The coronavirus pandemic has burdened many companies with adverse financial conditions, including a significant reduction of revenue and cash flows, a need for liquidity, increased leverage, and employee layoffs and furloughs.
As a result, many companies had to raise capital and liquidity through the debt and equity markets, while others face financial distress that may ultimately lead to bankruptcy and reorganization. Entities that enter Chapter 11 bankruptcy protection in the United States need to develop, negotiate, and confirm a plan of reorganization with their creditors and the bankruptcy court. As part of Chapter 11 proceedings, the debtor must prepare for review and approval of various documents including, but not limited to, disclosure statements, interim financial statements, business plans of core and noncore operations with details of financial projections, valuation analyses that will form the basis of the “reorganization value,” and a liquidation analysis.
Going through the bankruptcy process requires specialized knowledge and experience with valuation, accounting, tax, and legal matters.
The reorganization plan: (1) divides the creditors into classes based on the nature of their claims; (2) proposes treatment of each class of claims; and (3) provides the means for the execution of the plan, the goal of which is to ultimately repay the creditors, at least in part, and to have the successor entity be a viable going concern entity. The reorganization plan may involve restructuring of the existing debt, sale of assets, issuance of new instruments, infusion of new investors, or a merger with another entity.
As an entity moves through the bankruptcy process, it must meet certain criteria to qualify, upon emergence, for fresh-start reporting under FASB ASC Topic 852, Reorganizations. Such criteria include the loss-of-control test and the reorganization-value test.
Under the loss-of-control test, Paragraph 852-10-45-19 requires that “holders of existing voting shares immediately before confirmation receive less than 50 percent of the voting shares of the emerging entity” and that “[t]he loss of control contemplated by the plan must be substantive and not temporary. That is, the new controlling interest must not revert to the shareholders existing immediately before the plan was filed or confirmed.” If this does not occur, then the emerging entity does not qualify for fresh-start reporting.
Under the reorganization-value test, Paragraph 852-10-45-19 requires that the reorganization value of the assets of the emerging entity immediately before the date of confirmation be less than the total of all post-petition liabilities and allowed claims. Topic 852 defines reorganization value as “[t]he value attributed to the reconstituted entity, as well as the expected net realizable value of those assets that will be disposed of before reconstitution occurs. Therefore, this value is viewed as the 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.”
Paragraph 852-10-05-10 provides that “[t]he reorganization value of an entity is the amount of resources available and to become available for the satisfaction of post-petition liabilities and allowed claims and interest, as negotiated or litigated between the debtor-in-possession or trustee, the creditors, and the holders of equity interests.”
According to Paragraph 852-10-05-10, “[s]everal methods are used to determine the reorganization value; however, generally it is determined by discounting future cash flows for the reconstituted business that will emerge from Chapter 11 and from expected proceeds or collections from assets not required in the reconstituted business, at rates reflecting the business and financial risks involved.” Paragraph 852-10-05-10 also indicates that “[r]eorganization value generally approximates 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.” However, it may not truly represent fair value given it has been negotiated between “interested parties” in the bankruptcy process versus market participants in the context of Topic 820, Fair Value Measurement.
When estimating the reorganization value using a discounted-cash-flow (DCF) method, it is important to consider the following factors:
- Using forecast periods that extend until the prospective financial information (PFI) normalcy is reached. For example:
- Expected revenue growth rates.
- Changes in the operating cost structure/margins.
- Working/regulatory capital and capital expenditure requirements to sustain future business levels.
- Effective tax rate and specific tax considerations of the emerging entity (e.g., cancellation-of-debt and net operating loss limitations).
- Capital structure of the emerging entity based upon newly issued shares, options, and warrants and restructured debt level.
- Discount rate based on the current risk levels, capital structure, and market inputs.
- Addition of operating current liabilities to the enterprise value to arrive at a reorganization value.
- Current and forecasted economic and industry conditions.
- Impact of divestitures or other transactions should be separately valued and added back to the operating value.
Given the potential significant impact COVID-19 may have on prospective cash flows of a particular company and industry, it is recommended that various probabilistic scenarios and sensitivities of key value drivers over time be analyzed to arrive at the well-thought-out reorganization value, given the level of uncertainty that exists in today’s environment. Furthermore, when estimating the reorganization value, it is important that the preceding factors be considered based on the facts and circumstances that are known or knowable at the valuation date.
Reorganization value can be stated either as a range or a single-point estimate. A range is typically provided given sensitivities of key value drivers consistent with the entity’s emergence from bankruptcy. However, a single-point estimate will be needed to apply fresh-start reporting. A generally accepted valuation methodology of determining a company’s business enterprise value (BEV), or enterprise value, is typically used to derive the reorganization value. BEV represents the value of the underlying operations of a company, equates to the components of invested capital (i.e., long-term capital, including interest-bearing debt and equity capital). Adjustments are considered and made to the BEV, as appropriate, from a consistency perspective, such as the current and long-term non-interest-bearing liabilities, and the value of nonoperating or noncore assets to arrive at the reorganization value.
The Link LonkDecember 08, 2020 at 02:00AM
https://www.journalofaccountancy.com/news/2020/dec/fresh-start-reporting-reorganization-bankruptcy.html
Emergence through fresh-start reporting - Journal of Accountancy
https://news.google.com/search?q=fresh&hl=en-US&gl=US&ceid=US:en
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