This spate of bad news may be good news for accounting firms that become actively involved in bankruptcy proceedings. Debtors, creditors, and other interested parties are likely to seek help from knowledgeable CPAs to help get them through tumultuous times with the best possible outcomes.
CPAs looking to practice in this area need a unique skill set focused not only on accounting, but have also demonstrated command of the forensic issues that arise in litigated matters.
Reporting Requirements in Bankruptcy in General
CPAs often issue reports and schedules as part of services rendered in the bankruptcy and insolvency area. Many of these reports or schedules would generally be classified as financial statements. Because financial statements are issued, a CPA must determine if a compilation, review or audit report must be issued, or if the service that generated the statements is exempted from the attestation standards. (For more information, see Reporting Requirements in Bankruptcy Cases, American Bankruptcy Institute, https://www.abi.org/abi-journal/reporting-requirements-in-bankruptcy-cases.)
CPAs will need to look to one of three sets of AICPA standards for guidance in the performance of their services. The Statement on Standards for Consulting Services (SSCS-1), the Statement on Standards for Forensic Services (SSFS-1), or the Statement on Standards for Valuation Services (SSVS-1). Services in bankruptcy are typically covered by SSFS-1. SSFS applies in circumstances where there is actual or potential legal or regulatory proceedings before a trier of fact or an investigation in response to specific concerns of wrongdoing. It provides for additional standards that CPAs must adhere to, as well as certain limitations on fee arrangements and engagements.
When a CPA begins an engagement involving bankruptcy or insolvency issues, a decision must be made regarding application of the attestation standards or SSFS using the two-prong test in the standard. Attestation standards do not apply in connection with litigation services. Accordingly, any financial statements that might be issued from the services rendered under SSFS do not need to be accompanied by a CPA’s report.
Bankruptcy services provided by CPAs are generally accepted as a form of litigation services. If it is determined that the analysis or report to be issued comes as a form of litigation services, it is advisable to explain both the association and the responsibility, if any, through a transmittal letter or a statement affixed to documents distributed to third parties noting the limited use of the statement.
Accounting and Financial Reporting Prior to Entering Bankruptcy
According to PricewaterhouseCoopers’ comprehensive Bankruptcies and Liquidations guide (https://pwc.to/3jCQvnU), the following is a selection of items to consider when a reporting entity encounters significant financial difficulties that could result in a bankruptcy filing.
Debt. Companies under stress might violate covenants (financial and nonfinancial) in existing debt agreements. When there is a covenant violation, the debt may become due on demand or callable by the lender. Corresponding debt obligations may need to be classified as current, unless the lender has waived or lost the right to demand repayment for more than a year. If the long-term obligation agreement contains a grace-period provision, the obligation may need to be classified as current unless it is probable that the debtor will cure the violation within the grace period.
Companies that have violated a covenant but obtained a waiver at period-end should consider whether they will continue to meet the covenant in future periods. If a future violation is probable, the debt would be classified as a current obligation. If compliance is probable for the next 12 months, the debt obligation should continue to be classified as noncurrent. Companies should be mindful of the disclosure requirements associated with debt covenant violations and waivers.
Debt extinguishments and modifications. Companies may consider a variety of potential transactions to enhance liquidity. When debt instruments are either exchanged or modified, the debtor must first determine whether the exchange or modification meets certain criteria to be considered a “troubled debt restructuring.” These criteria include assessing whether the debtor is experiencing financial difficulty and whether the creditor has granted a concession.
If the criteria are met, a gain is recognized, but only to the extent that the gross cash flows of a new or modified debt instrument are less than the carrying amount of the old instrument. If the gross cash flows exceed the carrying amount of the old debt, no gain is recorded and a new effective interest rate is established, based on the carrying amount of the debt and the revised cash flows.
If an exchange or modification of an instrument is not a troubled debt restructuring, the debtor must still determine whether the transaction meets the criteria to be considered an extinguishment. If the modified or new debt instrument has substantially different terms from the old debt instrument, an extinguishment is recognized. If the exchange is considered a modification, the effects are generally reported prospectively utilizing a new effective interest rate determined based on the carrying amount of the original debt and the revised cash flows. Interest expense is recognized using the new effective interest rate.
Valuation allowance. A valuation allowance is a reserve that is used to offset the amount of a deferred tax asset. The amount is based on that portion of the tax asset for which it is more likely than not that a tax benefit will not be realized (Valuation Allowance for Deferred Tax Assets, PricewaterhouseCoopers, https://pwc.to/33DqXS0). Given what typically precedes a bankruptcy filing, including operational losses and deteriorating credit conditions, it may be that the tax benefits from deferred tax assets will not be realized and that a valuation allowance should be recorded. The reporting entity’s history of operating losses and the impact that a bankruptcy filing could have on the reporting entity’s ability to utilize deferred tax assets in the future are relevant to any analysis regarding a valuation allowance.
Liquidation may be a voluntary decision based on economic conditions, a defined event for a limited life entity, or an involuntary act brought about by an entity’s creditors, the bankruptcy court, or other parties.
The assumptions (such as earnings projections) used in assessing whether deferred tax assets will be realized should be consistent with the assumptions used in impairment testing and consideration of the reporting entity’s ability to continue as a going concern. This assessment will often lead to a conclusion that a valuation allowance is required prior to a bankruptcy filing.
Accounting and Financial Reporting During Bankruptcy
According to PricewaterhouseCoopers’ comprehensive Bankruptcies and Liquidations guide (https://pwc.to/3jCQvnU), once a reporting entity has filed a petition for bankruptcy under Chapter 11 of the Bankruptcy Code, its accounting and financial reporting fall under the scope of Accounting Standards Codification (ASC) 852-10. The most significant impact of ASC 852-10 on the financial reporting of balance sheet items involves the liabilities of a reporting entity in reorganization, as discussed below.
Liabilities subject to compromise. The balance sheet of an entity in Chapter 11 must distinguish prepetition liabilities subject to compromise from those that are not (such as fully secured liabilities that are expected not to be compromised) as well as postpetition liabilities.
Liabilities subject to compromise are prepetition obligations that are not fully secured and that have at least a possibility of not being repaid at the full claim amount. These liabilities can include any type of obligation, such as trade payables, contract obligations, or unsecured debt. The determination of which liabilities are subject to compromise is made at the date of the bankruptcy filing, based on whether the liability is adequately secured.
If unsecured, or if there is doubt as to the adequacy of the value of security related to a given liability, the entire liability should be included in liabilities subject to compromise. Liabilities subject to compromise are presented as a group on one line in the balance sheet and are classified outside of current liabilities. The principal categories and amounts of liabilities subject to compromise should be disclosed in the notes to the financial statements.
Under bankruptcy accounting, liabilities subject to compromise are presented at the expected amount of the total allowed claim. As a result, in most cases liabilities are initially presented at amounts higher than the expected settlement amount. Only later, as the claims are addressed by the court or the reorganization plan is confirmed, are they adjusted to their settlement amounts.
Fully secured liabilities that may become impaired in the reorganization plan should be included as liabilities subject to compromise. For example, if the asset that is securing a liability diminishes in value such that the liability is no longer fully secured, it may be appropriate to reclassify it as a liability subject to compromise.
Some claims may be finalized early in the bankruptcy process and should be reclassified from liabilities subject to compromise. The court often approves some level of payment for prepetition claims for critical vendors of the debtor early in the proceedings so that the debtor can continue to operate its business. When the character of a claim changes such that some or all of the claim will be paid, it may be appropriate to reclassify the portion of the claim approved for payment out of liabilities subject to compromise because, by definition, the claim is no longer subject to compromise.
Debt. The treatment of debt and debt issue costs depends upon whether the related debt is secured or unsecured (or undersecured). A debt discount or premium, as well as debt issuance costs, should be reported as an adjustment to the carrying amount of the related debt. However, costs associated with entering into a revolving line of credit or revolving debt arrangement meet the definition of an asset and should be recorded as such on the balance sheet.
Tax issues may arise when debt is cancelled. In general, cancellation of debt under a bankruptcy proceeding does not result in taxable income, as it might if the same debts were cancelled without the bankruptcy filing. Cancellation of debt (COD) for business entities can be complicated and require a knowledgeable professional to assist in navigating the rules.
Professional fees. Professional fees must be expensed as incurred and reported as reorganization items because these amounts and similar types of expenditures directly relating to the Chapter 11 proceeding do not result in assets or liabilities. It is not appropriate to defer professional fees and similar types of expenditures until the plan is confirmed and then reduce gain from debt discharge to the extent of the previously deferred expenses. Nor is it appropriate to accrue professional fees and similar expenditures upon the filing of the Chapter 11 petition.
Professional fees that become payable upon emergence from bankruptcy, often referred to as “contingent fees” or “success fees,” should be expensed upon emergence and recorded within reorganization costs. Professional fees, with perhaps the exception of certain debt issue costs as mentioned above, should not be capitalized for a reporting entity in bankruptcy.
Liquidation Basis of Accounting
The above discussion focuses primarily on bankruptcy as a mechanism to allow a business with financial difficulties to reorganize so that it can be viable as a going concern. However, a business can reach a point where the best result for its stakeholders is for the entity to cease operations, liquidate its assets, and settle its obligations, with any remaining resources distributed to its owners. Liquidation may be a voluntary decision based on economic conditions, a defined event for a limited life entity, or an involuntary act brought about by an entity’s creditors, the bankruptcy court, or other parties.
Regardless of the reason, the need for relevant financial reporting remains critical even when a business is liquidating. According to PricewaterhouseCoopers’ comprehensive Bankruptcies and Liquidations guide (https://pwc.to/3jCQvnU), the users of the financial statements of a business facing liquidation have different needs than investors in a going concern. When an entity has adopted the liquidation basis of accounting, its financial statement requirements change from a balance sheet and statements of comprehensive income and cash flows to a statement of net assets in liquidation and a statement of changes in net assets in liquidation.
Under the liquidation basis of accounting, the emphasis shifts from reporting about the entity’s economic performance and position to reporting about the amount of cash or other consideration that an investor might reasonably expect to receive upon liquidation—that is, after all of the entity’s assets have been liquidated and liabilities have been settled.
The recognition and measurement principle for an entity that has adopted the liquidation basis of accounting may include items which the entity did not previously recognize on its going-concern balance sheet, such as internally developed intangible assets. If such assets are expected to generate sales proceeds, the assets should be recognized upon adoption of the liquidation basis.
Prior to adopting the liquidation basis of accounting, an entity should consider whether any adjustments to its assets and liabilities are necessary while preparing going-concern financial statements. In the periods prior to the adoption of the liquidation basis of accounting, assets, including goodwill, intangible assets, and long-lived assets, should be evaluated for impairment under the applicable standards. Financial statements after the adoption of the liquidation basis of accounting generally do not reflect goodwill because it usually does not have any realizable value in a liquidation.