Insights & Best Practices for Restructuring Accounting
Making Sense of Fresh Start Accounting and ASC 852
Sometimes things are exactly as they sound. Case in point – there isn't much ambiguity in the term fresh start accounting. But just because the topic and term are pretty straightforward doesn't mean that the actual practice of fresh start accounting is intuitive. And that can be problematic for a company trying to regain its financial footing.
Here at Embark, we understand that your company might be in a tough spot right now. After all, you probably aren't reading this simply to pass the time. However, whether your preferred metaphor is a phoenix rising from the ashes, a butterfly emerging from a cocoon, or an equally corny but relevant metaphor, they can all ring true for your company. That is, as long as you understand how to proceed. And that's precisely what we're here to ensure.
What Is Fresh Start Accounting?
Whenever you see a cluster of Chapter 11 filings in the headlines, it's safe to assume that bad tidings are afoot. In recent weeks, it's been the repercussions of the COVID-19 crisis driving the sudden surge in bankruptcy filings. But we've seen similar dynamics in nearly every systemic shock to our economic equilibrium, including the Great Recession of 2008. Therefore, we're bound to see plenty of headlines concerning Chapter 11 filings – and, thus, the need for fresh start accounting – even when the coronavirus pandemic is thankfully behind us.
However, despite the negative connotations usually associated with bankruptcy, some companies truly can use it as a springboard to bigger and better things given a whole lot of diligence and maybe a wee bit of luck as well. As companies emerge from Chapter 11 bankruptcy, it’s imperative they record the details of the reorganization plan ordered by the court and account for the resulting effects.
Generally speaking, this is where fresh start accounting enters the equation, which, in a nutshell, basically establishes a new successor reporting entity that must measure the reorganization value and assign it to its post-emergence assets and liabilities. This valuation must conform to the acquisition method under ASC 805-20. If any portion of the reorganization value cannot be assigned to a specific tangible or intangible asset of the successor reporting entity, it is reported as goodwill.
That assignment of the reorganization value becomes the basis for the company's opening balance balance and fresh start reporting. Adjustments to arrive at these opening balances for fresh start accounting are reflected in the final statement of operations of the predecessor entity, as applicable. Therefore, the fresh start accounting process, as explained in ASC 852, Reorganizations, essentially leaves the "old" entity in the rearview mirror, which, much to your chagrin, prompts all of those hackneyed phoenix and butterfly metaphors.
Who Can Adopt Fresh Start Accounting?
As we said, a company must first meet specific criteria upon its emergence from Chapter 11 to adopt fresh start accounting. According to ASC 852-10-45-19, a company qualifies if:
- 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
- Holders of existing voting shares immediately before confirmation receive less than 50% of the voting shares of the emerging entity
Translating that first bullet point into actual English, the FASB is saying that, just before your reorganization plan gets the stamp of approval, your company must have an insolvent balance sheet. Put another way, the reorganized value of its assets is less than the sum of its liabilities and allowed claims after filing the bankruptcy petition.
If you meet both of those criteria, then you would adopt the fresh start accounting rules either once the court confirms your company's reorganization plan, or you resolve all precedent material conditions to the plan, whichever is later.
Considerations on Fresh Start Accounting
Now that we have the high-level information down pat, let's take a deeper dive into some of the more granular details and considerations involved with fresh start accounting.
Measuring Reorganization Value
We mentioned that fresh start accounting is similar to accounting for business combinations. However, that doesn't mean that they are exactly alike. One of the significant differences concerns the starting point for your valuation analysis, where, in a business combination, the purchase price is front-and-center.
Obviously, fresh start accounting does not include a purchase price, so it relies on the reorganization value of your company. However, it still uses ASC 805, Business Combinations, as a general guide, relying on the approximate value – before considering liabilities – that a willing buyer would have paid for the assets of your company immediately after restructuring.
Simply put, it's the value of your assets on your post-emergence balance sheet that determines your reorganization value. While most companies emerging from Chapter 11 use valuation specialists to estimate that critical fresh start initial value, the process of actually zeroing in on the figure comes from negotiations between the interested parties, as overseen and ultimately approved by the bankruptcy court. In general, the reorganization value is defined as a range of value rather than a single amount, where the reporting entity will select an amount within the range to apply its fresh start accounting.
Further, it's typical for discounted pro forma cash flow projections to form the basis of the reorganization value, all in an effort to maximize value for the business. From there, that value is the footing used to estimate what your creditors and equity holders receive, which is different from an entity’s business enterprise value.
Capital Structure Complexities
As post-emergence capital structures often demonstrate, a fresh start with a new reporting entity doesn't mean that the road ahead is simplified or more straightforward. To that point, restructuring often results in several separate security classes – stock options, warrants, and the like – each with different rights and privileges. And, like it or not, you must determine the fair value of each of those securities in relation to your enterprise value.
As you might have guessed, this can be a time-consuming and challenging process. For instance, you won't necessarily be able to use the same inputs in your option-pricing models to assign a valuation for share options and other instruments. Remember, that "old" entity is now behind you, as are the exercise behaviors and volatility measures you once used in your pricing models. But since newly public entities face the same issues, you can use ASC 718–10–S99 for a sense of direction.
Lastly, past retained earnings or accumulated deficits are zeroed out for the new successor reporting entity. This zeroing out also includes amounts in accumulated, other past comprehensive income such as cumulative translation adjustments.
Tangible & Intangible Asset Valuations
This is yet another area where accounting for business combinations can provide some much-needed insight. For tangible assets, most companies will use either the market approach, the cost approach, or some combination of the two. However, regarding the adjustments for physical and functional obsolescence in the cost approach, keep in mind that, because of the circumstances, economic obsolescence will likely have a much larger impact than it would have otherwise.
For the most part, companies use the income approach to value intangible assets like intellectual property and customer relationships. Obviously, given the inherent complexities in these asset valuations – as well as the searing spotlight on your post-Chapter 11 company – a valuation advisory services firm can be extremely helpful in ensuring you get these critical calculations right the first time.
Liabilities & Debt Obligations
Of course, as much as you would like them to, your liabilities don't suddenly disappear into the ether as part of the fresh start process. Instead, just like most of the other topics we've covered so far, accounting for business combinations provides a roadmap for assigning values to the liabilities that your new reporting entity will assume.
For any liabilities not settled during the bankruptcy process, you must record them at fair value as part of your fresh start accounting. Likewise, new obligations might arise from your negotiations with debtors and creditors, which won't necessarily reflect current market conditions. In these cases, you must adjust them to reflect fair value in your fresh start accounting.
Also, deferred revenue of an emerging entity will require adjustment to reflect the remaining performance obligation of the new reporting entity. The liability for the remaining performance obligation should reflect the fair value to provide the remaining goods, services, or right to use an asset.
Suffice it to say, someone sitting down with your financials might have some trouble keeping everything straight. Between the predecessor entity, your new reporting entity, adjustments for reorganization and fresh start accounting, and the many other moving parts involved, mentally getting from point A to point B can take some doing.
Therefore, your disclosures play a vital role in establishing transparency and a clear understanding of the many dynamics occurring within your financial reporting. In essence, you're trying to walk the user from your predecessor balance sheet before confirmation of the reorganization plan to the new reporting entity's fresh start balance sheet, disclosing the reorganization adjustments, court-ordered items, and fair value adjustments occurring between the two. It's usually best to present this information through an accompanying table in your disclosures, with additional descriptions of significant reorganization transactions to provide an appropriate level of transparency to the users of the financial statements.
We won't take a terribly deep dive into income tax issues stemming from a reorganization. However, there are a few things to keep in mind that might significantly impact the presentation and disclosure of both your current and deferred taxes.
- Any temporary difference between the fair value you allocate in your fresh start accounting and your tax basis
- Carryforward taxes, including net operating losses and its corresponding valuation allowance
- A different sequence for the recognition of tax benefits between the predecessor reporting period and your fresh start reporting
- The impact of any discharge of indebtedness income and your insolvency measurements
- Various effects at different levels of your organization, particularly between parent company and any subsidiary effects
Assuming you don't have an in-house expert on the tax implications of restructuring and fresh start accounting, this is, once again, an area where an outside specialist can help you avoid any missteps that could plague you down the road.
Other Best Practices & Considerations
Aside from those high-level considerations, we also have a handful of other insights and best practices to keep in mind as you set sail on the fresh start accounting seas.
Fresh start accounting is just that – a fresh start. If you so choose, your emerging entity can adopt new accounting policy elections that differ from the predecessor company. That's not to say that you have to abandon your previous elections but, at the very least, you now have the opportunity to take a different perspective. To the extent the predecessor and successor accounting policies differ and the operating results are presented together, the disclosures should highlight the differences between the two sets of accounting policies.
Measurement Period - Or Lack Thereof
We've mentioned the similarities between fresh start accounting and accounting for business combinations quite a bit thus far. However, a critical difference between the two is the lack of a measurement period in fresh start accounting that exists under ASC 805. ASC 852 does not provide for this period to make adjustments since the bankruptcy process itself is already so lengthy, generally giving you enough time to gather and integrate all relevant facts and information into the accounting.
Reorganization Reporting When You Don’t Qualify
If you don't meet the criteria for fresh start accounting, you must still record the bankruptcy reorganization plan's effects through your ongoing financial statements. Naturally, there would be no new reporting entity in this case, so everything we've discussed concerning fresh start accounting would not apply.
If you qualify for fresh start accounting and the approval happens to fall on an oddball date, the use of a more convenient date for accounting purposes is appropriate if you deem the intervening period as immaterial to both the predecessor and new reporting entity. For example, let's say you meet all of the required conditions and approval happens to hit on March 26. Assuming nothing of significance occurs in the following five days, you're allowed to adopt April 1 as the basis for your fresh start accounting.
Segment reporting for public entities might change due to a fresh start. Since your new reporting entity won't necessarily have the same organizational structure as the predecessor, you might need to consider potentially key differences between the old and new segment reporting, as discussed in ASC 280. Don't always assume that your past segment reporting will still apply to your new reporting entity.
Lease Contract Modifications
Contract modifications within the reorganization plan might require some thinking through. For example, if the plan modifies lease terms, you should not necessarily carryforward the classification of those leases. Typically, you will have to reassess classification based on any modified terms or conditions that result from the court proceedings.
Stock Comp Plans
There are additional considerations involved in stock comp plans since previous awards usually become worthless, where the court will often cancel those awards as part of the bankruptcy proceedings.
ASC 718 outlines specific accounting considerations when awards are cancelled and no replacement awards are issued, as is generally the case under these circumstances. On the other hand, where new stock compensation awards are granted, the successor entity would account for those as new award grants, again according to ASC 718.
Depending on your situation, there could very well be other considerations and issues that arise as you begin your "fresh start." However, these points certainly hit the most common areas of concern. Whatever your current situation is – a distressed company reading the tea leaves, an organization already knee-deep in restructuring, a post Chapter 11 company making sure you handled everything correctly – this is an opportunity to start with a clean slate, or at least something close to it. Take full advantage of the opportunity and, as always, Embark is here to lend a hand whenever it's needed.