Fresh Start Accounting – A Busy CFO’s Perspective

This article was originally published in FEI Daily on November 9, 2020.

CFOs need to start thinking about the financial reporting implications of Chapter 11 filing long before they emerge.

This year has brought about many challenges–natural disasters, civil unrest, political polarity and a global pandemic–with the latter, arguably, having the most far-reaching impact on our personal and professional lives. And just as individuals are beginning to return to the office, a second wave of infections is starting to look inevitable. The sense of fear regarding the implications of further lockdowns is palpable.

For some, this has led to them hitting the nuclear button named “Chapter 11”. This year has seen a record number of US corporates with assets over $1bn filing for bankruptcy, with levels set to surpass those seen during the 2009 financial crisis. For CFOs that have filed, or are contemplating filing, for bankruptcy there will be a lot weighing on their minds. What is the process and how long will it take? How can I protect my employees? How can I maintain relationships with key suppliers? Do I have to continue paying interest on my debts? What taxes are due? What do I have to disclose in my financial statements? Do I even have to prepare financial statements?

Trying to run a finance function in the current environment would be challenging enough. Throw in all the additional administration and complex accounting requirements that comes with a bankruptcy, many finance functions are struggling to stay on top of their workloads. Now is the time to ask for help, if you need it.

CFOs need to start thinking about the financial reporting implications of Chapter 11 filing long before they emerge. Most CFOs will be aware of the requirements of Accounting Standards Codification topic 852, Reorganizations (“ASC 852”), and the need to undertake “fresh start reporting” upon emergence from bankruptcy. However, ASC 852 also comes with additional provisions for accounting during bankruptcy. Beyond ASC 852, given the exceptional circumstances that an organization contemplating filing for bankruptcy finds themselves in, there will be a host of other accounting and financial reporting requirements both before and after the bankruptcy process.

While by no means an exhaustive list, the following article highlights the main areas that should be considered by CFOs as their organisations are going through the Chapter 11 Bankruptcy process.

Before Filing for Petition

It should come as no surprise that organizations yet to file for bankruptcy will continue to prepare their financial information in full accordance with US GAAP. But given the financial strain that the organization is under, several accounting topics need to be considered. Predominantly these will relate to the impairment of certain assets (e.g., goodwill, intangible assets, long-lived assets, inventory, etc) and accounting for the renegotiation of different contractual agreements (e.g., debt, leases, supplier arrangements, loyalty programs, etc).

With regards to goodwill and long-lived assets, there is no universal answer as to whether the impacts of COVID-19 and the resulting economic lockdowns are a triggering event for an impairment test. However, the likelihood that a triggering event has occurred has increased significantly.

Given the unprecedented shift in demand and consumer behaviours, the risk of inventory impairments is also likely to have increased. Often, organizations in financial trouble introduce sales incentives to increase demand and generate cash that can lead to the write down of its residual inventory. Similarly, with disruptions to supply chains and increased material costs, it may be harder for organizations to recover their inventory costs.

As part of restructuring its operations, an organization contemplating bankruptcy may also seek to modify or terminate some or all its leases. Under ASC 840 (for those not brave enough to early adopt ASC 842), a lease modification may result in a reclassification (i.e., operating to capital or vice versa). For terminations, this will depend upon the original classification. For operating leases, a liability for costs associated with the termination will need to be recorded and any related lease assets, e.g. favourable lease terms, may be derecognized. For capital leases, associated assets and liabilities will be derecognised and a gain or loss recognized for the difference (net of any termination penalties). Under ASC 842 if a lessee rejects a lease any difference between the carrying amounts of the right-of-use asset and the lease liability should be recorded in the income statement as a gain or loss. Related assets (including favour lease intangibles and vendor contributions) will also be derecognised.

However, for those contemplating filing for bankruptcy it will most likely be due to the burden of existing debt. As the US economy continued to grow in unprecedented fashion over the last several years, many companies increasingly took on significant and historically high levels of leverage. The pandemic therefore may serve as an economic tipping point for what may have otherwise been an inevitable crisis for these companies. Debt covenants could already have been breached and while this may not immediately result in enforcement proceedings; at a minimum it may result in creditors exercising acceleration clauses. In this case, debt will need to be reclassified as a current liability.

Many organizations will also be trying to avoid filing for bankruptcy and may attempt to renegotiate their existing debt arrangements. This could result in either a modification, an extinguishment or a “troubled debt restructuring”, each of which are accounted for differently.

But the sad truth is that for many they will have to make the hard decision to file for bankruptcy. Beyond the accounting and financial reporting implications of this decisions, there are some important commercial considerations.

For many organizations a significant proportion of the creditors will be unsecured and for some of those they will also be with key suppliers. In order to emerge from bankruptcy as a going concern, it is paramount to maintain a convivial relationships with these creditors, even though they will likely be amongst the most junior creditors in the waterfall (usually sitting only just above equity holders in the claims waterfall).

At the other end of the scale, the most senior creditors will likely emerge as the future equity shareholders. Given the constraints on the United States Bankruptcy Court system (with there only being about 350 federal bankruptcy judges), it is advisable to engage in friendly discussions with major creditor groups before filing for bankruptcy. While the bankruptcy process can be long and expensive, it is possible to enter the process with a “prearranged” or “prepackaged” plan of reorganization. In these situations, an organization can tackle several requirements of a Chapter 11 bankruptcy before filing a petition. A prearranged plan is where negotiations have begun with at least one class of creditors and the key terms of the restructuring have been approved by their representatives (noting that creditor approval is only formally solicited after the Court has approved the disclosure statement); whereas a prepackaged plan is one where the majority of stakeholders have approved the disclosure statement and plan of reorganization. These are then filed along with the petition and supporting voting ballots meaning that the court only must approve the disclosure statement and confirm the plan of reorganization before emergence can occur, which can significantly speed up the process.

After Filing for Petition

After an organization has filed a petition under Chapter 11, it will continue to apply US GAAP and will now also fall under the scope of ASC 852-10, Reorganizations. The additional financial reporting requirements of ASC 852-10, prior to emergence, are reasonably limited but reflect the changing needs of the users of the financial statements and are aimed at presenting the progression through the bankruptcy proceedings.

Any financial statements prepared during bankruptcy will be labelled as “debtor-in-possession” until the organization emerges from bankruptcy. Transactions related to the reorganization will need to be distinguished from those of the ongoing operations of the business. Also, liabilities are segmented between pre-petition (then further split between those subject to compromise and those that are not) and post-petition, and are separately disclosed on the face of the financial statements.

Pre-petition liabilities are not just those incurred and recorded prior to filing for petition but will also include those creditors that file an “allowed” claim with court that relate to the prepetition period. Until a filed claim is approved it will be accounted for in accordance with ASC 450, Contingencies. Accordingly, the claim will only be recognized when it is probable and reasonably estimable. In practice this typically occurs only once the court has allowed the claim. The claim is then measured at the full amount of the allowed claim, even if it is expected that the creditor will receive less from the bankruptcy settlement.

For liabilities incurred post-petition the expectation is that these will be settled in full and are therefore measured in accordance with GAAP and presented separately.

While requiring some judgement, reorganizational items are those that would not have been incurred had the organization not been in bankruptcy and are separately disclosed. These will include all expenses directly related to the reorganization and restructuring (e.g. any professional fees are expensed as incurred). It will also include any interest income that would not have been earned had the organization not been in bankruptcy.

On the flipside, Chapter 11 restricts the accrual of interest expense on unsecured prepetition liabilities (interest expense can be accrued on secured debt provided the collateral is in excess of its principal), however most organizations will disclose the interest that would have been accrued had this protection not been in place.

Beyond the financial reporting requirements, however, an organization may also be contemplating an alternative ending – a “Section 363” sale. These have become increasingly popular for financially distressed companies to utilize this method to sell significant assets or entire businesses. As the assets are sold free of existing liens or claims, it can generate a better price than would have been the case if the organization was not under Chapter 11. The use of a “stalking horse” is designed to promote interest and maximize value for creditors through starting an auction process. In these instances, you should consider how fees payable to the stalking horse are structured, and how the fees may be impacted by the bankruptcy proceedings in order to correctly account for them. Such fees may be deemed subject to compromise and may be presented as a reorganization item.

With regards to the reorganization plan, unless the organization had a prepackaged deal, there will be an iterative process with various classes of creditors to agree to the final plan (even if this contemplates a Section 363 sale). Once the creditors agree, the court will then approve the plan enabling the organization to emerge from bankruptcy. This will be the later of the date of the court approval and the date when all material unresolved conditions precedent are resolved.

For practical reasons, an organization may choose a more convenient date, say a month end, to prepare its emergence financial statement. This is permitted provided it is after the emergence date, does not straddle a reporting period end (i.e., quarterly or year-end), and that no material transactions occur in the intervening period. While there is no direct rule applicable to this, a period of few days is generally acceptable. However, the bigger the gap the harder it will be to justify that no material transactions have occurred requiring additional disclosures.

Upon Emergence

Having successfully emerged from bankruptcy, you will now need to prepare the opening balance sheet for the emerging entity. As this is akin to a newly acquired business, a procedure similar to purchase accounting under ASC 805, Business Combinations is undertaken, provided the organization passes the fresh start reporting criteria. For this there are two tests, one regarding reorganizational value and one regarding change of control, both of which must be passed if the organization is to apply fresh start reporting.

While the standard lists them in this order, practically speaking, it is often easier, and cheaper, to undertake the change of control test first, i.e. the pre-petition shareholders must lose control of the emerging entity by receiving less than 50% of the voting shares of the emerging entity. An organization must demonstrate that its existing shareholders, as a group, have lost control of the reporting entity, but it does not need to demonstrate that a single party has obtained control.

The loss of control contemplated by the plan must be substantive and not temporary. That is, the new controlling interest must not revert to the shareholders that held interests immediately before the plan was filed or confirmed. In this calculation, potentially dilutive instruments, such as warrants and options, are generally disregarded.

If this test is failed, there is no need undertake the more involved reorganizational value test and the organization will account for the plan of reorganization in accordance with GAAP and in particular ASC 310-40, Troubled Debt Restructuring. However, if this test is passed then the reorganizational value test should be undertaken.

It is a common misconception that the reorganization value will be determined by the court. The court-approved value (if provided) will be more aligned to enterprise value and therefore an independent assessment is likely to be required to ascertain what reorganizational value would be (as this is closer to fair value). An assessment would then need to be made by comparing this reorganizational value with the post-petition liabilities and allowed claims. If greater, this criterion is passed.

Once both criteria have been passed the organization is required to assign the reorganizational value to its underlying assets and liabilities in accordance with ASC 805, Business Combinations. Accordingly, and this may come as surprise, if there is a residual value left then goodwill is recorded.

This task, is substantial and the use of valuation professionals is essential.

All of the aforementioned considerations in this article are then disclosed in a four column format showing the financial progression from the closing balance sheet of the predecessor entity (column 1); the impact of the plan of reorganization (column 2); the allotment of the reorganizational value (column 3); and then the presentation of the opening balance sheet of the emerging entity (column 4). Whilst this is the single biggest output from fresh start reporting, if all of the above considerations are proactively addressed, this task should be relatively straightforward.

Additionally, as the emerging group are considered new entities, they can adopt new accounting standards and change accounting policies without the need for prior period adjustments. For example, those that haven’t early adopted may wish to consider implementing the new leasing standard. Or perhaps not…

There is mistaken belief that fresh start accounting relates solely to the final task of fair valuing the balance sheet of the emerging organization. However, there is significant work, both from an accounting and broader commercial perspective, that needs to be considered long before an organization even files for petition. With all indicators pointing towards an increase in likely bankruptcies, perhaps now is the time to start.