Question

Holmes Corporation has filed a voluntary petition with the bankruptcy court in hope of reorganizing. A statement of financial affairs has been prepared for the company showing these debts:

Holmes has 10,000 shares of common stock outstanding with a par value of $5 per share. In addition, it is currently reporting a deficit balance of $132,000.

Company officials have proposed the following reorganization plan:

• The company’s assets have a total book value of $210,000, an amount considered to be equal to fair value. The reorganization value of the assets as a whole, though, is set at $225,000.

• Employees will receive a one-year note in lieu of all salaries owed. Interest will be 10 percent, a normal rate for this type of liability.

• The fully secured note will have all future interest dropped from a 15 percent rate, which is now unrealistic, to a 10 percent rate.

• The partially secured note payable will be satisfied by signing a new six-year $30,000 note paying 10 percent annual interest. In addition, this creditor will receive 5,000 new shares of Holmes’s common stock.

• An outside investor has been enlisted to buy 6,000 new shares of common stock at $6 per share.

• The unsecured creditors will be offered 20 cents on the dollar to settle the remaining liabilities.

If this plan of reorganization is accepted and becomes effective, what journal entries would Holmes Corporation record?

Answer 1

The fresh start accounting deals with a company successfully leaving Chapter 11 status as a new entity and has its asset and liability accounts assigned to the said new entity. There are two ways that must be met for assets and liabilities to be adjusted at fair value according to U.S. GAAP standards. These two ways are described below:

• The first way is that the fair value of assets of the new entity must be less than the total value of the claims plus liabilities incurred as of the date of issue on the order for relief.

• The second criterion that must be met is that former members of the voting stock have less than 50 percent of the voting stock after the emergence of the company from the bankruptcy.

The reorganization value of $225,000 is less than the company's allowed debts. Thus, H Corporation has to use fresh start accounting. The original owners hold less than 50 percent of the voting stock after the reorganization.

The journal entries are used to record the financial data or business transactions of a company in a journal such that credits equal debits.

The journal entries for the reorganization plan are provided below:

Account Titles and Explanation	Debit ($)	Credit ($)
Reorganization value in excess of amount allocable to identifiable assets/Goodwill	$15,000
Additional paid in Capital		$15,000
(To recognize goodwill)
Salary Payable	18,000
10% Notes Payable (1 year)		18,000
(To record salary accrued exchanged for notes)
Notes Payable (partially secured)	140,000
Note payable (6 years)		30,000
Common stock		25,000
Additional paid in Capital		6,000
Gain on debt discharge		79,000
(To record exchange of notes payable)
Cash	36,000
Additional paid in Capital		6,000
Common stock		30,000
(To record 6,000 purchased by investor at $6 per share)
Notes payable	50,000
Accounts payable	10,000
Accrued expenses	4,000
Cash		12,800
Gain on debt discharge		51,200
(To record payment of unsecured debts—20% payment made.)
Gain on debt discharge	130,200
Additional paid in capital	1,800
Retained earnings (deficit)		132,000
(To adjust additional paid in capital to appropriate balance)

Workings :

The book values after emerging from reorganization are calculated below:

• The total book value of assets is $248,200 {$225,000 reorganization value plus proceeds of sale of stock of $36,000 less $12,800 payment made to settle unsecured liabilities}

• The total book value of liabilities is.

• The value of common stock is $105,000 (11,000 additional shares are issued with a $5 per share par value. Thus the total outstanding shares are 21,000 @ $5 each)

• The amount of deficit is zero (eliminated by the reorganization)

• The additional paid-in capital is $25,200 (figure needed to balance above accounts after reorganization)