Prepetition liabilities are settled by the debtor in accordance with the reorganization plan approved by the Court. A creditor may receive cash, equity or debt securities in the emerged entity, or a combination thereof in settlement. Any difference between the fair value of the consideration the creditor receives and the allowed claim amount should be recognized in the statement of operations of the predecessor as a reorganization item. Any future obligations to be paid by the emerged entity are recorded as liabilities at fair value in the application of fresh-start reporting.

Adjustments for the effects of the reorganization plan include settlement of prepetition liabilities discussed in earlier chapters of this guide. Liabilities incurred to settle prepetition balances are recorded at fair value taking into consideration the settlement terms of the reorganization plan. For example, assume under the reorganization plan that a $70 allowed claim is settled for future cash payments that have a fair value of $40. The reorganization adjustments upon confirmation would include a $30 gain for this particular liability ($70 allowed claim less the fair value of future payments of $40).

Entities emerging from bankruptcy will often adjust their pre-existing deferred revenue balances. Deferred revenue recorded at emergence should relate to a performance obligation of the reporting entity that will continue to exist upon emergence from bankruptcy, such as an obligation to provide goods, services, or the right to use an asset. The liability should be recorded at fair value similar to other liabilities recognized upon emergence. Fresh-start adjustments to the carrying value of liabilities should be recorded as a reorganization item. See FV 7.3.3.6 for further discussion of fair value adjustments to deferred revenue.

If post-retirement benefit plans are amended as part of the reorganization plan, the effects of changes to the plans should be included in determining the accumulated post-retirement benefit obligations of the fresh-start reporting entity. The net gain or loss resulting from the adjustment, settlement, or curtailment of the benefit obligations or assets required by the plan of reorganization should be reported separately as a reorganization item by the predecessor. The measurement of the plan obligation and plan assets should be based on current assumptions (such as discount rate and expected long-term rate of return on plan assets) as of the emergence date. Planned or anticipated changes to benefit plans that are not part of the reorganization plan would be accounted for prospectively.

Prior to the issuance of ASC 805, Practice Bulletin 11, Accounting for Preconfirmation Contingencies in Fresh-Start Reporting (PB 11), provided specific guidance on the accounting for contingent assets and liabilities at the time of plan confirmation. In most cases, these items are estimated as of the fresh-start adoption date since these items are considered during the bankruptcy process and the interested parties implicitly have determined their value in connection with developing the reorganization plan. After application of fresh-start reporting, if the actual settlement of the contingent asset or liability differed from the estimate, the adjustment was recorded in the statement of operations of the emerged entity and not as an adjustment to the opening balance sheet. While ASC 805 nullified PB 11, we believe such adjustments would still continue to be recorded in the statement of operations in the period following emergence.

It is not uncommon for multiple classes of securities (e.g., preferred stock, common stock, or options and warrants thereon) to be issued in conjunction with a reporting entity's plan of reorganization. The fair value of each security should be determined considering the reporting entity's enterprise value. A proper determination of value for each class of security is important because the accounting for subsequent equity transactions could be influenced by the initial determination of fair value (e.g., subsequent issuances of share-based awards to employees).

Retained earnings, or accumulated deficit, is zero for the newly emerged entity. In addition, accumulated other comprehensive income (AOCI), including the cumulative translation adjustment, is zero upon emergence. Adjustments to the components of AOCI generally should be recorded through the statement of operations, consistent with the impact of applying fresh-start reporting to the respective assets or liabilities which gave rise to the component of other comprehensive income. Each component of AOCI should be carefully assessed to ensure appropriate treatment.

Example BLG 4-2 has been prepared to illustrate a four-column presentation, including reorganization and fresh-start reporting adjustments, for a simplified fact pattern.

EXAMPLE BLG 4-2
Example of reorganization and fresh-start reporting adjustments

Assume the following facts:

Note that the gain recorded on emergence would be $1,400, which reflects the gain on settlement of liabilities subject to compromise of $500 and the adjustments from adopting fresh-start reporting of $900.

Question BLG 4-3 illustrates lease considerations for entities applying fresh-start reporting.

Entities emerging from bankruptcy should assess changes to existing leases as a result of court-approved modifications to the lease terms. If the terms of a reporting entity's lease agreements have been modified during the reorganization process, the reporting entity should reassess the classification of any such lease on the date of the modification. Upon emerging from bankruptcy, a reporting entity should not otherwise reassess the classification for each of its lease agreements, which is consistent with the guidance for a business combination. See BCG 4.3.3.7 for further discussion of the treatment of lease agreements in a business combination. LG 5 addresses the accounting for modifications, including termination, of a lease contract under the new leases standard, ASC 842, which updated the previous guidance under ASC 840. It also addresses the accounting for lease remeasurements for events that are not modifications.

When accounting for a lease acquired in a business combination in accordance with ASC 805-20-25-8, the classification of a lease contract is based on the contractual terms at the inception of the contract, unless the contract has been significantly modified. A reporting entity emerging from bankruptcy should continue to classify its leases in the same manner it did prior to entering into bankruptcy unless the modifications to the agreement made as a result of the reorganization plan are deemed to constitute a new agreement.

Changes in classification and modifications made to leases that existed prior to bankruptcy should be reflected in the predecessor final statements. In accordance with the guidance in ASC 852-10-45-21, the effects of the adjustments on the reported amounts of individual assets and liabilities resulting from the adoption of fresh-start reporting are reflected in the predecessor entity's final statement of operations. When a reporting entity concludes that a lease modification resulting from its reorganization plan should be accounted for as a new lease, the new lease should be recorded as of the modification date when approval is received from the court.

Assets and liabilities associated with leases should be recognized as of the date of emergence at fair value in accordance with the provisions of ASC 805.

In a typical bankruptcy proceeding, where a reporting entity is insolvent, the pre-bankruptcy share-based compensation awards are usually worthless and canceled by the Court along with the reporting entity's outstanding shares. In this scenario, the awards are accounted for as a cancellation with no replacement awards pursuant to ASC 718-20-35-9. Accordingly, the predecessor recognizes any remaining unrecognized compensation expense related to the canceled awards and generally will recognize a deferred tax asset to the extent of the book compensation expense recorded, which likely will be accompanied by an increase in a related valuation allowance.

The cancellation of the awards results in a write-off of the deferred tax asset and the related valuation allowance. A shortfall results because the tax deduction (which is zero) is less than the book compensation expense (which is not reversed). Write-offs of deferred tax assets, net of any valuation allowance, are charged to the statement of operations.

New share-based compensation awards granted to employees by the emerging entity should be accounted for as new awards in accordance with ASC 718. When new awards of the successor entity are granted, prior to its emergence from bankruptcy the reporting entity should consider whether any compensation cost should be attributed to the predecessor period. Compensation cost is generally recognized over the requisite service period, which begins with the service-inception date. Typically, the service-inception date is the same as the grant date. However, the service-inception date could precede the grant date when the criteria from ASC 718-10-55-108 through ASC 718-10-55-109 are satisfied. See SC 2.6.4 for additional information.

When fresh-start reporting is applied, deferred taxes are recorded to reflect differences between fair values and tax bases of the assets and liabilities, similar to a business combination. A deferred tax asset is also established for any loss or tax credit carryforwards. In the unusual circumstance that tax-deductible goodwill exceeds the book goodwill recorded through the allocation of reorganization value, a deferred tax asset is recorded for the excess tax basis through an adjustment to goodwill, using a simultaneous equation to determine the gross-up deferred tax asset. However, if book goodwill exceeds tax-deductible goodwill, no deferred tax liability is recorded. A valuation allowance is recognized for net deferred tax assets if realization is not considered more likely than not (a likelihood greater than 50 percent) based on all available evidence.

Bankruptcy plans of reorganization often create ownership changes pursuant to Section 382 of the Internal Revenue Code. In general, Section 382 imposes an annual limitation on a corporation's use of its net operating losses, certain built-in losses, and credit carryforwards if there has been more than a 50% change in ownership of the corporation's stock. The annual limitation, however, may not apply to a corporation emerging from a bankruptcy or similar proceedings. Specifically, if the emerging corporation meets the following criteria it is eligible to elect to not have the Section 382 limitation apply: (1) immediately before the change, the corporation is under the jurisdiction of the Court in a Chapter 11 or similar case and (2) the shareholders and creditors of the corporation immediately before the change (i.e., the predecessor) own 50% or more of the stock, in vote and value, of the reorganized corporation after the change (i.e., the successor). In these circumstances, the amount of the net operating losses and credit carryforwards may be recomputed to exclude certain interest deductions and other adjustments previously reported by the predecessor. However, if an ownership change occurs within two years of the date the reporting entity emerges from bankruptcy, the losses and carryforwards will be effectively eliminated. If a corporation does not meet the eligibility criteria or is eligible but elects to apply the Section 382 limitation, the limitation is determined using a modified calculation. In particular, the equity value of the corporation (the basis for calculating the limitation) is measured after the reduction of creditors' claims in the reorganization.

Consideration should also be given to the assessment of the valuation allowance for deferred tax assets that are recorded in fresh-start reporting. It may be necessary to consider the extent to which the weight of available evidence provides assurance that the reorganized enterprise will have future taxable income from sources other than reversals of temporary differences. This is a significant area of judgment and the analysis should focus on the post-reorganization outlook of the reporting entity.

Similar to the guidance under ASC 805, the post-confirmation release of a valuation allowance established in fresh-start reporting is recorded in earnings (subject to the intraperiod allocation principles of ASC 740, Income Taxes). Likewise, subsequent adjustments to liabilities or benefits for uncertain tax positions generally are recorded in earnings. Other tax considerations, such as a reporting entity's indefinite reinvestment assertion for foreign earnings under ASC 740-30, may be impacted upon the reporting entity's emergence from bankruptcy. For reasons such as these, the effective tax rate may be more volatile in periods following the emergence from bankruptcy.

For tax purposes, a reporting entity generally realizes income from the cancellation of indebtedness (COD) when the indebtedness is satisfied for less than the tax basis in the debt. COD income is excluded from taxable gross income if the cancellation is granted by the Court or is pursuant to a liquidation or reorganization plan approved by the Court. Any COD income excluded from gross income under this bankruptcy exception is generally applied to reduce certain tax attributes and tax basis of the reporting entity in the following order: net operating losses, general business credits, minimum tax credits, capital losses, basis of property, passive activity loss and credit carryovers, and foreign tax credits. Companies can make an election to change the order to instead first reduce the basis of property. In either case, the basis of property is reduced only to the extent aggregate tax bases exceeds total liabilities.

A reduction in tax attributes such as net operating losses or credit carryforwards would result in a write-off of any related deferred tax assets. If a valuation allowance exists against the assets, it would be released. When there is excess COD income after reducing tax attributes, the excess is permanently excluded from the reporting entity's taxable income without ever generating a corresponding attribute reduction. This amount is commonly referred to as "black hole" income. However, black hole income may result in the recognition of a tax liability to the extent it triggers tax on an excess loss account. An excess loss account relates to a parent reporting entity's tax basis in its investment in a subsidiary which may not have previously resulted in a deferred tax liability on the basis that the tax law provided a means through which the tax could be avoided.

However, the specific tax attributes and bases to be reduced are not identified until the end of the tax year that includes emergence from bankruptcy. This is generally considered favorable to the successor because tax attributes and tax bases used to reduce current year taxable income and tax liability are not available for reduction. The appropriate accounting upon emergence for the taxable and deductible temporary difference from the discharge of debt will depend on facts and circumstances.

To account for deferred taxes as part of fresh-start reporting we believe the reporting entity should project taxable income (and other changes in tax attributes) between emergence and the end of the tax year and record deferred taxes based on the attributes and tax bases expected to be in existence at the end of the tax year. This is consistent with the principles of ASC 740 which require the recognition of deferred taxes for the estimated future tax effects attributable to temporary differences. Importantly, ASC 740-270-25-2 requires the use of an Annual Effective Tax Rate (AETR) for purposes of calculating the interim provision (see TX 16.2). This requires an estimate of both ordinary income (or loss) as well as an estimate of tax for the year. If a reporting entity is able to estimate ordinary income (or loss) for purposes of determining the AETR, the impact of that estimate on attributes and tax bases generally should be considered in recording deferred taxes as part of fresh-start accounting. Under this approach, the successor period will only be impacted to the extent that the activity in the successor period is different from the projection at the fresh-start date.

However, in a case where a reporting entity is unable to reliably estimate its successor activity, the reporting entity would record deferred taxes without adjusting for changes in tax attributes and tax bases estimated to occur by the end of the tax year. This approach will likely result in a larger impact to the effective tax rate in the successor period than if the reporting entity had utilized projections to determine the attribute reduction at the fresh-start date.

The true-up of the deferred tax amount at the end of the tax year would generally be recorded in the financial statements of the successor entity to the extent it represents a change in estimate.