Liabilities under ASC 852-10 are separated into obligations that were incurred prior to the filing of the bankruptcy petition—prepetition liabilities—and those incurred after the filing—postpetition liabilities. Prepetition liabilities are further segregated into those that are subject to compromise and those that are not subject to compromise, as explained in ASC 852-10-45-4.

Figure BLG 3-1 illustrates a sample balance sheet for a reporting entity that is in bankruptcy.

Figure BLG 3-1
Sample balance sheet under ASC 852-10

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, which generally make up the majority of liabilities in a bankruptcy filing, can include any type of obligation of the reporting entity, such as trade payables, contract obligations, lease liabilities, or unsecured debt. Other prepetition obligations may be classified outside of liabilities subject to compromise when they can be demonstrated to be fully secured. The determination of which liabilities are subject to compromise is initially 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. For example, if a debtor's $100 liability to a vendor is secured by a specific asset with a fair value of $80 as of the petition filing date, the entire amount of the liability—not just the undersecured $20 portion—would be included as a liability subject to compromise.

Liabilities subject to compromise are presented in aggregate as one line on the balance sheet and are classified outside of current liabilities but included in total liabilities. Under the Bankruptcy Code, most prepetition claims are not allowed to be paid until after the reorganization plan has been confirmed, the timing of which in most cases cannot be predicted. The Discussion of Conclusions in SOP 90-7, which was not carried forward in the Codification, implied that the liabilities subject to compromise should be presented outside of current liabilities since it often takes more than a year for a bankruptcy proceeding to run its course. Furthermore, the principal categories and amounts of liabilities subject to compromise should be disclosed in the notes to the financial statements.

As stated in ASC 852-10-45-5, liabilities subject to compromise, including claims that become known after the bankruptcy petition is filed, should be reported on the basis of the expected amount of the total allowed claims, even if the claims will be settled at lesser amounts (in other words, the allowed claims balance should not be reported at “cents on the dollar” amounts).

An allowed claim is one that begins as either (1) included in the debtor's listing of liabilities filed with the Court or (2) submitted by a creditor to the Court and not objected to by the debtor. Once the debtor accepts a claim, or decides not to object to a claim submitted by a creditor, a claim is generally considered an allowed claim, even if the Court has not explicitly approved the claim.

The recognition and measurement of allowed claims should follow the model described in ASC 450-20, Loss Contingencies, and thus should reflect the reporting entity's best estimate of its total allowed claims. Accordingly, a reporting entity's liabilities subject to compromise balance will generally differ from the prepetition measurement of the underlying liabilities which make up this balance. Claims not subject to reasonable estimation should be disclosed in the notes to the financial statements, which may include unliquidated, contingent, or disputed claims filed by creditors. In some cases, such as rejected leases or other contracts, the allowed claim amount might be determined by the Court or through negotiations with the Court. The expected allowed claim amounts may in fact change as the bankruptcy proceedings run their course (e.g., based on actions of the Court) and new or better information becomes available. As the estimates change, the amounts recorded should be updated in the subsequent financial statements. Figure BLG 3-2 illustrates disclosure of a bankrupt entity's liabilities subject to compromise.

Figure BLG 3-2
Sample disclosure (abridged) ¹ – Liabilities subject to compromise

Liabilities subject to compromise represent liabilities incurred prior to the commencement of the bankruptcy proceedings which may be affected by the Chapter 11 process. These amounts represent the reporting entity's allowed claims and its best estimate of claims expected to be allowed which will be resolved as part of the bankruptcy proceedings.

Liabilities subject to compromise consist of the following:

¹ The sample disclosure illustrates an abridged version of what a reporting entity in bankruptcy would disclose for its liabilities subject to compromise. The sample is not meant to be an all-inclusive representation of what information would need to be disclosed. A reporting entity should consider the specific facts and circumstances surrounding its liabilities subject to compromise and disclose accordingly.

Under bankruptcy accounting, liabilities subject to compromise are presented at their 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. This concept is critical in preparing the financial statements of a reporting entity in bankruptcy.

For example, assume a reporting entity files for bankruptcy on June 15. At the time of filing, it owes one of its unsecured creditors $100 for a prepetition trade payable. In preparing its June 30 financial statements, the reporting entity expects that this liability will be an allowed claim in the amount of $100. Based on discussions with its bankruptcy advisors, the reporting entity believes that its unsecured claims will eventually be paid in the "20 cents on the dollar" range. Given these facts, the reporting entity will measure this claim in its June 30 balance sheet within liabilities subject to compromise at its expected allowed claim amount of $100. As mentioned above, expected settlement amounts are not considered for financial reporting purposes until the reorganization plan is confirmed by the Court. The adjustments that take place after confirmation are discussed in BLG 4.4.2.

If the allowed claim is later adjusted by the Court on December 15 to a revised allowed claim amount of $70, the reporting entity would present the allowed claim at $70 in its December 31 balance sheet. The $30 adjustment would be recorded as a reorganization item in the income statement for the period ended December 31. Reorganization items are discussed later in this chapter.

Figure BLG 3-3 illustrates the changes that a prepetition liability may encounter as the bankruptcy proceeding evolves.

Figure BLG 3-3
Liabilities subject to compromise during a typical bankruptcy proceeding

¹The expected amount of the allowed claim may differ from the expected settlement amount.

Obligations (or liabilities) not subject to compromise are prepetition obligations that are fully secured and are expected to be settled in full. These liabilities are recorded under the GAAP that would apply outside of bankruptcy and presented in the financial statements as they were before the filing of the petition.

ASC 852-40-45-7 addresses liabilities that may change classification as the bankruptcy evolves.

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 that liability to a liability subject to compromise. On the other hand, 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 since, by definition, the claim is no longer subject to compromise. For example, if at an interim hearing, $40 of a debtor's $100 liability to a vendor is approved for payment, $40 of the liability should be reclassified from liabilities subject to compromise. The remainder would continue to be classified as subject to compromise. This specific change is supported by the activity of the Court and is not based on management intent.

In BLG 1, the legal concept of impairment of claims was discussed. Regardless of whether creditor claims are presented in the reorganization plan as impaired or unimpaired, the classification on the balance sheet is generally determined by whether the claim is a pre or postpetition liability and whether it is subject to compromise based on the extent of any security.

Although the definitions of impairment and subject to compromise are similar, the classification of a claim as impaired or unimpaired in a reorganization plan reflects only the debtor's intent until the plan is confirmed. The eventual determination of how these claims will be resolved is made when the plan is confirmed by the Court. As such, the debtor's treatment of a liability in the reorganization plan does not necessarily reflect whether the claim should be classified as subject to compromise. In most cases, claims that are not fully secured have an element of uncertainty regarding whether they will ultimately be confirmed as unimpaired. As a result, these claims would usually be presented in the financial statements as liabilities subject to compromise and would remain in this category until the plan is confirmed or the Court otherwise approves their payment during the proceedings.

Example BLG 3-1 illustrates the accounting treatment for Court-approved payments of certain prepetition liabilities while a reporting entity is in bankruptcy.

EXAMPLE BLG 3-1
Treatment of Court-approved payments

During the initial hearings of Company T's Chapter 11 bankruptcy on December 20, 202X, the Court approved certain payments for some of the reporting entity's key suppliers. These suppliers provide key materials and services that the reporting entity needs to operate its business during the proceedings to preserve the value of the estate. The Court approved payments of 75% of the prepetition liabilities for these key suppliers with payments to be made on January 10 of the following year. The remaining 25% of the suppliers' claims will continue to be represented as allowed claims against the reporting entity.

How should Company T present these liabilities in its December 31, 202X balance sheet?