Chapter 20, Problem 20.6P

Chapter 11 Reorganization

During the recent recession, Polydorous Inc. accumulated a deficit in retained earnings. Although still operating at a loss, the company posted better results during 20X1. Polydorous is having trouble paying suppliers on time and is paying interest when it is due. The company files for protection under Chapter 11 of the Bankruptcy Code and has the following liabilities and stockholder's equity accounts at the time the petition is filed:

A plan of reorganization is filed with the court, which approves it after review and obtaining creditor and investor votes. The plan of reorganization includes the following actions:

1. The prepetition accounts payable will be restructured according to the following: (a) $40,000 will be paid in cash, (b) $20,000 will be eliminated, and (c) the remaining $100,000 will be exchanged for a five-year, secured note payable paying 12 percent interest.

2. The interest payable will be restructured as follows: elimination of $10,000 of the interest and payment of the remaining $10,000 in cash.

3. The 10 percent, unsecured notes payable will be restructured as follows: (a) $60,000 of them will be eliminated, (b) $10,000 of them will be paid in cash, (c) $240,000 of them will be exchanges for a five-year, 12 percent secured note, and (d) the remaining $30,000 will be exchanged for 3,000 shares of newly issued common stock having a par value of $10.

4. The preferred shareholder will exchange their stock for 5,000 shares of newly issued $10 par common stock.

5. The common shareholder will exchange their stock for 2,000 shares of newly issued $10 common stock.

After extensive analysis, the company's reorganization value is determined to be $510,000 prior to any payments of cash required by the reorganization plan. An additional $10,000 in current liabilities have been incurred since the petition was filed. After the reorganization is completed, the capital structure of the company will be as follows:

An evaluation of the assets' fair values was made after the company completed its reorganization, immediately prior to the point the company emerged from the proceedings. The following information is available:

Required

a. Prepare a plan of reorganization recovery analysis for the stockholders' equity accounts of Polydorous Inc. on the day plan of reorganization is approved. (Hint: The liabilities on the plan's approval are $530,000, which is $520,000 from prepetition payables plus $10,000 in additional accounts incurred postpetition.)

b. Prepare an analysis showing whether the company qualifies for fresh start accounting as it emerges from the reorganization.

c. Prepare journal entries for execution of the plan of reorganization with its general restructuring of debt and capital.

d. Prepare the balance sheet for the company on completion of the plan of reorganization.

To determine

Reorganization: Chapter 11 of bankruptcy involves a reorganization of a debtor’s business affairs. It allows legal protection from creditors’ during the time needed to reorganize and return to a profitable level. A company in financial distress files for bankruptcy may receive protection from creditors, the company continues to operate while it prepares a plan for reorganization.

A plan of reorganization recovery analysis for the liabilities and stockholders’ equity

Answer to Problem 20.6P

Pre-petition liabilities $520,000 and equity $700,000

Explanation of Solution

		Recovery
	Pre-confirmation ($)	Elimination of debt & equity ($)	Surviving debt ($)	Cash ($)	12%Secured Notes ($)	Common%	Stock value ($)	Total($)	Recovery %
Post − petition liabilities	(10,000)		(10,000)					(10,000)	100
Claims/ Interest:
Accounts payable	(160,000)	20,000		(40,000)	(100,000)			(140,000)	88
Interest payable	(20,000)	10,000		(10,000)				(10,000)	50
Notes payable 10%	(340,000)	60,000		(10,000)	(240,000)	30	(30,000)	(280,000)	82
Total	(520,000)	90,000
Preferred shareholders	(100,000)	50,000				50	(50,000)	(50,000)
Common shareholders	(150,000)	130,000				20	(20,000)	(20,000)
Retained earnings deficit	80,000	(80,000)
Total	(700,000)	190,000	(10,000)	(60,000)	(340,000)	100%	(100,000)	(510,000)

To determine

Reorganization: Chapter 11 of bankruptcy involves a reorganization of a debtor’s business affairs. It allows legal protection from creditors’ during the time needed to reorganize and return to a profitable level. A company in financial distress files for bankruptcy may receive protection from creditors, the company continues to operate while it prepares a plan for reorganization.

The analysis showing whether the company qualifies for fresh start accounting as it emerges from the reorganization.

Answer to Problem 20.6P

The analysis shows that company qualifies for the fresh start accounting as it emerges from reorganization.

Explanation of Solution

First condition for fresh start:

Post-petition liabilities	$10,000
Liabilities deferred pursuant to chapter 11	520,000
Total post-petition liabilities and claims	$530,000
Reorganization value	(520,000)
Excess of liabilities over reorganization value	$20,000

Second condition:

Holders of existing voting shares immediately before confirmation receive 20% of voting shares of emerging entity.

Therefore, both conditions for a fresh start occur, and fresh start accounting is used to account for the company.

To determine

Reorganization: Chapter 11 of bankruptcy involves a reorganization of a debtor’s business affairs, it allows legal protection from creditors’ during the time needed to reorganize and return to a profitable level. A company in financial distress files for bankruptcy may receive protection from creditors, the company continues to operate while it prepares a plan for reorganization.

The entries for execution of the plan of reorganization with its general restructuring of debt and capital.

Explanation of Solution

Particulars	Debit $	Credit $
Liabilities subjected to compromise	520,000
Cash		60,000
Notes payable		340,000
Common stock		30,000
Gain on debt discharge		90,000
(Recognition of debt discharge)
Preferred stock	100,000
Common stock old	150,000
Common stock new		70,000
Additional paid-in capital		180,000
(Recording of exchange of stock)
Reorganization value in excess of amounts
Allocation to identifiable assets	30,000
Gain on debt discharge	90,000
Additional paid-in capital	180,000
Accounts receivable		30,000
Inventory		7,000
Property, plant, and equipment		183,000
Retained earnings deficit		80,000
(Record fresh start accounting and elimination of deficit)

Schedule to support allocation of reorganization value:

	Book value	Fair value	difference
Cash	$30,000	$30,000	0
Accounts receivable	140,000	110,000	(30,000)
Inventory	25,000	18,000	(7,000)
Property, plant and equipment	445,000	262,000	(183,000)
Reorganization value in excess of amounts allocable to identifiable assets	0	30,000	30,000
Total	$640,000	$450,000	$(190,000)

To determine

Reorganization: Chapter 11 of bankruptcy involves a reorganization of a debtor’s business affairs, it allows legal protection from creditors’ during the time needed to reorganize and return to a profitable level. A company in financial distress files for bankruptcy may receive protection from creditors, the company continues to operate while it prepares a plan for reorganization.

The balance sheet for the company on completion of the plan of reorganization.

Answer to Problem 20.6P

Balance sheet total as per balance sheet $450,000

Explanation of Solution

Note showing effect of plan of reorganization balance sheet:

	Pre-confirmation $	Adjustments			Re-organized balance sheet $
		DebtDischarge $	Exchange of Stock $	FreshStart $
Assets:
Cash	90,000	(60,000)			30,000
Accounts receivable	140,000			(30,000)	110,000
Inventory	25,000			(7,000)	18,000
	255,000	(60,000)	0	(37,000)	158,000
Property, plant & equipment	445,000			(183,000)	262,000
Reorganization value in Excess amount allocated to identifiable assets				30,000	30,000
Total assets	700,000	(60,000)	0	(190,000)	450,000
Liabilities:
Not subjected to compromise:
Current liabilities	(10,000)				(10,000)
Subjected to compromise	(520,000)	520,000
Notes payable		(340,000)			(340,000)
Total liabilities	(530,000)	180,000	0	0	(350,000)
Shareholders’ equity
Preferred stock	(100,000)		100,000
Common stock old	(150,000)		150,000
Common stock new		(30,000)	(70,000)		(100,000)
Additional paid-in capital			(180,000)	180,000
Retained earnings	80,000	(90,000)		90,000
				(80,000)	0
Total Liabilities and Equity	(700,000)	60,000		190,000	(450,000)

P Company

Balance sheet

	$
Assets:
Cash	30,000
Accounts receivable	110,000
Inventory	18,000
Total current assets	158,000
Property, plant and equipment	262,000
Reorganization value	30,000
Total assets	450,000
Liabilities:
Accounts payable	10,000
Notes payable	340,000
Total liabilities	350,000
Shareholders’ equity:
Common stock	100,000
Total liabilities and shareholders’ equity	450,000