Accounting for Businesses Subsequent to Reorganization
Overview of the Restructuring and Mergers & Acquisitions Market
While global M&A volume of $2.4 trillion in 2009, some 24% below 2008 levels, was the lowest annual total since 2004, restructuring (bankruptcy or distressed) M&A transactions reached the highest annual volume on record at $320.2 billion, according to Dealogic. The decrease in global M&A would have been slightly greater were it not for the extraordinary government interventions across the world, comprising some $198 billion of total volume on such investments as the U.S. insurer American International Group Inc. and the U.K.’s Royal Bank of Scotland Group Plc. But despite this fall, there were signs that activity was picking up towards the end of 2009 when global M&A volume reached $740 billion in the last quarter of the year, an increase of 46% on the third quarter. I often hear from a Chief Executive Officer or the main shareholder of a business being sold that I have agreed the headline price with the buyer and now I will leave the details to my team. This is music to the ears of an experienced buyer who often say, “Let them decide the headline selling price as long as I can decide the structure!” and I will be good. This is because an experienced buyer or seller will have in his/her arsenal a wide range of options to adjust the net sales price, especially when buyers, typically private equity, ask the sellers to roll over a proportion of the equity in their business.
In the U.S., 2009 deal volume fell by 10% to $767 billion from $851 billion in 2008. The number of deals also decreased by 17% to 7,140 (2008: 8,614). In Europe, the decrease was more precipitous. Deal volume fell by 44% to $691 billion in 2009 compared to $1.24 trillion in 2008.
In addition to normal stock sales, an unusually large number of cases in 2009 were resolved via auction sale of a debtor’s assets, as governed by Section 363(f) of the U.S. Bankruptcy Code. High uncertainty about the stability of the recent economic environment coupled with the fast pace of recent distressed stock sales and 363 auction procedures has made the due diligence process all the more challenging, while the “as is” nature of the sale and purchase agreement makes the due diligence effort even more critical, especially when trying to establish the true run-rate of the business and detect unrecorded or contingent liabilities.
In addition to factoring in the costs of the diligence effort and the potential risks when due diligence on distressed companies is limited by timing, logistics, or other issues, potential acquirers of distressed companies or assets need to understand and analyze, as part of the deal costs, the expense and time involved in accounting and tax issues unique to the distressed deal environment. From an accounting perspective, if a company emerges from bankruptcy via a transfer of more than 50% of the voting shares of the emerging entity, and certain other conditions are met, the entity is required to adopt “fresh-start” reporting, resulting in a new, fair-market value basis for its assets and liabilities.
Upon emergence from bankruptcy, the accounting for debtors-in-possession was previously covered under the American Institute of Certified Public Accountants Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code” (“SOP 90-7”). Now under Financial Accounting Standards Board Accounting Standards Codification 852, Reorganizations (“FASB ASC 852”), certain emerging entities will adopt fresh-start accounting, which calls for them to apply fair value concepts in determining their reorganization value and establishing a new basis for financial reporting. In addition, the debtor-in-possession and acquirer have new opportunities to adjust the structure and timing of the transaction to minimize the tax liability for either the emerging entity or the estate.
The emergence of a debtor-in-possession under fresh-start reporting is a multidimensional process that requires valuation, accounting, and tax expertise. The debtor entity should deploy this expertise, whether in-house or from a third party, as early in the process as possible to ensure that the final reorganization plan is structured to facilitate the adoption of fresh-start reporting. Set out below are some of the key issues that the debtor must consider in addition to the extra costs and resources required to implement fresh-start reporting.
Financial Reporting by Entities Subsequent to Reorganization
An Introduction to FASB ASC 852
Under FASB ASC 852, debtors emerging from Chapter 11 are required to adopt fresh-start reporting when the following two conditions are met:
The Reorganization Value of the emerging entity immediately before the confirmation of the reorganization plan (“Plan”) is less than the total of all post-petition liabilities and allowed claims; and
Less than 50% of the existing voting shareholders immediately before confirmation are retained post confirmation.
The above two conditions are required to prevent either (1) solvent companies; or (2) companies in situations where loss of control contemplated by the Plan is not substantive or is temporary, from adopting fresh-start reporting.
In simple terms, fresh-start reporting results in starting from zero on the income statement, statements of cash flow and other financial statements, and the resetting of the values of assets and liabilities on the balance sheet to fair value. The balance sheet must reflect changes in the debt and equity structure as a result of the reorganization. Fresh-start accounting does not apply to liquidations or asset purchases (i.e., 363 auctions) out of Chapter 7 or 11.
Fresh-start reporting also provides a unique opportunity for the emerging company to implement new and different accounting policies from those of the pre-petition entity. Examples that we have observed in practice include changes to the bad debt reserve policy formulas and inventory accounting methods.
Allocation of Reorganization Value
Fresh-start reporting is implemented in the following manner:
The Reorganization Value is allocated to the debtor’s assets based on the market value of the individual assets. Any part of the Reorganization Value not attributable to specific tangible assets or identifiable intangible assets should be reported as an intangible asset (goodwill), in accordance with Financial Accounting Standards Board Accounting Standards Codification 350, Intangibles-Goodwill and Other (“FASB ASC 350”), previously covered by paragraph 6 of FASB Statement No. 142, Goodwill and other Intangible Assets. Under FASB ASC 350, a two-step fair value impairment test at the reporting unit level is required at least annually and on an interim basis if conditions or events indicate that an interim evaluation is warranted. The application of fresh-start reporting must also conform to Financial Accounting Standards Board Accounting Standards Codification 805, Business Combinations (“FASB ASC 805”), previously covered by Statement of Financial Accounting Standard 141, Business Combinations.
In practice, the allocation of Reorganization Value to individual tangible and intangible assets often requires the use of valuation professionals. Buyers of stock in companies emerging from bankruptcy should make sure to factor the cost of the valuation effort into the deal costs when evaluating the proposed acquisition.
Liabilities that survive the reorganization should be shown at the present value of amounts to be paid, determined at appropriate current interest rates at the date of the reorganization.
Each year, management should re-evaluate the future cash flows for the debt and record an adjustment, if needed, to the present value of the liability. Any change in the liability, other than payment of principal, will have an impact on current earnings.
Deferred taxes are reported in conformity with the provisions of Financial Accounting Standards Board Accounting Standards Codification 740, Income Taxes (“FASB ASC 740”) (previously covered by Statement of Financial Accounting No. 109, Accounting for Income Taxes). A deferred tax asset or liability must be established based on the difference between the tax basis and the allocated value of assets. This deferred tax cannot be discounted even though there may be several years before the deferred tax is fully used. Benefits realized from pre-confirmation net operating loss carry forwards should be used to first reduce Reorganization Value in excess of amounts allocable to identifiable assets and other intangibles; the balance is reported as a direct addition to paid-in capital.
Disclosure in Initial Financial Statements
FASB ASC 852-10 indicates that when fresh-start reporting is used, the notes to the initial financial statement should disclose the following:
Adjustments to the historical amounts of individual assets and liabilities;
The amount of debt forgiven;
The amount of prior retained earnings or deficit eliminated; and
Significant matters relating to the determination of the Reorganization Value.
Fresh-start financial statements prepared by entities emerging from Chapter 11 will not be comparable with those prepared before their plans were confirmed because they are, in effect, those of a new entity. Thus, comparative financial statements that straddle a confirmation date should not be presented.
When Conditions Are Not Met For Fresh-Start Reporting
Debtors that do not meet both of the conditions for adopting fresh-start reporting should record any debt issued or liabilities compromised by confirmed plans at the present values of amounts expected to be paid in the future.
Assets may not be “written up” to their market values; however, if there has been a permanent impairment in the value of the assets, they should be “written down” to their impaired value.
Opening reserves, deficits or surpluses cannot be eliminated, and there will be no goodwill arising, as assets are not allowed to be written up.
The new entity needs to carefully consider the tax issues related to the reorganization. The impact of the reorganization can be significant on the presentation and disclosure of current and deferred taxes, including (1) the tax effects of the temporary differences, which can be significant, resulting from the difference between the (new) fair value allocated in fresh-start reporting and the tax basis; (2) the potential impact of the reorganization on carry forward tax attributes, such as net operating losses and any corresponding valuation allowances assigned to such attributes; and (3) the different ordering sequences for pre- and post-fresh-start reporting periods for recognition of tax benefits.
In most cases, neither a section 338 nor section 338(h) 10 election, which permits the buyer to obtain a fair market basis (usually a step-up) for the assets acquired as a result of a stock purchase, will be available. As a result, there is generally no opportunity to step up the basis of assets for tax purposes in reorganization. This may result in a deferred tax asset, if the differences between accounting values and tax basis are temporary, since the original tax basis (which may be higher than the revised accounting book value of the assets) will normally be used in calculating taxable income and income tax payable after the reorganization.
The company must understand the tax outcomes of the reorganization plan to account for them. The complexity of the tax laws in this context requires very careful consideration to avoid accounting and tax issues in the future, which generally means that tax professionals will have to be engaged to assist with the process.
Tax Attribute Carryover
Although a separate estate is created when a chapter 7 or 11 petition is filed, there is no change in taxpayer. As a result, the estate succeeds to the following key income tax attributes of the debtor:
Net operating loss and capital loss carryovers under section 1212;
Debtor’s basis in, holding period for, and character in the debtor’s hand of any asset of the debtor; and
3. Debtor’s method of accounting.
The debtor-in-possession should carefully consider the year in which to exit bankruptcy so as to manage the cancellation of indebtedness and concomitant reduction of tax attributes for any cancellation of indebtedness excluded from income by reason of the reorganization.
In this regard, recent legislation may impact this decision. First, The Worker, Homeownership and Business Assistance Act of 2009 permits taxpayers to carry back net operating losses from a taxable year ending in either 2008 or 2009 for three, four or five preceding taxable years. This five-year carry back may be utilized before the reduction of such net operating losses by cancellation of indebtedness, but may mean a greater reduction in other tax attributes, such as the tax basis of the debtor’s assets. Second, The American Recovery and Reinvestment Act of 2009, permits a corporation that realizes cancellation of indebtedness income in 2009 or 2010 to elect to defer recognition of cancellation of indebtedness income and instead recognize such income ratably over a five-year period beginning in 2014 and ending in 2018 even if the corporation reorganizes in bankruptcy.
Conclusions For those buyers who can successfully navigate a restructuring transaction and implement a turnaround, the current marketplace opportunities are abundant and the resulting returns on investment may be significant. However, the complexities of the process, in terms of legal, accounting, valuation and tax issues, and the related challenges of the due diligence effort and turnaround process can be daunting for even the most experienced buyers to tackle on their own, especially as it is usually a one-time event for the company being acquired out of bankruptcy. Therefore, even the most capable management and accounting teams may lack the fresh-start experience necessary to design a plan that addresses key issues up front and successfully implement the necessary accounting, financial and tax reporting requirements. To successfully meet these challenges, buyers in a distressed transaction need a deep playbook and a strong team, perhaps supplemented by outside advisors, who know how the game is played on this particular field.