Reporting the Post-restructuring Balance Sheet Its Not Always What You Would Expect
The general presumption in reporting the effects of a restructuring upon emergence from bankruptcy is that the company will revalue its assets and liabilities to fair-market value, under so-called "fresh-start" reporting. However, there are other methods that must be considered and applied when appropriate, which could result in a dramatically different presentation of assets and liabilities. As these differences may be material, it is important for all turnaround professionals involved to have a general understanding of how the decision is reached.
The accounting framework for debt restructurings can be comprehensive bankruptcy filings, out-of-court situations, troubled company circumstances, and certain situations where the debtor is acquired and will remain a separate subsidiary with SEC reporting requirements. As presented herein, the descriptions of relevant technical accounting pronouncements have been summarized to the extent necessary to provide an overview of these general concepts and their results.
Fresh-start Reporting: SOP 90-7
Most practitioners assume that a debtor will adopt fresh-start accounting upon emergence from bankruptcy. Generally, most bankrupt companies meet the three criteria for its use: (1) they have filed for chapter 11; (2) reorganization value is less than allowed (pre-filing) claims plus post-petition debt; and (3) pre-confirmation shareholders receive less than 50 percent of the voting shares of the reorganized company. These criteria imply that the company is a new entity with new owners and should be accounted for in a similar way to a purchase transaction.
The balance sheet of a debtor is revalued from its historical-cost basis to a new fair-market-value basis. Assets and liabilities are now presented at fair-market value with any excess of the reorganization value of the entity above the fair-market value of its assets reported as goodwill. New retained earnings are set to zero. (Financial advisors and accountants should reference the authority of SOP 90-7 and the recent newly enacted Statements of Financial Accounting Standards (SFAS) 141, "Business Combinations," and SFAS 142, "Goodwill and Other Intangible Assets." These recent statements were discussed in last December's ABI Journal article, "New Rules for Business Combinations, Intangibles and Goodwill Accounting.").
Companies in bankruptcy that do not meet fresh-start requirements may still fall under the guidance of SOP 90-7 if they generally restate their liabilities in the restructuring. The term generally has been interpreted by some practitioners to mean that more than 50 percent of the debtor's liabilities are subject to compromise. Assuming that the debtor meets this criterion, its assets, liabilities and stockholders' equity accounts would retain their historical basis, except for those liabilities subject to compromise that would be restated upon emergence to their new present value based on their revised terms. Since the majority of a debtor's liabilities are typically subject to compromise in most bankruptcy cases, the application of SOP 90-7 in reporting the emerging balance sheet may still prevail even when fresh-start reporting cannot be adopted. If less than 50 percent of the debtor's liabilities are subject to compromise, SFAS 15, discussed below, may apply.
Troubled Debt Restructurings: SFAS 15
Troubled companies that do not meet SOP 90-7 criteria will generally utilize the direction provided under SFAS 15 "Accounting by Debtors and Creditors for Troubled Debt Restructurings." These companies will keep the historical-cost basis of their assets and liabilities and retained earnings rather than restate assets and liabilities to fair market value. The accounting guidance focuses the financial advisor solely on how to account for the book value of the newly restructured debt (based on the restructuring agreement) and how much gain, if any, will be recognized.
The requirements to utilize SFAS 15 guidance are (1) the debtor does not meet SOP 90-7 fresh-start reporting requirements and (2) less than 50 percent of the debtor's liabilities are subject to comprise; (3) the debt restructuring involves (3)(a) a reduction in the face amount of existing debt, (b) a modification of terms of existing debt—i.e., maturity or interest rate, or (c) an exchange of new debt for old debt; and (4) the debtor's poor financial condition was the primary reason to renegotiate debt (a so-called "troubled debt restructuring").
The Financial Accounting Standards Board (FASB) believes that the determination of whether a debt restructuring is a troubled debt restructuring should focus on whether there are "economic and legal considerations related to a debtor's financial difficulties that in effect compel the creditor to restructure a receivable in ways more favorable to the debtor than it would otherwise consider." (SFAS 15 paragraph 61). In other words, no single factor taken alone, including either (a) a reduction in the face amount of a debt or (b) a decrease in the effective interest rate of any new or modified marketable debt, is itself determinative of whether the modification or exchange is a troubled debt restructuring. Rather, all specific facts and circumstances should be considered.
SFAS 15 may typically apply to out-of-court workouts and pre-arranged or pre-packaged bankruptcy cases where the restructuring is limited to a specific bond issue(s), but does not impair other senior secured debt and trade debt. For the emerged or restructured entity, assets and liabilities (other than the restructured debt) will remain at historical values. The restructured debt is reduced below its pre-restructured book value only to the extent that the new future interest and principal payments (on a non-discounted basis) are less than the carrying value of the old debt.
For example, assume that Troubled Company Inc. has a $45 million loan bearing interest of 10 percent and maturing in one year. In negotiating with Troubled Company, its bank agrees to forgive $10 million of principal, extends the maturity an additional three years, and leaves the interest rate unaltered. With future undiscounted P&I payments of $49 million ($35 million and $14 million, respectively), no gain would be recorded by Troubled Company, and $4 million of interest expense ($49 million future P&I less $45 million carrying amount of debt) would be recognized over the four remaining years of the loan. If we further assume that the interest rate is reduced to 5 percent, then a gain on the restructuring of debt would be $3 million ($42 million future P&I less $45 million carrying amount of debt), no interest expense is recorded between the date of the restructuring and the new maturity date of the debt, and all future cash payments are recorded as reductions in debt. In this case, the book value of the restructured debt on the company's balance sheet would be $42 million. This result is significantly different from the SOP 90-7 impact, where the restructured debt presented on the balance sheet would be no more than $35 million (perhaps less since 5 percent is a below-market rate of interest).
The rationale for this treatment is that the creditors have granted the company's shareholders a concession to protect their investment that they otherwise would not have provided. This concession is best reflected in reducing the effective interest rate on the old principal balance rather than considering the restructured debt an entirely new instrument on the company's books and records. In this way, the creditors' concession is reflected through reduced future interest expense over the new debt's amortization.
Debt Modifications or Exchanges: EITF 96-19
Companies involved in out-of-court restructurings that do not meet the facts and circumstances of a troubled debt restructuring apply the guidance provided under Emerging Issues Task Force (EITF) 96-19, "Debtor's Accounting for Modification or Exchange of Debt Instruments." The impact on the restructured balance sheet is similar to SFAS 15 in that no conversion to fair-market value occurs, and the focus is on how to record the new debt and to what extent gain is recognized.
The criteria for using EITF 96-19 is (1) the debtor is not in bankruptcy; and (2) the restructuring is not a troubled debt restructuring as specified earlier in SFAS 15. In applying EITF 96-19, the old value of the debt on the balance sheet will only be adjusted to the new restructured value if the new debt is substantially different, meeting a 10 percent difference in present value of the new debt versus the old debt.
Both the old and the new debt are discounted at the effective interest rate of the old debt. The old effective interest rate is utilized instead of the new market interest rate because the 10 percent difference test is attempting to determine whether the old debt instrument has been substantially changed.
Generally, the EITF 96-19 threshold limits gain recognition, as does SFAS 15, but is an easier test to meet because SFAS 15 compares the difference in cash flows between old and new debt on a non-discounted basis.
Push-down Accounting: SAB 5-J
Push-down accounting refers to establishing a new basis of accounting in the separate stand-alone financial statements of the acquired enterprise based on a purchase of stock of the acquired enterprise. When the acquired company's operations are maintained in a separate subsidiary after a purchase business combination, the question arises as to whether (1) the new parent's basis resulting from the business combination or (2) the historical pre-transaction basis should be reflected in the financial statements of the subsidiary. If the debtor's financial statements are to be included in an SEC filing by either the acquired company or its parent (if applicable) and the acquirer controls between 80 to 95 percent of the voting securities, the parent may generally elect to use its acquisition cost in the debtor and push down its basis in recording the debtor's emerging balance sheet. The parent will generally be required to use push-down accounting if more than 95 percent of the debtor's voting securities are controlled.
Push-down accounting is not required for enterprises that are not SEC registrants, but is acceptable when 80 percent or more of the enterprise's voting securities are acquired in a purchase transaction.
In applying push-down accounting, the total acquisition cost will be the sum of the cost of previous transactions plus the basis contributed in the new plan including the value of liabilities assumed. In accordance with SFAS 141, the assets and liabilities of the debtor will be recorded at fair-market value. Goodwill will be recorded to the extent that the parent's basis exceeds the fair market value of the tangible and intangible assets. It should be noted that differences between the reorganization value and the parent's basis may occur due to a number of reasons, including that the debtor's value may have changed since the parent acquired its interests.
A recent example where we applied push-down accounting was a restructuring of bonds to be effected either out of court through an exchange transaction pursuant to an exemption from the registration requirements under the Securities Act of 1933, or through a pre-packaged chapter 11 bankruptcy proceeding. A former bondholder sponsored the restructuring plan by contributing the debtor's bonds it held, a certain amount of stock in its publicly held company and cash. In exchange, the acquirer was to receive 100 percent of the debtor's stock. Existing bondholders were offered notes with reduced collateral provisions. As an SEC reporting company, the acquirer was required to prepare the post-restructuring financial statements of the debtor in accordance with push-down accounting regardless of how the restructuring was to be implemented. When applicable, pushdown accounting requirements will override the use of any other methodology in reporting the emerging balance sheet, including SFAS 15 or SOP 90-7.
Keeping the General Framework in Mind
As demonstrated, accounting for the emerging balance sheet is subject to several tests which can produce significantly different results. Financial advisors must look to several criteria in determining the applicable reporting requirements. The accompanying chart summarizes the issues so that all professionals in the case will have a general insight into the decision framework.