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According to ASC 852-10-45-20 and ASC 852-10-45-21, adjustments are made in the predecessor accounts upon emerging from bankruptcy and adopting fresh-start reporting.

Excerpt from ASC 852-10-45-20

Entities that adopt fresh-start reporting in conformity with the preceding paragraph shall apply the following principles:
  1. The reorganization value of the entity shall be assigned to the entity's assets and liabilities in conformity with the procedures specified by Subtopic 805-20. If any portion of the reorganization value cannot be attributed to specific tangible or identified intangible assets of the emerging entity, such amounts shall be reported as goodwill in accordance with paragraph 350-20-25-2.
  2. Deferred taxes shall be determined under the requirements of paragraph 852-740-45-1.

ASC 852-10-45-21

The financial statements of the entity as of and for the period immediately preceding the date determined in conformity with the guidance in paragraph 852-10-45-17 shall reflect all activity through that date in conformity with the guidance in paragraphs 852-10-45-1 through 45-16. Additionally, the effects of the adjustments on the reported amounts of individual assets and liabilities resulting from the adoption of fresh-start reporting and the effects of the forgiveness of debt shall be reflected in the predecessor entity's final statement of operations. Forgiveness of debt, if any, shall be reported as an extinguishment of debt and classified in accordance with Subtopic 220-20. Adopting fresh-start reporting results in a new reporting entity with no beginning retained earnings or deficit. When fresh-start reporting is adopted, the notes to the initial fresh-start financial statements shall disclose the additional information identified in paragraph 852-10-50-7.

The emergence from bankruptcy and adoption of fresh-start reporting are generally displayed in the footnotes using a four-column format that presents (1) the balance sheet just prior to confirmation of the plan, (2) reorganization adjustments, (3) fresh-start adjustments, and (4) the closing balance of the predecessor company, which becomes the opening balance sheet of the successor entity. The typical format is illustrated in Example BLG 4-2.
The predecessor's final statement of operations should reflect the impact of adopting fresh-start reporting and the recognition of reorganization items. The statement will include the effects of adjustments to individual assets and liabilities, forgiveness of debt, and separately, any related tax effects. While ASC 852-10-45-21 explicitly requires the effects of adjustments of assets and liabilities resulting from the application of fresh-start reporting to be reflected in the statement of operations, it does not provide guidance on how adjustments to equity should be recorded. Typically as part of its emergence from bankruptcy, the predecessor company's equity will be cancelled and new equity of the successor company will be issued. We believe the cancellation of predecessor equity (i.e., capital stock) in fresh-start reporting generally should be recorded as a direct adjustment to equity and should not be reflected in the predecessor's final statement of operations.
The impact of emerging from bankruptcy and adopting fresh-start reporting on significant areas of the balance sheet is discussed below.

4.4.1 Assets (bankruptcy emergence)

The reorganization value of the reporting entity should be assigned to the reporting entity's assets similar to acquisition accounting (ASC 805, Business Combinations), which generally involves recording the assets at fair value. The recognition of identifiable intangible assets could result in previously unrecognized intangible assets being recorded. Appropriate consideration should be given to the period of benefit of the intangible assets and pattern of consumption (i.e., useful life and method of amortization). If a portion of the reorganization value cannot be attributed to specific tangible or identified intangible assets of the emerging entity, that amount should be recorded as goodwill. Adjustments to the carrying amount of assets as a result of the application of fresh-start reporting should be recorded through the predecessor's statement of operations as reorganization items.
While acquisition accounting under ASC 805 is used to apply fresh-start reporting, an important distinction is that in fresh-start reporting, the adjustment to record the reporting entity’s net assets to their respective fair values is recorded in the predecessor’s statement of operations as a “fresh-start adjustment.” In a business combination, the acquirer records the target’s assets and liabilities assumed at fair value, and any difference between these amounts and the target’s carrying amounts would not result in an adjustment to the acquirer’s income statement.

4.4.2 Liabilities (bankruptcy emergence)

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 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.

4.4.3 Preconfirmation contingencies (bankruptcy emergence)

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.

4.4.4 Equity (bankruptcy 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 of reorganization and fresh-start reporting adjustments
Assume the following facts:
  • At the time of confirmation, liabilities subject to compromise payable to various lenders were determined to be $3,400
  • The reorganization plan, as confirmed by the Court, calls for the issuance of shares of the successor's common stock to the Reporting Entity's former lenders (i.e., its liabilities subject to compromise) in satisfaction of the claims for these debts. The enterprise value of the emerged entity, as confirmed by the Court, is $2,900. The reorganization value is $3,500
  • The predecessor's common stock will be cancelled upon confirmation
  • The Reporting Entity hired a valuation firm to assist in the determination of fair values for the assets and liabilities of the emerged entity
  • For ease of illustration, the tax impacts of adopting fresh-start reporting have been ignored

Reorganization adjustments
Fresh-start adjustments
Accounts receivable
Property, plant, & equipment
600 2
100 2
Intangible assets
200 2
Total assets
Accounts payable
Accrued liabilities
Liabilities subject to compromise
(3,400) 1
Total liabilities
Predecessor common stock
(10) 3
Predecessor additional paid-in capital
(690) 3
Successor common stock
100 1
Successor additional paid-in capital
2,800 1
Retained earnings (accumulated deficit)
500 1
1,600 4
Total stockholders' equity (deficit)
Total liabilities and stockholders' equity
(1) Reorganization adjustments reflect the discharge of $3,400 of liabilities subject to compromise in accordance with the plan of reorganization as follows:
Liabilities subject to compromise
New common stock and paid-in capital issued to satisfy lender claims
Gain on settlement of liabilities subject to compromise
(2) Fresh-start adjustments to PP&E, goodwill, and intangible assets reflects the adjustment of the assets of the successor to their fair values, including intangible assets not previously recognized:
Property, plant & equipment
Goodwill (excess of reorganization value above identifiable assets)
Total asset adjustments
(3) Fresh-start adjustments to predecessor common stock and APIC reflect the cancellation of the predecessor's common stock. In practice, it is commonly accepted to reflect the cancellation of predecessor equity as a reorganization adjustment.
(4) Fresh-start adjustment to retained earnings (accumulated deficit) resets accumulated deficit to zero.

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.
The first three columns of the table above represent accounting by the predecessor in the period just prior to emergence. The fourth column represents the opening balance sheet for the successor after the adoption of fresh-start reporting. It should be noted that the total assets on the opening balance sheet are equal to the reorganization value. Equity of the new reporting entity equals the enterprise value since the new reporting entity does not have any interest-bearing debt.

4.4.5 Leases (bankruptcy emergence)

Question BLG 4-3 illustrates lease considerations for entities applying fresh-start reporting.
Question BLG 4-3
When applying fresh-start reporting, should a reporting entity reassess the classification for each of its lease agreements (i.e., capital and operating)?
PwC response
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 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.

4.4.6 Share-based compensation (bankruptcy emergence)

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.

4.4.7 Taxes (bankruptcy emergence)

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.

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