Insolvency and Secured Transactions

Pre, During and Post Bankruptcy: Financial Reporting to Be Mindful of at Each Stage

Author: Gino Scipione

After a wild spring, the financial disruptions created by COVID-19 are leading to some concerning outcomes for businesses. Even with the assistance of state and federal funding for businesses — and whether or not companies have highly leveraged capital structures — more restructurings and bankruptcies to avoid default are on the horizon for companies in many of the hardest hit sectors. Those could include travel, transportation, energy, and discretionary retail and manufacturing.

While there are many balls to juggle during these challenging times, accounting and financial reporting still remains very relevant given the environment in which all of us are operating. Below explains some of the general accounting principles of bankruptcy and restructuring accounting — pre, during and post — for companies that prepare financial statements under U.S. GAAP.

Financial Reporting Prior to Bankruptcy

A company may file for bankruptcy because of a single negative event, such as an unfavorable litigation outcome or severe adverse financial hit. In other cases, a bankruptcy is led by a slow decline in financial condition and will typically give rise to certain accounting treatment that might not be easily observable when a company is profitable. Some of those considerations are outlined below.

Impairments
Generally, a bankruptcy filing is not the first triggering event for an impairment assessment. Asset impairments and triggering events usually come well before a bankruptcy filing given the financial decline that a company typically faces, which may also be occurring throughout the broader industry in which it operates. Impairments are usually associated with declines in the company's cash flows from operations and a corresponding decline in the fair values of underlying assets.

Disposal Activities, Exit Costs and Restructuring
Companies may decide to exit or restructure existing businesses, including terminating employees, to improve profitability and liquidity. The recognition of costs for employee terminations, for example, is affected by the type of termination as well as any future service requirements associated with termination benefits to be paid. Because different types of termination arrangements may fall within the scope of various sections of the accounting standards with differing measurement and reporting criteria, it is important to understand the guidance that applies in the specific situation.

Debt
Given the negative financial conditions usually associated with companies moving toward bankruptcy, companies might violate covenants (financial and nonfinancial) in existing debt arrangements. For example, when a covenant violation is triggered, the debt may become technically due on demand. Under accounting guidance for debt, these obligations may need to be classified as current unless the lender has waived or subsequently lost the right to demand repayment for more than a year from the balance sheet date. Also, companies that have violated a covenant but obtained a waiver at period-end should consider whether they will continue to meet the covenant in future periods. If a future violation is probable, the debt would be classified as a current obligation. Companies should be aware of the disclosure requirements associated with debt covenant violations and waivers. This would include disclosure in the notes of the financial statements about the circumstances and amounts regarding any default of principal, interest, sinking fund or redemption provisions, or breach of contract that has not been subsequently cured.

Income Taxes
The financial difficulties a company may experience prior to a bankruptcy filing may have certain income tax accounting consequences, particularly with respect to management’s assertions regarding indefinite reinvestment of foreign subsidiaries, long-term investment nature of intercompany loans, recoverability of investments in domestic subsidiaries and valuation of deferred tax assets.

Disclosures of Risks and Uncertainties
ASC 275 requires entities to disclose information about risks and uncertainties in their financial statements in the following areas:

  1. Nature of operations
  2. Use of estimates in the preparation of financial statements
  3. Certain significant estimates
  4. Current vulnerability resulting from certain concentrations

An estimate should be disclosed when known information available before the financial statements are issued (or are available to be issued for private companies), indicating that the following criteria are met:

  1. It is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events.
  2. The effect of the change would be material to the financial statements.

Companies considering a bankruptcy filing face unique challenges from an operational and financial perspective. Entities should consider disclosure of these difficulties and the potential for a bankruptcy filing under ASC 275. This could include the state of the operations and any restructuring or exit activities initiated to increase liquidity.

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