Organizations filing for protection under Chapter 11 of the U.S. Bankruptcy Code are subject to Accounting Standards Codification (ASC), Reorganizations (ASC 852). Under this guidance, certain companies emerging from bankruptcy are required to adopt “fresh-start” accounting, which calls for measuring the fair value of assets and liabilities for the post-emergence entity. Doing that can be complex and requires a thorough understanding of the business, its assets and liabilities, industry and economic conditions, and the latest best practices in valuation.
While many of the accounting and valuation concepts contained within ASC 852 are similar to those used under the acquisition method for a business combination under ASC 805, Business Combinations, certain aspects of fresh-start accounting may require specific consideration. Such nuances require close coordination among management, independent valuation professionals, external auditors and tax professionals.
When Is Fresh-Start Accounting Applied?
The following criteria must be met for fresh-start accounting to be applied to a company emerging from Chapter 11 bankruptcy (per ASC 852-10-45-19):
• The reorganization value of the assets of the emerging entity immediately before the date of confirmation is less than the total of all post-petition liabilities and allowed claims — i.e., the company is balance-sheet insolvent.
• Holders of voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity.
If both criteria are met, fresh-start reporting is applied when the bankruptcy court has confirmed a company’s reorganization plan, or as of a later date when all material conditions precedent to the plan becoming binding have been resolved. Companies may adopt fresh-start reporting on a period-end date near the confirmation date to avoid the need to perform financial reporting requirements twice within the same month, as long as the selected date does not have a material effect on the financial statements.
What Standard of Value Is Used for Fresh-Start Accounting?
Fresh-start accounting guidance in ASC 852 references ASC 805. In a business combination, ASC 805 requires the acquirer to record the assets acquired and liabilities assumed at fair value as of the acquisition date. Fair value is defined in ASC 820, Fair Value Measurement, as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.
Differences between Fresh-Start Accounting and Business Combinations
Reorganization Value: One of the major differences between accounting for a business combination and fresh-start accounting is the starting point for the analysis. A business combination considers the purchase price as negotiated between unrelated third parties, while fresh-start accounting relies on the concept of reorganization value. ASC 852 defines reorganization value as the value of the entity before considering liabilities [that] approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring. In other words, the total value of the assets on the post-emergence opening balance sheet will equal a company’s reorganization value — usually determined as a range of values rather than a single-point estimate. However, the company must conclude on a single-point estimate for fresh-start reporting.
Outside financial advisers typically estimate the reorganization value, but it is ultimately determined based on negotiations by the parties involved in the bankruptcy process. The terms of the plan underlying the reorganization are determined after extensive arms-length negotiations between the interested parties as overseen and approved by the court. The reorganization value is typically based on discounted pro forma cash flow projections that were determined as part of the reorganization plan, with a view to achieving maximum value for the business. Once determined, the reorganization value provides a foundation for estimating the value to be received by the entity’s creditors and equity holders. In a business combination, a purchase price is negotiated between a specific buyer and seller.
The reorganization value used in a bankruptcy proceeding is different from business enterprise value. A company’s enterprise value represents the fair value of its interest-bearing debt and equity capital, while the reorganization value can be derived from the enterprise value by adding back non-interest-bearing liabilities.
Capital Structure Considerations: Once the reorganization value has been established, consideration should be given to the capital structure of the entity upon emergence. The restructuring process often gives rise to multiple classes of securities (stock options, warrants, etc.), each with different rights and privileges. As such, the fair value of each security should be determined in the context of the company’s overall value.
Determining the fair value of share-based payment awards for a company emerging from bankruptcy presents some unique challenges. Valuation assumptions used in option-pricing models for share options and similar instruments measured on, and subsequent to, emergence should be carefully analyzed and evaluated. Historical employee exercise behavior and historical volatility measures may no longer reflect the expected volatility of the emerging entity’s share price. ASC 718-10-S99, which reflects the codification of certain SEC guidance on share-payments in Staff Accounting Bulletin (SAB) Topic 14, can be used as a reference point to address these issues, as it provides guidance applicable to newly public entities measuring the cost of employee share options and similar instruments.
Asset Valuations: The approaches and techniques to value intangible and tangible assets for fresh-start accounting are generally similar to those used in accounting for business combinations. The primary intangible assets of a company are generally valued using some form of the income approach, with certain secondary intangible assets valued using an income and/or cost-based approach. Intangible assets commonly valued using the income approach include, but are not limited to, customer relationships, patents and trademarks. The cost approach tends to be used to value such intangible assets as internally developed software and assembled workforce.
Tangible assets are generally valued using the market approach and/or the cost approach. In applying the cost approach, it is common to make adjustments for physical and functional obsolescence for both fresh-start accounting and business combination valuations. However, the existence of economic obsolescence tends to be more prevalent in fresh-start accounting projects given the circumstances surrounding entities that file for bankruptcy. Appropriate quantification of economic obsolescence can require significant input from senior management and operations personnel. Valuation professionals knowledgeable of both financial valuation theory and tangible asset valuation concepts should be actively involved in the process to address this issue.
Liabilities and Contractual Obligations: Consistent with the accounting for business combinations, the liabilities to be assumed by the new entity also need to be valued as part of the fresh-start process. Any liabilities not settled as part of the bankruptcy process must be recorded at fair value in the application of fresh-start accounting. Certain contractual obligations of the new entity may arise from negotiations between debtors and creditors during the bankruptcy process. In these instances, negotiated terms may not necessarily reflect market conditions and therefore should be adjusted to reflect fair value.
Tax Matters: It is common for companies emerging from bankruptcy to have net operating losses (NOLs). Section 382 of the U.S. Tax Code imposes an annual limitation on a company’s use of NOLs if there has been more than a 50 percent change in ownership. Generally, the Section 382 limitations for a company emerging from bankruptcy are calculated using the equity value of the company after reduction of creditors’ claims in the reorganization. Under certain circumstances, the annual limitation of Section 382 can be modified for a corporation emerging from bankruptcy.
Companies emerging from bankruptcy also frequently encounter issues related to cancellation of indebtedness (COD). For tax purposes, a company generally realizes income from COD when the indebtedness is satisfied for less than the face amount of the debt. COD income is excluded from gross income if the cancellation is granted in a bankruptcy. (COD income is also excluded from gross income if a company is insolvent but not in bankruptcy.) The exclusion is limited to the amount of the insolvency. Any COD income excluded from gross income under these exceptions is generally applied to reduce certain tax attributes (NOLs, general business credits, capital loss carry-overs, minimum tax credits, basis in property, etc.).
Emergence from bankruptcy provides management a unique opportunity for a “fresh start” with regard to how to operate and manage its business. However, the complexities of the fresh-start accounting process can result in challenges for management, particularly after going through the stresses of a potentially prolonged and contentious bankruptcy process. These factors, along with staff resource constraints and diminished employee morale can present difficult challenges to overcome in emerging from bankruptcy. Proactive planning and close coordination among management, valuation professionals, independent auditors and tax professionals can help contribute to an efficient process, resulting in supportable and defendable conclusions.
Richard Law is managing director of Alvarez and Marsal, a professional services firm specializing in turnaround and interim management, performance improvement and business advisory services.