Chapter 11 Sunnyside Up

The U.S. economy continues to churn under stormy skies, as inflation grows, credit markets remain sluggish, and the number of companies filing for bankruptcy rises. Many experts predict that during the next couple of years, we will see a significant increase in the number of firms that will seek to reorganize under Chapter 11.

This means some hard work ahead for the management teams who will need to develop and implement reorganization plans. It also means that reorganizing companies will most likely reflect new asset and liability values on their "emergence" balance sheets. Given changes in law that limit the time to file a plan of reorganization ("Plan") (generally, up to 18 months to avoid the loss of exclusivity in filing a Plan) and the appetite to achieve prepackaged or prenegotiated plans (which are negotiated before the actual filing), companies must plan early in the restructuring process to address the accounting requirements upon emergence from bankruptcy. These accounting requirements are a part of Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code ("SOP 90-7").

Issued by the AICPA in 1990, SOP 90-7, provides financial reporting guidance for businesses that have filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code and expect to reorganize as going concerns. This guidance covers financial reporting both for the period in bankruptcy and upon emergence from Chapter 11. As practice has demonstrated over the years, SOP 90-7 has resulted in a significant improvement in the consistency and quality of reporting for emerging companies. The most significant impact of SOP 90-7 has resulted from requirements regarding Fresh Start reporting. Upon emergence, the reporting entity must determine whether or not it must adopt Fresh Start reporting.

A company (whether a parent or subsidiary) must adopt Fresh Start reporting if it meets two conditions:

1. Immediately prior to confirmation of its plan of reorganization, it is "balance sheet insolvent" -- that is, the reorganization value of its assets is less than the sum of its post-petition liabilities and allowed claims.

2. Holders of voting shares before the court confirms the bankruptcy plan receive less than 50 percent of the emerging company's voting shares.

What is clear from SOP 90-7 and from the experience of the many companies that have come out of bankruptcy in the intervening years is that the managers of companies in Chapter 11 have some difficult, complex matters to orchestrate over a short time frame. Before dealing with the accounting issues, the first and most obvious is to develop, negotiate, and confirm a Plan. Then, the accounting effort can be divided into two main categories: (1) recording the effects of the bankruptcy plan and, if Fresh Start applies, (2) reporting on a new successor entity for accounting purposes, including a revaluation of the consolidated balance sheet.

At first blush, this may not seem much more onerous than accounting for any other acquisition. However, those who have been through the process have learned otherwise. As with any transaction, each case is based on a unique set of facts and is negotiated or litigated to a unique conclusion. Bankruptcy law and the resulting accounting implications, however, add complexities not seen in an acquisition or out-of-court restructuring.

Many of the bankruptcy concepts impacting financial reporting are not well understood, or at times misunderstood, by financial executives unfamiliar with bankruptcy. In addition, the Fresh Start revaluation is not applied just to an acquired business, but to the entire corporate enterprise (including subsidiaries that are not part of the bankruptcy filing).