Page 124 - Bankruptcy Volume 1

Debt Exceeds Reorganization Value

To satisfy the first requirement, the prepetition claims stated at the estimated amount of the allowed
claim and postpetition liabilities must be greater than the business’ going-concern value. Note that pre-
ferred stock that is not considered equity for financial statements purposes is considered equity in this
test because the preferred equity is not a claim for bankruptcy purposes.

Liabilities reflected on the financial statement that do not represent claims should be excluded (for ex-
ample, deferred taxes or capital lease obligations for assumed leases in excess of any administrative
claim that would result in the event of a conversion to Chapter 7). Liabilities that have a carrying value
different from the allowed claim must be adjusted before the test is applied. In addition, unrecorded con-
tingent liabilities must be considered based on the likelihood of liability and the related probabilities (see
also the discussion related to liabilities in chapter 9, "Financial Reporting During the Reorganization").

The FASB master glossary defines reorganization value as "the value attributed to the reconstituted enti-
ty, as well as the expected net realizable value of those assets that will be disposed of before reconstitu-
tion occurs." Therefore, this value is viewed as the fair value of the entity before considering liabilities
and approximates the amount a willing buyer would pay for the assets of the entity immediately after the
restructuring. The focus in determining the reorganization value is on the value of the assets, normally
determined by discounted future cash flows. The reorganization value, however, is not generally deter-
mined by one approach but by several depending on the circumstances. fn 2 For example, in cases in
which the discounted cash flows are used to determine the value, the results may be validated by the use
of the capitalization of earnings. Accountants should realize that in most cases their responsibility is not
to determine the reorganization value of the debtor, but to report in the financial statements the value de-
termined through negotiations among the debtor, secured parties, official committee(s), and other inter-
ested parties. However, the accountant should understand the transaction and the basis upon which the
resulting values were determined.

Professionals involved in bankruptcy cases are aware of the limitations on the usefulness of book values.
For example, information on market values is sought in the schedules of a debtor’s assets and liabilities
that are filed with the bankruptcy court. Value determined in light of the purpose of the valuation and
the proposed disposition of property is the standard for determining secured status under Section 506 of
the Bankruptcy Code.

Change in Control

With regard to the second requirement — holders of existing stock fn 3 retain less than 50% of the voting
stock — FASB ASC 852-10-45-19 states that the loss of control by the holders of existing voting shares
immediately before confirmation contemplated by the plan must be substantive and not temporary.
Thus, the new controlling interest must not revert to the shareholders existing immediately before the
plan was confirmed. For example, a plan that provides for shareholders existing prior to the confirma-
tion to reacquire control of the company at a subsequent date may prevent the debtor from adopting

fn 2 For a discussion of the approaches to determining reorganization values, see Grant W. Newton, Bankruptcy and Insolvency Ac-
counting, vol. 1, Practice and Procedure, 7th ed. (New York: John Wiley & Sons, Inc., 2009), chapter 11.

fn 3 For purposes of this test, dilutive instruments such as warrants and options are disregarded, as those instruments have not been
exercised and will generally be cancelled as part of a plan of reorganization.

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