As the potential for a significant economic downturn looms on the horizon, more companies may find themselves under financial duress and consider bankruptcy as a path forward. As a company emerges from Chapter 11 bankruptcy, a wide range of accounting considerations must be contemplated to ensure the process goes smoothly and is in compliance with U.S. GAAP. Companies need to consider various valuation and accounting ramifications as they navigate ASC 852, the accounting standard codification that governs fresh-start accounting.
Upon emergence from bankruptcy, the entity's assets and liabilities need to be restated and recorded at their fair value on the opening balance sheet, akin to business combination procedures. Fresh-start accounting valuations, however, have several differences from standard valuations for business combinations, and those handling this process should take note of several important aspects of the fresh-start valuation process.
Fresh-start accounting qualification and preparation
First, it is necessary to understand if the company qualifies for fresh-start accounting. In order to qualify, a company must first analyze if the value of the emerging entity's assets immediately after the restructuring ("reorganization value") is less than the court-allowed claims plus post-petition liabilities. Second, the company needs to determine whether there is a loss of control, which means the old shareholders now emerge with less than 50% of the shares and this loss is not temporary.
While this calculation sounds simple, timing of these processes and events are crucial, as ASC 852 stipulates both such tests must be performed immediately prior to the company's reorganization plan confirmation ("plan confirmation date"), which is in advance of the emergence date.
Calculating reorganization value
Calculating the reorganization value typically begins with enterprise value, and then cash and noninterest-bearing liabilities are added back. However, a detailed understanding of exactly what is included in enterprise value and how enterprise value was determined by the bankruptcy advisors is important. For example, if the court-approved enterprise value already included cash, cash should not be added back to arrive at reorganization value. Valuation considerations related to reorganization value are found later in this article.
Loss of control
Loss of control is a different assessment than the one most are familiar with under ASC 805, in which you assess gain of control. An entity must ensure the existing voting shareholders immediately before the plan confirmation date lose majority control and receive less than 50% of the emerging entity's voting shares.
Understanding the emergence date
It is important to understand exactly when the emergence date is so that a company can prepare to apply fresh-start accounting.
In most bankruptcies, there is a plan that is approved by the entity, creditor and court to establish the new organization (the "plan of reorganization"), which usually conveys a list of conditions that must be satisfied prior to emergence. To formally emerge, and thus become the successor entity, a company must diligently track and understand when these conditions have been met.
Without a full understanding of the conditions and when they are met, a company may not recognize the proper emergence date, which could create significant issues. The emergence date is the date in which the reorganization value must be established, the predecessor entity must be closed, and the successor entity starts with a new opening balance sheet.
Increased reporting requirements for creditors and investors
Once a company declares bankruptcy, it is typically required to comply with additional reporting requests. Examples of this include:
- 13-week cash flow;
- Additional balance sheet line items to accurately separate pre-bankruptcy and post-bankruptcy liabilities;
- Disclosure of reorganization/bankruptcy fees separately on income statement, cash flows, etc.; and
- Incremental narrative disclosures to describe the bankruptcy filing, process and ongoing financial position.
Lastly, upon emergence, an entity may run into new accounting standards or requirements due to certain elements of the plan or new policies put into place by management such as bonus or stock compensation, new debt or warrants, or a new consolidation structure. These challenges are in addition to various reporting requirements:
- Disclosure of details and effects of the agreed upon plan of reorganization;
- The calculated reorganization value of the emerging entity and their assets;
- And, if fresh-start accounting applies, all balance sheet effects of the plan of reorganization and fair valuation as they apply to the predecessor balance sheet in order to create the new successor balance sheet.
Establishment of the enterprise value of the post-emergence entity
Following the emergence from bankruptcy, the company will first need to establish its enterprise value, which is the starting point in the determination of the reorganization value.
In a typical business combination, the purchase consideration is defined. By contrast, in a bankruptcy reorganization, there is usually a range of value agreed upon by the plan's controlling stakeholders that is specified in the plan documents filed with courts. An independent analysis must be conducted to establish the enterprise value applicable for the post-emergence entity. This conclusion of value frequently falls in the middle of the range disclosed in emergence documents. If a specific value or a range of values is not defined in the plan, then an independent valuation of the post-emergence entity must be conducted.
If market conditions indicate a meaningful change in the key assumptions underlying the prospective financial information used to determine the enterprise value filed with the courts, then this could present valuation challenges to reconcile the indicated value on the emergence date with the valuation agreed upon by key stakeholders when the plan was filed and subsequently approved by the court. The most common example of this would be for businesses whose value is meaningfully impacted by commodity prices, and if there is a material change in commodity prices between the plan filing and when the company actually emerges from bankruptcy.
Proper identification of intangibles
While the identification of intangible assets would mimic a valuation for business combinations, one would not expect to find a high level of residual goodwill in a fresh-start valuation analysis since the entity was in financial distress prior to emergence and the new owners would likely not be willing to pay for any goodwill. If there is any goodwill, it is likely restricted to the fair value of the assembled workforce (which is subsumed into goodwill).
Ultimately, companies should be sure they are properly capturing the economics of the bankruptcy transaction as it applies to the post-emergence entity and reflect that in the valuation of intangible assets.
Fair value of debt and warrants
The post-emergence entity would likely have new indebtedness on the balance sheet. Similar to procedures in any business combination valuation, it is important to assess whether the terms of the new debt reflect market rates on the emergence date. If this is not the case, then the fair value of the entity's new debt should be assessed.
Certain stakeholders in the bankrupt company may receive warrants as part of the emergence terms. The fair value of these warrants also need to be estimated as part of the valuation of the entity's equity and reported accordingly as part of the fresh-start valuation project.
Complexity of bankruptcy emergence
Proper fresh-start accounting following Chapter-11 bankruptcy emergence has a myriad of complexities and concerns for filers. A proper understanding of the necessary steps to prepare and an adherence to the needed timeline can aid a company in handling the process with success.
