Imagine this: After dreaming of a fantastic new concept, you and some friends decide to bring the idea to life by opening a restaurant. That restaurant grows into two restaurants, which turns into three restaurants and eventually into twenty locations within five years. Despite struggling to make ends meet after making the initial investment, you and your partners achieve strong growth and profitability in your restaurants. Unfortunately, over time, competitors crowd into the market, which starts to dig into the business’ top and bottom lines. This trend continues at an accelerated rate, foot traffic declines, and you are left with no other choice than to file for bankruptcy–the unfortunate byproduct of an often volatile industry characterized by fierce competition.
In the aftermath of the bankruptcy decision, the accountant is left to determine the appropriate accounting treatment. Under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 852-10 (ASC 852-10), Reorganizations, one must consider several criteria to determine the appropriate approach to accounting for bankruptcy. Under ASC 852-10, an entity must apply fresh-start reporting upon emergence from bankruptcy if it meets two criteria:
- The reorganization value of the emerging entity immediately before the date of confirmation is less than the total of all post-petition liabilities and allowed claims, which is sometimes referred to as being “balance sheet insolvent;” and
- The holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity.
For entities that do not qualify for fresh-start reporting, the effects of the bankruptcy are recorded through their financial statements, and a new accounting entity is not created. In this case, the following guidance should be applied and recorded at the confirmation date:
- Debt discharge is recorded as an extinguishment of debt, in accordance with applicable accounting guidance (FASB ASC 470, Debt);
- Liabilities that were compromised under the bankruptcy process are recorded at present value of amounts to be paid, with any resulting gain being recorded as a reorganization item;
- Asset values are not adjusted to fair value; and
- Retained earnings or deficit are not reset to zero.
The resulting gain from the extinguishment of debt and the compromise of liabilities is typically classified in accounting as a reorganization item outside of income from operations.
While business owners hope the initial decision to open a restaurant will lead to nothing but prosperity, the fiercely competitive restaurant industry landscape dictates that this is often not the reality. Knowing the accounting ramifications of bankruptcy decisions is important to ensure appropriate records are being kept.