LEGAL LIQUIDATION ADVANCED FINANCIAL ACCOUNTING

LEGAL LIQUIDATION AND REORGANIZATION TEACHING MATERILA FOR DVANCED ACCOUNTING COURSE

1. Course: Advanced FA Presentation Section 1 Group 5 PREPARED BY: Abel Getu GSE/3599/14 Blen Getachew GSE/2486/14 Belayneh Mengistu GSE/8548/14 Ajaib Zinab GSE/2533/14

2. CHAPTER 5 Accounting for Legal Liquidations and Reorganization 5.1 Legal Liquidation 5.1.1 Accounting for Legal Liquidations 5.1.2 Bankruptcy Proceedings 5.1.3 Classification of Creditors 5.1.4 Classification of Unsecured Liabilities 5.1.5 A Statement of Financial Affairs 5.1.6 The role of the trustee in the liquidation of a company

3. 5.1. Legal Liquidation Liquidation : is the process of selling off all the assets of an entity, settling its liabilities distributing any remaining funds to shareholders closing it down as a legal entity and its name is removed from the registries at company house .

4. 5.1.1 Accounting for Legal Liquidations A basic assumption of accounting is that a business is considered a going concern unless evidence to the contrary is discovered. As a result, assets such as inventory , land , buildings , and equipment are traditionally reported based on historical cost rather than net realizable value. Unfortunately, not all companies prove to be going concerns.

5. CONT’D What happens to these businesses after they fail ? Is bankruptcy the equivalent of a death sentence? Who gets the assets? Are the creditors protected? How does the accountant reflect the economic plight of the company?

6. CONT’D Virtually all businesses undergo financial difficulties at various times. Different factors can create cash flow difficulties for even the best-managed organizations . Those are:- Economic downturns , poor product performance , and litigation losses Most companies take remedial actions and work to return their operations to normal profitability.

7. CONT’D If problems persist, a company can eventually become insolvent , unable to pay debts as the obligations come due . When creditors are not paid, they obviously attempt to protect their financial interests in hope of reducing the possibility of loss. They may seek recovery from the distressed company in several ways: Repossessing assets, F iling lawsuits, F oreclosing on loans, and so on. An insolvent company can literally become besieged by its creditors.

8. CONT’D Bankruptcy laws:- have been established in the United States to structure this process, provide protection for all parties, and ensure fair and equitable treatment . Bankruptcy Reform Act of 1978 Based on an original provision of the U.S. Constitution, Congress is responsible for creating bankruptcy laws . Consequently , the Bankruptcy Reform Act of 1978 as amended continues to provide the legal Structure for most bankruptcy proceedings. It strives to achieve two goals in connection with insolvency cases : ( 1) The fair distribution of assets to creditors and ( 2) The discharge of an honest debtor from debt.

9. The most important decision in any bankruptcy filing (either voluntary or involuntary) is the method by which the debtor will be discharged from its obligations . One obvious option is to liquidate the company’s assets with the proceeds distributed to creditors based on their secured positions and the priority ranking system. 5.1.2 Bankruptcy Proceedings

10. Voluntary and Involuntary Petitions When insolvency occurs, any interested party has the right to seek protection under the Bankruptcy Reform Act.8 Thus, the company itself can file a petition with the court to begin bankruptcy proceedings. If the company is the initiator , the process is referred to as a voluntary bankruptcy . In such cases, the company’s petition must be accompanied by exhibits listing all debts and assets (reported at fair value). Company officials also must respond to questions concerning various aspects of the business’s affairs. Such questions include: When did the business commence? In whose possession are the books of account and records ? When was the last inventory of property taken? CONT’D

11. CONT’D Creditors: also can seek to force a debtor into bankruptcy (known as an involuntary bankruptcy) in hope of reducing their potential losses. To avoid nuisance actions, bankruptcy laws regulate the filing of involuntary petitions . If a company has 12 or more unsecured creditors, at least 3 must sign the petition. In addition, under current rules, the creditors that sign must have unsecured debts of at least $ 13,475.10. If fewer than 12 unsecured creditors exist, only a single signer is required, but the $13,475 minimum debt limit remains. NOTE THAT :- Neither a voluntary nor an involuntary petition automatically creates a bankruptcy case.

12. CONT’D The court rejects voluntary petitions if the action is considered detrimental to the creditors . Involuntary petitions also can be rejected unless evidence exists to indicate that the debtor is not actually able to meet obligations as they come due. Merely being slow to pay is not sufficient. The debtor may well fight an involuntary petition fearing that its reputation will be tainted in the business community .

13. If the court accepts the petition, an order for relief is granted. This order halts all actions against the debtor, thus providing time for the various parties involved to develop a course of action. In addition, the company comes under the authority of the bankruptcy court so that any distributions must be made in a fair manner. CONT’D

14. Classification of Creditors: Following the issuance of an order for relief, the possible risk of loss obviously influences each creditor’s view of a bankruptcy case . Based on this creditors classified in to three. Those are:- SECURED CREDITORS PARTIALLY SECURED CREDITORS UNSECURED CREDITORS 5.1.3 Classification of Creditors

15. SECURED CREDITORS: many creditors may have already obtained some measure of security for themselves . When a debt is created, the parties can agree to attach a mortgage lien or security interest to specified assets (known as collateral ) owned by the debtor. Such action is most likely when the amounts involved are great or the debtor is experiencing financial difficulty. In the event that the liability is not paid when due, the creditor has the right to force the sale (or, in some cases, the return) of the pledged property with the proceeds being used to satisfy all or part of the obligation. CONT’D

16. PARTIALLY SECURED CREDITORS: Conversely, a liability is partially secured if the value of the collateral covers only a portion of the obligation. UNSECURED CREDITORS: The remainder is considered unsecured; these creditors have no legal right to any of the debtor’s specific assets. They are entitled to share only in any funds that remain after all secured claims have been settled. Obviously, unsecured creditors are in a precarious position. Unless a debtor’s assets greatly exceed secured liabilities (which is unlikely in most insolvency cases ), these creditors can expect significant losses if liquidation proves to be necessary . CONT’D

17. The Bankruptcy Reform Act; identifies several types of unsecured liabilities that have priority and must be paid before other unsecured debts are settled . There are two basic types of unsecured liabilities. Those are:- 1. Unsecured Liabilities with priority 2. Unsecured Liabilities without priority 5.1.4 Classification of Unsecured Liabilities

18. 1. Unsecured Liabilities With Priority: The following liabilities have priority:- Claims for administrative expenses Obligations arising between the date that a petition is filed with the bankruptcy court and the appointment of a trustee or the issuance of an order for relief. Employee claims for wages earned during the 180 days preceding the filing of a petition. Employee claims for contributions to benefit plans earned during the 180 days preceding the filing of a petition . Claims for the return of deposits made by customers to acquire property or services that the debtor never delivered or provided . Government claims for unpaid taxes . CONT’D

19. CONT’D 2. Unsecured Liabilities without priority Account Payable Portion uncovered from partially secured creditors

20. 5.1.5 A Statement of Financial Affairs At the start of bankruptcy proceedings, the debtor normally prepares a statement of financial affairs. This schedule provides information about the company’s current financial position and helps all parties as they consider what actions to take . The statement of financial affairs is produced under the assumption that liquidation will occur. Thus , historical cost figures are not relevant. The various parties to the bankruptcy desire information that reflects:- The net realizable value of the debtor’s assets and, The ultimate application of these proceeds to specific liabilities.

21. CONT’D All parties involved with an insolvent company should consult a statement of financial affairs before deciding the fate of the operation . This statement is especially important in assisting unsecured creditors as they decide whether to push for reorganization or liquidation. The debtor’s assets and liabilities are reported according to the classifications relevant to a liquidation . The statement of Financial Affairs is prepared:- To present the financial condition of the debtor enterprise. On quitting concern assumption not a going concern. For a business enterprise entering to liquidation. 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.

22. CONT’D Consequently, assets are labelled as follows: Pledged with fully secured creditors. Pledged with partially secured creditors. Available for priority liabilities and unsecured creditors (often referred to as free assets). The company’s debts are then listed in a parallel fashion: Liabilities with priority. Fully secured creditors. Partially secured creditors. Unsecured creditors. Stockholders are included in this final group.

23. CONT’D The information found in a statement of financial affairs can affect the outcome of the bankruptcy. If, for example, the statement indicates that unsecured creditors are destined to suffer a material loss in liquidation, this group will probably favor reorganizing the company in hope of averting such a consequence. Conversely, if the statement shows that all creditors will be paid in full and that a distribution to the stockholders is also possible, liquidation becomes a much more viable option.

24. CONT’D Illustration: Chaplin Company recently experienced severe financial difficulties and is currently insolvent. It will soon file a voluntary bankruptcy petition, and company officials are trying to decide whether to seek liquidation or reorganization. Consequently, they have asked their accountant to produce a statement of financial affairs to assist them in formulating an appropriate strategy. A current balance sheet for Chaplin, prepared as if the company were a going concern, is presented in Exhibit 13.1.

25. CONT’D EXHIBIT 13.1

26. CONT’D Prior to the creation of a statement of financial affairs, additional data must be ascertained concerning the insolvent company and its assets and liabilities. In this illustration, the following information about Chaplin Company has been accumulated: The land and building are in an excellent location and can be sold for a figure 10 % more than book value. Interest of $5,000 on the company’s long-term liabilities has not been accrued for the first six months of 2010. By spending $5,000 for repairs and marketing, Chaplin can sell its inventory for $50,000. The investment reported on the balance sheet has appreciated in value since being acquired and is now worth $20,000. Dividends of $500 are currently due from this investment, although Chaplin has not yet recognized the revenue. Officials estimate that $12,000 of the company’s accounts receivable can still be collected despite the bankruptcy proceedings.

27. CONT’D 6. The company will receive a $1,000 refund from the various prepaid expenses, but its in- tangible assets have no resale value. 7. The equipment was specially designed for Chaplin. Company officials anticipate having trouble finding a buyer unless the price is reduced considerably. Hence, they expect to receive only 40 % of current book value for these assets. 8. Administrative costs of $21,500 are projected if the company does liquidate. 9. Accrued expenses include salaries of $13,000. Of this figure, one person is owed a total of $12,000 but is the only employee due an amount in excess of $10,950. 10. Payroll taxes withheld from wages but not yet paid to the government total $3,000. Company records currently show only a $1,000 portion of this liability.

28. CONT’D

29. CONT’D

30. CONT’D From this information, the statement of financial affairs presented in Exhibit 13.2 for Chaplin Company was prepared. The current and long-term distinctions usually applied to assets and liabilities are omitted. Because the company is on the verge of going out of business, such classifications are meaningless. Instead, the statement is designed to separate the secured and unsecured balances. Book values are included on the left side of the schedule but only for informational purposes. These figures are not relevant in a bankruptcy. All assets are reported at estimated net realizable value, whereas liabilities are shown at the amount required for settlement.

31. CONT’D 3 . Both the dividend receivable and the interest payable are included in Exhibit 13.2, although neither has been recorded on the balance sheet. The payroll tax liability also is reported at the amount the company presently owes. The statement of financial affairs must disclose currently updated figures. 4. Liabilities having priority are individually identified within the liability section (point A). Because these claims will be paid before other unsecured creditors, the $36,500 total also is subtracted directly from the free assets (point B). Although not yet incurred, estimated administrative costs are included in this category because such expenses will be necessary for liquidation. Salaries are also considered priority liabilities. However, the $1,000 owed to one employee in excess of the individual $12,000 limit is separated as an unsecured claim (point C).

32. CON’T According to this statement, if liquidation occurs, Chaplin expects to have $57,000 in free assets remaining after settling all liabilities with priority (point D). The liability section shows unsecured claims with a total of $95,000. These creditors, therefore, face a $38,000 loss ($95,000 - $57,000) if the company is liquidated (point E). This final distribution is often stated as a percentage: = = 60% Thus, unsecured creditors can anticipate receiving only 60 percent of their claims. An individual, for example, to whom this company owes $400 should anticipate collecting $240 ($400 X 60%) following liquidation.  

33. CON’T If the statement of financial affairs had shown the company with more free assets (after subtracting liabilities with priority) than unsecured claims, all creditors could expect to be paid in full with any excess money going to Chaplin’s stockholders.

34. To begin, the court appoints an interim trustee to oversee the company and its liquidation. This individual is charged with preserving the assets and preventing loss of the estate. Thus , creditors are protected from any detrimental actions that management, the ownership, or any of the other creditors might undertake. The interim trustee (as well as the permanent trustee, if the creditors subsequently select one) must perform a number of tasks shortly after being appointed. 5.1.6 The role of the trustee in the liquidation of a company

35. CONT’D These functions function/tasks performed by the trust include (but are not limited to): Changing locks and moving all assets and records to locations the trustee controls. Posting notices that the U.S. trustee now possesses all business assets and that tampering with or removing any contents is a violation of federal law. Compiling all financial records and placing them in the custody of the trustee’s own accountant. Obtaining possession of any corporate records including minute books and other official documents.

36. CONT’D In the liquidation of any company, the trustee is a central figure. This individual must recover all property belonging to the insolvent company, preserve the estate from any further deterioration, liquidate noncash assets, and make distributions to the proper claimants. The trustee can also void any transfer of property (known as a preference ) made by the debtor within 90 days prior to filing the bankruptcy petition if the company was already insolvent at the time. The recipient must then return these payments so that they can be included in the debtor’s free assets.

37. END OF PRESENTATION THANK YOU!