Global challenges like the after-effects of the pandemic, high inflation, rising interest rates, the looming threat of recession, supply chain constraints, the emerging monkeypox virus, and the war in Ukraine continue to test businesses across many industries. The number of companies facing financial distress has increased, forcing some to file bankruptcy or reorganize. Though the bankruptcy process involves distributing the remaining assets to the failing business’s creditors, it also allows some organizations to make a fresh start by reorganizing to be more economically feasible.
There are six different types of bankruptcy filings under the Bankruptcy Code, and the most common for US businesses is Chapter 11, which allows companies to reorganize. If your business is considering a bankruptcy filing, it’s important to understand the benefits, qualifications, and challenges of fresh-start reporting.
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What Fresh-start Reporting Allows
To reorganize under Chapter 11, a business must prepare a reorganization plan that is subject to court approval. Once that plan is approved by the court and the company has emerged from bankruptcy, the business can begin to apply fresh-start reporting if it meets the associated requirements under ASC 852 – Reorganizations (outlined below).
Under fresh-start reporting, the business starts anew, with its balance sheet items adjusted based on newly determined fair values. The business is considered separate from its predecessor company (the organization that has undergone a default) and now has clean financials and possibly a stepped-up value of assets. Fresh-start reporting provides an opportunity for most companies, as it denotes that the emerging entity is more robust and has a promising future.
The Criteria for Fresh-start Reporting
As stated in the American Institute of Certified Public Accountants Statement of Position (SOP) 90-7, Financial Reporting Entities under Bankruptcy Code, a reporting entity must apply fresh-start reporting after emerging from bankruptcy if it qualifies on both of the following criteria:
• Reorganization value test. The reorganization value of the emerging entity immediately before the date of confirmation (when the court approves the reorganization plan) must be less than the total of all post-petition liabilities (the liabilities incurred after the bankruptcy is filed) and allowed claims. This test aims to prevent companies that are solvent and able to finance their operations from applying fresh-start reporting.
• Loss of control test. The holders of existing voting shares immediately before confirmation must receive less than 50% of the voting shares of the emerging entity. This test prevents companies from filing a bankruptcy petition to adopt fresh-start reporting and write-up value of assets.
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A Closer Look at the Reorganization Value Test
The reorganization value is the approximate fair value of the company’s assets without considering its liabilities. Though it may sound straightforward, obtaining the reorganization value requires extensive arms-length negotiations among various parties. This process is vital, as it serves as the basis for determining the value received by the business’s creditors and equity holders.
The reorganization value is commonly determined as a range rather than a single-point estimate; however, an entity will choose a value within a range. Companies typically use the discounted cash flow (DCF) method to arrive at the fair value, as it is the most commonly used valuation method (although methods such as acquired cost or book value, appraised or replacement cost, multiples of revenue or turnover, projected cash flow, and earnings capitalization also may be used).
The DCF approach discounts the business’s projected cash flows to present at a rate equal to the cost of capital. It comprises:
• Present value of cash flows during the projection period
• Present value of the residual value at the end of the projection period
• Value of the assets considered unnecessary to operate the newly reorganized entity, such as excess working capital or assets liquidated as part of the plan
DCF considers factors such as the discount rates adjusted to risk levels, the capital structure and market inputs, prospective financial information related to revenue growth rates and operating margins, and specific tax considerations of the emerging business.
The reorganization value differs from the enterprise value, also referred to as the market value of invested capital. Enterprise value represents the fair value of the company’s interest-bearing debt and shareholder’s equity, while reorganization value considers the impact of working capital and liabilities other than interest-bearing debt.
For example, suppose a business has an enterprise value of $1.3 million and working capital and other liabilities amounting to $200,000. The reorganization value would be the total of the two, or $1.5 million. However, businesses emerging from bankruptcy also should evaluate other considerations, such as environmental liabilities, deferred taxes, and estimated cash balances, to arrive at an appropriately reconciled reorganization value.
A Closer Look at the Loss of Control Test
Fresh-start reporting includes considering the percentage of shares held by a shareholder before and after bankruptcy emergence. To qualify, the existing shareholder group of the predecessor company should have lost control of the emerging entity, meaning, they should not have more than a 50% controlling interest in the emerging business, but it’s not necessary to demonstrate that a single party has obtained control.
In addition, the loss of control should be substantive and not temporary. For example, the new controlling interest must not revert to the shareholders who held interests immediately before filing or confirming the plan. When computing loss of control, potentially dilutive instruments such as share options and warrants are disregarded.
Establishing the Reporting Date
If a business emerges from bankruptcy and meets both the reorganization value test and the loss of control test, the company can begin to apply fresh-start reporting according to SOP 90-7 “as of the confirmation date, or as of the later date when all material conditions precedent to the plan’s becoming binding are resolved.” Material conditions include obtaining sufficient exit financing in the reorganization process.
While SOP 90-7 doesn’t specify a particular date for beginning fresh-start reporting, for convenience purposes and to avoid business disruption the new reporting often begins at a fiscal month-end, close to the court confirmation date or when the unresolved material conditions precedent is resolved.
The Challenges of a Fresh-start
Fresh-start reporting is an intricate process that requires careful consideration to determine the appropriate reporting dates and measure the business’s adjusted balance sheet items. If continued global challenges significantly impact future cash flows, the valuation process will become even more complex and uncertain. In turn, companies should consider only highly probable scenarios and preceding events known at the valuation date.
Even the process of qualifying for fresh-start reporting is a challenge, requiring the business to prepare a viable and financed reorganizational plan which concludes that the emerging entity will be solvent and its operations will be feasible. SOP 90-7 also imposes strict rules and timelines for implementing fresh-start reporting.
How Scrubbed Can Help
Fresh-start reporting is a critical consideration for companies in financial distress, enabling them to start with no deficit or retained earnings and restructured assets and liabilities. But since the stakes are high and the process is complex, business leaders may find it difficult to tackle on their own. That’s where an outsourced accounting and finance firm like Scrubbed can make the difference.
Scrubbed is uniquely qualified to help companies that opt to take the fresh-start reporting approach, with the deep knowledge and experience required to overcome the potential challenges and avoid delays that could result in significant penalties. Scrubbed works with businesses emerging from bankruptcy to ensure they consider every relevant factor in pursuing reliable financial reporting, maintain effective and efficient operations, and stay compliant with laws and regulations. The Scrubbed Technical Accounting* Group, in partnership with our Corporate Financial Services* Group, also provides valuation assistance and thoroughly analyzes the impact of complex and unusual accounting transactions.
Are you considering leveraging the opportunity for fresh-start reporting? Contact Scrubbed to learn how we can help your business approach the fresh-start reporting process effectively.
The information contained herein is general and is not intended to address the circumstances of any particular individual or entity. It is not intended to be relied upon as accounting, tax, or other professional services. Please refer to your advisors for specific advice. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.
*Disclaimer: Services being offered do not require a state license.
About the Author
Angel Lou Ruiz is a Senior Supervisor of the Technical Accounting Group of Scrubbed. She assists public and private companies in preparing technical memoranda, performs an extensive review of IFRS and US GAAP financial statements (i.e., 10-Q and 10-K reports), including note disclosures and account reconciliations, and provides technical accounting consultation. Before joining Scrubbed, she had nearly four years of professional experience with PricewaterhouseCoopers (PwC) Philippines handling financial statement audits, reviews, and agreed-upon procedures for public and private companies.