With the spike in bankruptcies in recent years, an increasing number of public companies are getting a firsthand lesson in a niche area of Generally Accepted Accounting Principles – the chapter known as “fresh start” accounting.

Companies that reorganize under Chapter 11 of the U.S. Bankruptcy Code are required under the Accounting Standards Codification Topic 852 to remeasure all assets and liabilities for the emerging entity using fair value. It resets the balance sheet to current values by allocating the bankruptcy court's determination of the value of the emerging entity across the new entity's various assets and liabilities.

“It's really purchase accounting,” says Dan Gary, a partner with KPMG who has counseled a number of companies through the process. It's similar to what happens in a business combination, such as a merger or acquisition, where an acquiring or controlling company adds a new entity to its balance sheet by applying fair value to the new entity's various assets and liabilities. In the case of a fresh start for a company emerging from bankruptcy, “it gets amplified, because it's the entire company,” Gary says.

Chapter 11 bankruptcies have skyrocketed in recent years, jumping from 5,736 filings in 2007 to 13,683 in 2009 and 11,774 in 2010, according to U.S. Bankruptcy Court data. That means an increasing number of companies are applying fresh start accounting, putting them on a different footing from an accounting standpoint from their competitors, says Gary. That may lead to concerns about financial statement comparability among otherwise comparable competitors, he says.

“When you look at two companies in an industry, one went through bankruptcy and one did not, they're different,” Gary says. “When you're comparing the companies, they're on a different basis of accounting – one at current fair value and the other at older historical costs. To illustrate the difference, Gary says, consider a manufacturing company emerging from bankruptcy. It may own plants and equipment that were booked at historical cost and amortized over many years to have little or no residual value. Emerging from bankruptcy, they will be measured at fair value.

“Even though it is old, those assets still have value, and they will be stepped up to fair value, which leads to more expense in the future, which makes earnings look worse,” Gary says. The flip side, however, is that the emerging entity will shed a great deal of debt, which reduces interest expense and makes earnings look better, he says.

John Grivetti, a partner with Crowe Horwath, concurs that the financial statements of fresh start companies stacked against continually operating companies may skew their comparability. “The big benefit through bankruptcy is debt reduction,” he says. “You're also going to write up your assets to fair value, or write them down, if you've got significant assets that are worth more or less than your historical amortized cost.”

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