
Filing a voluntary petition constitutes an order for relief.
The bankruptcy petition (either voluntary or involuntary) is

an official form that initiates bankruptcy proceedings and
establishes an estate consisting of the debtor’s assets.
Slide
10-11
Bankruptcy
Bankruptcy
Involuntary Petitions
Creditors initiate the action by filing a petition for
liquidation or reorganization with the bankruptcy court.
The bankruptcy court will generally enter an order for

relief against the debtor only if evidence indicates that
the debtor, in fact, has not been paying its debts as they
become due.
Slide
10-12
Bankruptcy
Bankruptcy
Secured and Unsecured Creditors

Secured creditors are those whose claims are secured by
liens or pledges of specific assets.
If the proceeds from the sale of a pledged asset(s)

exceed the secured claim, the excess proceeds are
available for distribution to unsecured creditors.
Slide
10-13
LO 4 Secured and unsecured creditors.
Bankruptcy
Bankruptcy
Review:
True/ False: Voluntary bankruptcy petitions
may be filed under either Chapter 7 or
Chapter 11 of the Reform Act.
True
Slide
10-14
Bankruptcy
Bankruptcy
Review:
True/ False: Unsecured creditors with
priority will receive full satisfaction before
secured creditors are paid.
False
Slide
10-15
Liquidation
Liquidation (Chapter
(Chapter 7)
7)
A voluntary or involuntary petition for liquidation may be
filed under Chapter 7 of the Reform Act.
Upon filing, the bankruptcy court must decide whether to
accept or dismiss the petition.
 Dismissals occur infrequently.
 Debtor may dispute an involuntary petition.
 If accepted,
 an order for relief is entered and
 the bankruptcy court will appoint an interim
trustee until a permanent trustee is selected.
Slide
10-16
LO 7 Chapter 1 versus Chapter 7.
Reorganization
Reorganization Under
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
Creditors of an insolvent debtor may believe their interests

would be served by rehabilitating or reorganizing the
debtor.
In such a case:
Creditors and debtor may agree to a plan for

reorganization. or
Debtor or creditors may prefer to file with the

bankruptcy court a petition for reorganization under
Chapter 11 of the Reform Act.
Slide
10-17
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
Fresh Start Accounting and Quasi Reorganization

When firms emerge from bankruptcy, FASB ASC
paragraph 852-10-45-19 to 20 provides for fresh start
accounting.
 Assets and liabilities are reported at fair values.
 Beginning retained earnings is reported at zero.
Two conditions must exist:

 Fair value of assets must be less than the post
liabilities and allowed claims, and
 Original owners must own less than 50% of the voting
stock after reorganization.
Slide
10-18
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
Fresh Start Accounting and Quasi Reorganization

Quasi reorganization
Per FASB ASC 852- 10-45-20 three steps are required:
1. Authorization from creditors and stockholders is
required.
2. All assets are revalued to fair values with losses
recorded in retained earnings.
3. The deficit in retained earnings is eliminated by
charging to (reducing) paid-in capital.
Slide
10-19
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
Accounting for Reorganization – Troubled Debt

Debt may be restructured in any one (or a combination) of
the following methods:
1. The debtor may transfer assets in full settlement of
the payable.
2. The debtor may give an equity interest in its firm in
full settlement of the payable.
3. The creditor may modify terms of the payable.
Slide
10-20
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)

Transfer of Assets
A debtor that transfers assets to a creditor in full
settlement of a payable recognizes a gain.
The gain is measured by the excess of the carrying value of

the payable over the fair value of the assets transferred.
The difference between the fair value and the carrying

amount of the assets transferred is a gain or loss and is
reported as a component of net income for the period of
transfer.
Slide
10-21
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)

Grant of an Equity Interest
A debtor that issues an equity interest in its firm to a
creditor in full settlement of a payable shall account for the
equity interest at its fair value.
Difference between the fair value of the equity interest

issued and the carrying amount of the payable is reported as
a gain on restructuring.
Debtor determines its gain based on undiscounted cash flows.
Slide
10-22
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)

Modification of Terms
A debtor, in a troubled debt restructuring involving only
modification of terms of a payable, accounts for the effects
of the restructuring prospectively from the time of
restructuring.
The carrying value of the payable is not changed at the time

of restructuring unless the carrying value exceeds the total
future cash payments specified by the new terms.
Slide
10-23
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
Review:
True/False: In a reorganization involving a
transfer of assets, the debtor will recognize a
gain on restructuring measured by the excess
of the carrying value of the payable settled
over the book value of the assets transferred.
False
Slide
10-24
Reorganization
Reorganization –– Transfer
Transfer of
of Assets
Assets
E10-3: Bar Company, which is in financial difficulty and

in the process of a voluntary reorganization, has agreed
to transfer to a creditor a copyright it owns in full
settlement of a $150,000 note payable and $15,000 in
accrued interest. The copyright, which originally cost
$100,000, has an accumulated amortization balance of
$55,000 and a current fair value of $95,000.
Required:
a. Prepare the journal entries on Bar Company’s books to
record the transfer of the copyright.
Slide
10-25
Reorganization
Transfer of
of Assets
Assets
E10-3 a. Prepare the journal entries on Bar Company’s

books to record the transfer of the copyright.
Copyright 50,000
Gain on Transfer of Assets 50,000
Revalue copyright to fair value. $95,000 – ($100,000 - $55,000)
Notes Payable 150,000

Accrued Interest Payable 15,000
Accumulated Amortization – Copyright 55,000
Copyright ($100,000 + $50,000) 150,000
Gain on Debt Restructuring 70,000
Slide
10-26
Reorganization
Transfer of
of Assets
Assets
E10-3 b. Explain the proper treatment of any gain or loss

recognized in (a).
The gain on transfer of assets ($50,000) should be

reported as a separate component (assuming
material in amount) of operating income; the gain
on restructuring ($70,000) should also be reported
as a separate component of operating income.
Slide
10-27
Reorganization
Transfer of
of Assets
Assets
E10-3 c. Assuming the fair value of the copyright was

$30,000, repeat the requirement in (a).
Loss on Transfer of Assets 15,000

Copyright 15,000
Revalue copyright to fair value. $30,000 – ($100,000 - $55,000)
Notes Payable 150,000

Accumulated Amortization – Copyright 55,000
Copyright ($100,000 - $15,000) 85,000
Gain on Debt Restructuring ($165,000 - $30,000) 135,000
Slide
10-28
Reorganization
Reorganization –– Modification
Modification of
of Terms
Terms
E10-4: Lake Company, a major creditor of financially

troubled Spain Company, has agreed to modify the terms of
a debt owed to Lake Company. The debt consists of a
$900,000, 12% note that is due currently along with accrued
interest of $95,000. Lake Company agreed to extend the
due date of the note and accrued interest for three years
and to reduce the interest rate to 5% per annum (on both
maturity value and accrued interest), with interest to be
paid annually.
Required:
a. Should a gain on restructuring be recognized by Spain
Company? Explain.
Slide
10-29
Reorganization
Modification of
of Terms
Terms
E10-4 a. Should a gain on restructuring be recognized by

Spain Company? Explain.
No gain should be recognized because the total future

cash payments specified by the new terms of
$1,144,250 ($995,000 carrying value plus 3 years’
interest at $49,750 per year) exceed the current
carrying value of the debt, $995,000.
Slide
10-30
Reorganization
Modification of
of Terms
Terms
E10-4 b. Prepare the entry that should be made on Spain

Company’s books on the date of restructure.
Note Payable 900,000

Restructured Debt 995,000
Slide
10-31
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
Review:
True/ False: Restructuring gains that arise
from troubled debt restructurings are
reported by the debtor as extraordinary gains.
False
Slide
10-32
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
The “Accounting” Statement of Affairs

A plan for reorganization must show that creditors will
receive as much as if the debtor were liquidated.
The Statement of Affairs is an accounting report that is

designed to permit the user to determine:
 the total expected amounts that could be realized on the
disposition of the assets,
 the priorities in the use of the realization proceeds in
satisfying claims, and
 the potential net deficiency that would result if the assets
were realized and claims liquidated.
Slide
10-33
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
E10-7: Ball Company is facing bankruptcy proceedings. A balance
sheet and other information are presented below:
Ball Company Balance Sheet - June 30, 2012
Cash $ 20,400 Accounts payable $ 350,000
Accounts receivable 170,000 Accured wages 120,000
Inventory 180,000 Notes payable 200,000
Property and Equipment, net 430,000 Common stock 400,000
Retained earnings (deficit) (269,600)
$ 800,400 $ 800,400
Estimated realizable values:
Accounts receivable $ 95,000
Inventory 110,000
Property and Equipment, net 320,000
Accounts receivable and inventory are each pledged as security on

individual notes payable in the amount of $100,000 each.
Slide
10-34
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
E10-7: Statement of Affairs
Book Realizable Deficiency
Value Assets Value Account
(Loss) / Gain
Assets Pledged with Fully Secured Creditors:
$ 180,000 Inventory $ 110,000 $ (70,000)
Note Payable 100,000 10,000
Assets Pledged with Partially Secured Creditors:

170,000 Accounts Receivable 95,000 (75,000)
Note Payable 100,000
Free Assets
20,400 Cash 20,400
430,000 Property and Equipment 320,000 (110,000)
Total Net Realizable Value 350,400
Liabilities having Priority – Wages 120,000
Net Free Assets 230,400
Estimated Deficiency to Unsecured Creditors 124,600

$ 800,400 $ 355,000 $ (255,000)
Slide
10-35
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
E10-7: Statement of Affairs
Book Realizable Deficiency
Value Equities Value Account
Liabilities Having Priority: (Loss) / Gain
$ 120,000 Accrued Wages $ 120,000
Fully Secured Creditors:

100,000 Note Payable 100,000
Partially Secured Creditors:

100,000 Note Payable 100,000
` 95,000 5,000
Unsecured Creditors:
350,000 Accounts Payable 350,000
Stockholders’ Equity
400,000 Common Stock 400,000
(269,600) Retained Earnings (deficit) (269,600)
$ 800,400 $ 355,000 $ 130,400
Estimated deficiency * $ (124,600)
Slide * ($255,000) loss - $130,400 gain = $124,600 deficiency

10-36
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
E10-7: Deficiency Account
BALL COMPANY
Deficiency Account
Estimated Losses Estimated Gains

Accounts Receivable $ 75,000 Common Stock $400,000
Inventory 70,000 Retained Earnings (269,600)
Property and Equipment 110,000 Estimated Deficiency to
Unsecured Creditors 124,600
$ 255,000 $255,000
Slide
10-37
Reorganization
Under Reform
Reform Act
Act (Chapter
(Chapter 11)
11)
Review:
True/ False: The statement of affairs is a
report designed to estimate the amount
expected to be earned by a debtor company
during the time period needed to complete a
reorganization.
False
Slide
10-38
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
Trustee (appointed to assume responsibility of managing

the debtor’s business while the reorganization plan is
developed or the business is liquidated) takes title to
the debtor’s assets and is accountable to the court, the
creditors, and other parties for the subsequent
utilization or realization of the assets.
If new books are opened (frequently used approach):
 Trustee records the assets at their book values.
 No existing liabilities are recorded by the trustee.
 Payment of preexisting debts reduces the assets.
Slide
10-39
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
E10-9: TRX Company has been forced into receivership.

The trustee has decided to open a new set of books to
distinguish between transactions occurring before and
after the appointment. The following account balances
were reported on September 1, 2012:
Cash $ 26,700 Allowance for uncollectibles $ 16,000
Accounts receivable 130,400 Accumulated depreciation 211,500
Inventory 191,900 Accounts payable 308,400
Property and Equipment, net 590,400 Capital stock 800,000
Retained earnings (deficit) (396,500)
$ 939,400 $ 939,400
Required: Prepare journal entries to record the following

on the trustee set of books.
Slide
10-40
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
E10-9: Record the receipt of TRX Company assets.
Cash 26,700
Accounts Receivable (old) 130,400
Inventory 191,900
Property and Equipment 590,400
Allowance for Uncollectibles (old) 16,000
Accumulated Depreciation 211,500
TRX Company – in Receivership * 711,900
* ($939,400 – $16,000 - $211,500)

Slide
10-41
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
E10-9: 1. Sales were made in the amount of $296,000, of

which $31,500 were cash sales.
Cash 31,500
Accounts Receivable (new) 264,500
Sales 296,000
Slide
10-42
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
E10-9: 2. Receivables were collected in the following

amounts:
Old receivables $ 76,800
New receivables 242,200
Cash 319,000
Accounts Receivable (old) 76,800
Accounts Receivable (new) 242,200
Slide
10-43
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
E10-9: 3. Additional inventory was purchased on account in

the amount of $127,500.
Purchases 127,500
Accounts Payable (new) 127,500
Slide
10-44
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
E10-9: 4. Cash payments were made as follows:

On old accounts payable $206,500
On new accounts payable 61,600
For operating expenses 46,000
For trustee fees 13,000
TRX Company – in Receivership 206,500

Accounts Payable (new) 61,600
Operating Expenses 46,000
Trustee Expenses 13,000
Cash 327,100
Slide
10-45
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
E10-9: 5. Journal entries were made to record:

a. Bad debt expense of $21,600, of which $8,600 related
to new accounts receivable.
Bad Debt Expense 21,600

Allowance for Uncollectibles (new) 8,600
Slide
10-46
Trustee
Trustee Accounting
Accounting and
and Reporting
Reporting
E10-9: 5. Journal entries were made to record:

a. Bad debt expense of $21,600, of which $8,600 related
to new accounts receivable.
b. Depreciation expense of $32,400.
c. Write-off of old accounts receivable of $21,000.
Depreciation expense 32,400

Accumulated Depreciation 32,400

Account Receivable (old) 21,000
Slide
10-47
Realization
Realization and
and Liquidation
Liquidation Account
Account
The court expects to receive periodic reports summarizing

the realization and distribution activities of the fiduciary.
The report, realization and liquidation account, has three
main sections—assets, liabilities, and revenues and expenses.
The asset section consists of four parts, illustrated as
follows:
Assets
Assets to be realized Assets realized

Assets acquired Assets not realized
Slide
10-48
Realization
Realization and
and Liquidation
Liquidation Account
Account
The court expects to receive periodic reports summarizing

the realization and distribution activities of the fiduciary.
The report, realization and liquidation account, has three
main sections—assets, liabilities, and revenues and expenses.
The liabilities section consists of four parts, illustrated as
follows:
Liabilities
Liabilities liquidated Liabilities to be liquidated

Liabilities not liquidated Liabilities incurred
Slide
10-49
Realization
Realization and
and Liquidation
Liquidation Account
Account
FASB issued exposure draft (Oct., 2008) on ‘Going Concern.’

 Board decided to carry forward the going concern guidance
from AU Sec. 341, subject to modifications to align with IFRSs.
 One modification is to change the time horizon for the going

concern assessment.
 AU Section 341 states that there is a “responsibility to evaluate
whether there is a substantial doubt about the entity’s ability to
continue as a going concern for a reasonable period of time, not to
exceed one year beyond the date of the financial statements being
audited.”
Slide
10-50
Realization
Realization and
and Liquidation
Liquidation Account
Account
FASB issued exposure draft (Oct., 2008) on ‘Going Concern.’

 IAS 1 requires that an entity consider “all available information
about the future, which is at least, but is not limited to, twelve
months from the end of the reporting period” when assessing
whether the going concern assumption is appropriate .
 The other modification includes using the wording in IAS 1 with

respect to the type of information that should be considered in
making the going concern assessment (all available information
about the future).
Slide
10-51
Copyright
Copyright
Copyright © 2012 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act
without the express written permission of the copyright owner
is unlawful. Request for further information should be
addressed to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for his/her own
use only and not for distribution or resale. The Publisher
assumes no responsibility for errors, omissions, or damages,
caused by the use of these programs or from the use of the
information contained herein.
Slide
10-52

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Slide

Advanced Accounting, Fifth Edition

1. Distinguish between a Chapter 7 and a Chapter 11 bankruptcy.

When a business becomes insolvent, it generally has three

1. Debtor and its creditors may enter into a contractual

2. Debtor or its creditors may file a bankruptcy petition, after

3. Debtor or its creditors may file a petition for reorganization

1. An extension of payment periods.

3. Formation of a creditors’ committee.

4. Voluntary assignment of assets.

Extension of Payment Periods

FASB ASC paragraph 470-50-40-6

No gain is recognized when the restructuring involves an

Creditors are often given some immediate cash payment,

Formation of a Creditors’ Committee

Voluntary Assignment of Assets

Any proceeds remaining after payment of the creditors,

A business unable to pay its obligations, may attempt to

 creditors (an involuntary petition).

 reorganization under Chapter 11.

Filing a voluntary petition constitutes an order for relief.

The bankruptcy petition (either voluntary or involuntary) is

The bankruptcy court will generally enter an order for

Secured and Unsecured Creditors

If the proceeds from the sale of a pledged asset(s)

Creditors of an insolvent debtor may believe their interests

Creditors and debtor may agree to a plan for

Debtor or creditors may prefer to file with the

Fresh Start Accounting and Quasi Reorganization

Two conditions must exist:

Fresh Start Accounting and Quasi Reorganization

Accounting for Reorganization – Troubled Debt

Accounting for Reorganization – Troubled Debt

The gain is measured by the excess of the carrying value of

The difference between the fair value and the carrying

Accounting for Reorganization – Troubled Debt

Difference between the fair value of the equity interest

Debtor determines its gain based on undiscounted cash flows.

Accounting for Reorganization – Troubled Debt

The carrying value of the payable is not changed at the time

E10-3: Bar Company, which is in financial difficulty and

E10-3 a. Prepare the journal entries on Bar Company’s

Notes Payable 150,000

E10-3 b. Explain the proper treatment of any gain or loss

The gain on transfer of assets ($50,000) should be

E10-3 c. Assuming the fair value of the copyright was

Loss on Transfer of Assets 15,000

Notes Payable 150,000

E10-4: Lake Company, a major creditor of financially

E10-4 a. Should a gain on restructuring be recognized by

No gain should be recognized because the total future

E10-4 b. Prepare the entry that should be made on Spain

Note Payable 900,000

The “Accounting” Statement of Affairs

The Statement of Affairs is an accounting report that is

Accounts receivable and inventory are each pledged as security on

Assets Pledged with Partially Secured Creditors:

Estimated Deficiency to Unsecured Creditors 124,600

Fully Secured Creditors: