Bankruptcy Liquidation and Reorganization

Unit 4

Bankruptcy Liquidation and Reorganization

4.1 Introduction

Changes in business environment are common. If they are not properly managed, they may cause business failures. More specifically, the causes of business failures include poor management, excessive debt, and inadequate accounting. These result in the inability of firms to pay their liabilities when they become due. This would bring about bankruptcy. This chapter is concerned with bankruptcy liquidation and reorganization.


4.2 Insolvency Vs Bankruptcy

The term insolvent and bankrupt are often used interchangeably. Such usage is technically incorrect. Insolvent refers to the financial condition of a person or business enterprise whereby the sum of debts is greater than all of the fair value of its property. On the other hand, bankrupt refers to a legal state.


4.3 Bankruptcy Liquidation

Bankruptcy liquidation refers to the process that 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. There are four classes of creditors in bankruptcy liquidation. There are:

  1. Fully secured creditors. They are entitled to obtain satisfaction of all or part of their claims from the assets pledged as collateral.
  2. Partially secured creditors.
  3. Unsecured creditors with priority. The claims of these creditors are satisfied in full from proceeds of realization of the debtor’s noncollateralized assets.
  4. Unsecured creditors without priority. This class of creditors receive cash from proceeds available from the realization of the debtor’s assets.


4.3.1 Debtor’s Petition (Voluntary Petition)

According to bankruptcy code, any person may file a petition in a court for voluntary liquidation. The debtor’s bankruptcy petition must be accompanied by supporting exhibits of the debts and property of the petitioner. The debts are classified into three. There are:

  1. Creditors having priority
  2. Creditors holding security
  3. Creditors having unsecured claims without priority

The property of the debtor is reported into three categories

  1. Real property
  2. Personal property
  3. Property claimed as exempt


  1. Valuation of property are at market or current fair value
  2. A statement of financial affairs also accompanies the debtor’s bankruptcy petition.


4.3.2 Creditors’ Petition (Involuntary Petition)

If the debtor owes unpaid amounts to 12 or more unsecured creditors who are not employees, relatives, stockholders, or other insiders, three or more of the creditors who have unsecured claims totaling $10,000 or more may file in a federal bankruptcy court a creditors’ petition for bankruptcy. The creditors’ petition is also called involuntary petition. If the number of unsecured creditors is less than 10, one or more creditors having unsecured claims of $10,000 or more may file the petition. The petition of the creditors for bankruptcy may claim anyone of the following:

  1. The debtor is not paying debts as they come due
  2. The debtor is not paying debts within 120 days prior to the date of the petition


4.3.3 Unsecured Creditors with Priority

Unsecured creditors may be classified into unsecured creditors with priority and unsecured creditors without priority. If adequate cash is not available for all unsecured creditors, the available cash needs to be paid in full to the unsecured creditors with priority. Debts which are found in this category include:

  • Administrative costs
  • Claims arising in the course of the debtors business or financial affairs after the commencement of a creditors’ bankruptcy proceeding but before the appointment of a trustee or order for relief.
  • Claims for wages, salaries, and commissions (including vacation, severance, and sick leave pay not in excess of $4000 per claimant) earned within 90 days before the date of filing petition for bankruptcy or cessation of the debtor’s business.
  • Claims for contributions to employee benefit plans arising within 180 days before the date of filing the petition for bankruptcy cessation of the debtor’s business.
  • Claims by producers of grain against a grain storage facility or by fisherman against a fish storage or processing facility not in excess of $4000 per claimant
  • Claims for cash deposited for goods/ services for the personal, family, or household use of the depositor, not in excess of $1800 per claimant.
  • 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.
  • Claims or government entities for various taxes or duties, subject to varying time limitations.

Note that settlement of the above debts would be in the order specified.


4.3.4 Property Claimed as Exempt

Certain property of a bankruptcy petitioner is not included in the debtors’ estate. These include:

  • Residential property exemptions provided by homestead laws.
  • Exemptions for life insurance policies payable on death to the spouse or a relative of the debtor.


4.3.5 Role of Court in Liquidation

All aspects of the bankruptcy proceedings are dealt with by the Federal Bankruptcy Court (USA) with respect to a debtor’s and creditor’s petition for bankruptcy liquidation. The roles of the court include:

  1. Dismiss the debtor’s or creditor’s bankruptcy petition or to grant an order for relief. An order for relief is given for the filling of a debtor’s petition in bankruptcy. The court also gives order for relief in a creditor’s petition after a hearing at which the debtor may attempt to refuse the creditors’ allegations that the debtor was not pay debtors as they came due. Thus, the creditors’ petition may be dismissed or order for relief be given by the court. Any suits that are pending against a debtor for whom a debtor’s or creditors’ bankruptcy petition is filed 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 debtor’s discharge is determined by the court.
  2. The court appoints an interim trustee to serve permanently or until the trustee is elected by the creditors. This is done after the court granted the order for relief.
  3. The court calls a meeting of the creditors after the order for relief within 10 to 30 days.


4.3.6 Role of Creditors

As indicated above, within a period of 10 to 30 days after order for relief, the court calls a meeting of the creditors. One of the responsibility of the creditors is to appoint a trustee to manage the debtor’s estate. A majority vote is required for actions by creditors in appointing the trustee.


4.3.7 Role of the Trustee

The trustee may be appointed by the court or elected by the creditors. The trustee is required to assume the custody of the non-exempt property of the debtor. The principal duties of the trustee are:

  1. Continue to operate the debtor’s business (if directed by court)
  2. Realize the free assets of the debtor’s estate
  3. Pay cash to unsecured creditors
  4. Keep accounting records to enable the filing of a final report with the court
  5. Invalidate a preference

Preference is defined 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 filing of the bankruptcy petition. This is the case if the transfer caused the creditor to receive more cash or property than would be received in the bankruptcy liquidation. In this case, the trustee may recover from the creditor the cash or property constituting the reference and include it in the debtor’s estate.


4.3.8 Discharge of Debtor

Discharge refers to the release of the debtor from all unliquidated debts. It is the court that determines the debtor’s discharge. The role of the trustee is to liquidate the debtor’s property and pay the necessary claims.

After all properties have been liquidated, all secured and priority creditor claims have been paid, and all remaining cash has been paid to unsecured, nonprority creditors.

Discharge of the debtor does not include:

  1. taxes payable by the debtor
  2. debts resulting from the debtor’s obtaining money or property under false representations, or willful conversion of the property of others.
  3. debts not scheduled by the debtor in support of the bankruptcy petition.
  4. debts arising from embezzlement or other fraudulent acts by the debtor acting in a fiduciary 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 fines, penalties, or forfeitures payable to government entities, other than for tax penalties
  8. Debts for educational loans made, insured or guaranteed by governmental entities, or by nonprofit universities or colleges.

Note that a debtor will not be discharge if:

!    The debtor for commits any crimes, misstatements, or other malicious acts that are in connection with the court proceedings.

!!   The current bankruptcy petition was fined within six years of a previous bankruptcy discharge to the same debtor.


 4.3.9 Role of Accountant in Bankruptcy Liquidation

The role of the accountant in liquidation proceedings is concerned with proper reporting of the financial condition of the debtor and adequate accounting and reporting for the trustee for the debtor. There are

1. The Statement of Affairs.

The statement of Affairs is prepared to present the financial condition of the debtor enterprise. The statement is prepared on the assumption of quitting concern. This is due to the fact that a business enterprise that enters bankruptcy liquidation proceedings is a quitting concern and not a going concern. As a result, the balance sheet is not appropriate for an enterprise in liquidation. Thus, Statement of Affairs is the financial statement designed for a business enterprise entering liquidation.

The purpose of the Statement of Affairs is to display the assets and liabilities of the debtor enterprise from the point of liquidation. The assets of the debtor enterprise are valued at current fair values and the carrying values are presented on a memorandum basis. Besides, assets and liabilities are classified according to the rankings and priorities.  They are not prevented according to the current classification used in the traditional balance sheet. 

2. Statement of Realization and liquidation 

Liquidation involves realization of the assets of the debtor’s estate. Statement of Realization and liquidation is based on the assumed activities of the trustee for the estate of the bankrupt firm. This statement is accompanied by the statement of cash receipts and cash payments.


4.4 Bankruptcy Reorganization

When a business becomes insolvent, it does not have enough cash to meet its interest and principal payments. Then the decision must be made whether to dissolve the firm through liquidation or to permit it to reorganize and thus stay alive. The decision to force a firm to liquidate versus permit it to reorganize depends on whether the value of the reorganized firm is likely to be greater than the value of the firm’s assets if they are sold off piecemeal. The issue of liquidation was discussed earlier.

In a reorganization, a committee of unsecured creditors is appointed by the court to negotiate with the management on the terms of a potential reorganization., the reorganization may call for a restructuring of the firm’s debt. The restructuring of debts involve:

  1. Reduce interests rate
  2. Lengthen the term to maturity
  3. Exchange some debts for equity

The purpose of restructuring is to reduce the financial charges to a level that the firm’s cash flows can support.

In addition to committee, the court may appoint trustee to oversee the reorganization.


4.4.1 Appointment of trustee or examiner

The management or owners of the business enterprises may continue to operate the enterprise as debtor in possession. Alternatively, the court may appoint a trustee to manage the enterprise.

The purposes of appointing the trustee are

  1. To reduce fraud, dishonesty, incompetence or gross management by current owners or managers
  2. To protect the interest of the creditors or stockholders of the enterprise.

Where the reorganization involves the trustee, examiner may be appointed to investigate possible fraud or mismanagement by the current managers or owners of the enterprise.

The powers and duties of the trustee include:

  1. Prepare and file a list of creditors in court. The list includes class of creditors and their claims and lest of stockholder of each class.
  2. Investigate the acts, conduct, property, liabilities, and business operations on the enterprise. The trustee indicates the desirability of continuing operations.
  3. Report to the bankruptcy judge any facts ascertained as to fraud against or mismanagement of the debtor enterprise.


4.4.2 Plan of Reorganization

The management or trustee is required to submit the plan of the organization to the bankruptcy court. The same plan may also be given to the creditors and stockholders of the enterprise. The purpose of submitting the plan of reorganization is for confirmation by the bankrutpcy court. Before the plan of reorganization is confirmed by the court, the plan must be accepted by the following parties:

  1. Majority of the creditors, whose claims must account for two thirds of the total liabilities.
  2. Stockholder owning at least two thirds of the outstanding capital stuck of each class.

If one or more classes of stockholders or creditors has accepted a plan, the bankruptcy court may conform if the plan is fair and equitable to the nonacceptors. If the plan of reorganization is confirmed by the bankruptcy court, it becomes binding on the debtor enterprise, on all creditors and owners of the enterprise, and on any other enterprise issuing securities or acquiring property user the plan.


4.4.3 Accounting for a Reorganization

Accounting for reorganization involves journal entries for the following adjustments:

  1. Carrying amounts of assets
  2.  Reduction of par or sated value of capital stock
  3.  Extensions of due dates and revisions of interest rates of notes payable
  4. Exchanges of debt securities for equity securities (debt securities include notes payable, bond, etc. Equity securities primarily include common stock and preferred stock).
  5.  The elimination of a retained earnings deficit. 

The reorganized enterprise is essentially a new enterprise whose assets and liabilities should be valued at current fair values and whose shareholders’ equity consists only of paid in capital.

To illustrate accounting for reorganization, suppose Topcon Company has the following assets. Liabilities, owners equity before bankruptcy petition by the debtors.


Stockholders and all unsecured creditors have approved the plan of reorganization and the bankruptcy court has conformed it.

The plan of reorganization is described below

  1. Deposit Br 40,000 with escrow agent, to cover liabilities with priority and costs of reorganization proceedings (Br. 7000). Salaries and wages and employee income taxes payable are liabilities with priorities. 
  2. Amend articles of incorporation to provide for 10,000 shares of authorized common stock of Br.1 par. The new common stock is to be exchanged on a share for share basis for the 600 shares of outstanding Br.100 par common stock.
  3. Extend due date of unsecured notes payable to suppliers totaling Br. 50,000 for three years until December 31,2007. Increase the interest rate on te notes from the stated rate of 10% to 12%.
  4. Exchange 2000 shares of new Br.1 par common stock (at current fair value of Br.20 a share) for unsecured notes payable to suppliers totaling Br. 40,000. 
  5. Pay suppliers 60 cents per dollar of trade accounts payable owed.

Assuming that fresh start reporting is appropriate for the company under consideration after the plan of organization has been carried out. The following journal entry is made to eliminate retained earnings deficit.

Paid in capital in excess of par                                        29000

Gain from discharge of indebtedness in Bankruptcy           8000

       Costs of Bankruptcy proceedings                                        7000

       Retained earnings                                                              30,000


4.4.4 Disclosure of Reorganization

Notes to the financial statements are used to present the complex issues that are involved in bankruptcy reorganization. The disclosure should include for the period in which the plan of reorganization was carried out.


4.5 Summary

The failed business may be liquidated or reorganized. In the case of bankruptcy liquidation non-cash assets are sold and the claims of the various parties be satisfied, usually beginning with creditors. The quest for liquidation may be initiated b y the debtors or creditors. The court, creditors, trustee and accountants are among the major parties involved in liquidation.

On the other hand, a firm in failure state may be reorganized if the value of the reorganized firm is likely to be greater than the value of the firm’s assets if they are sold off piecemeal.


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