As a result of the persistent poor economy, more companies are filing for reorganization under Chapter 11 of the U.S. Bankruptcy Code. So-called “fresh start” accounting is available for many of them. New accounting pronouncements, however—principally new rules for business combinations and fair-value measurements—have made the application of fresh-start accounting even more complicated than ever.

Fresh-start accounting begins with Accounting Standards Codification Topic 852, Reorganizations. The concept of a fresh start allows a company that has undergone a legal reorganization essentially to erase its prior accounting records and start anew, by establishing a new basis of accounting for all (or most) individual assets and liabilities and new accounting policies appropriate for a new company. The whole idea is based on the notion that the reporting entity that emerges from a reorganization is a brand new company wholly separate from its predecessor, even though it may survive in legal name and form.

You can adopt fresh-start accounting upon emergence from Chapter 11 if both the balance sheet is considered insolvent (that is, the reorganization value of the assets of the new entity is less than the sum of the post-petition liabilities and allowed claims), and the shareholders before the bankruptcy filing lose control of the entity by receiving less than 50 percent of the voting shares of the emerging entity. If those two conditions are met, a new reporting entity is born, and assets and liabilities would be recorded at their fair value.

A company would next apply the guidance in ASC 805, Business Combinations, to assign the reorganization value to the entity’s assets and liabilities. Applying fresh-start accounting will likely increase differences between the values used for accounting purposes and those used for tax purposes. That means deferred taxes would be reported in accordance with ASC 805-740, Business Combinations-Income Taxes, any forgiveness of debt would be accounted for in accordance with ASC 225-20, Income Statement-Overall, and disclosures would be prepared in accordance with ASC 852-10-50, Reorganizations-Overall Disclosures.

All this brings us back to our friend, fair-market value. As you probably know by now, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” ASC 820, Fair Value Measurements and Disclosures, establishes a fair-value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels:

Level 1. Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date. Most reliable measure of fair value and should be used whenever available.

Level 2. Quoted prices for similar assets or liabilities in active markets. Quoted prices for identical or similar assets in inactive markets (few transactions, prices are not current, price quotations vary, little public information). Observable inputs such as interest rates, yield curves, volatilities, prepayment speeds, credit risks, default rates, and so forth. Market-corroborated inputs.

Level 3. Unobservable inputs.

This new approach to measuring fair value has created new challenges in applying fresh-start accounting. The rules do not permit entities to consider management’s plans for assets and liabilities to be re-measured to fair value. Fair value is dependent on an “exit” price notion, where you determine value based upon what an asset would fetch when sold to market participants or what cost you would incur to transfer a liability.

Additionally, fair value of the assets would be based on their highest and best use by market participants, without considering how the company intends to use the asset. For example, an intangible such as a trademark would be assigned a value based on a market participant’s highest and best use of that intangible, even if the company has no intention of using the trademark.

This will also include valuing potential assets that may not be included on the balance sheet at the time of bankruptcy. For example, the fair value of technology or company brands might be recorded on the opening balance sheet for the very first time—and they must be recorded at the value a market participant would assign them based on their highest and best use. Management’s intent is irrelevant.

Other new intangible assets could include in-process research and development, customer relationships, and favorable contracts. To minimize future impairment problems, you must consider segments and reporting units when allocating fair value, since that allocation could affect future impairment accounting. Management should keep in mind that net income will be affected by new asset valuations and useful life estimates. Assets and liabilities may also be moved among entities as reorganizations occur and new business units are possibly created.

Additionally, a new company might be required to record goodwill on the opening balance sheet. Further complicating the determination of the reorganization value is that some accounts, such as employee benefit and income tax-related accounts, may be recorded under specific accounting requirements rather than at fair value. This residual difference between the amounts required under Generally Accepted Accounting Principles and fair value can give rise to goodwill.

Determining “stub period information,” recording transactions to the sub-ledgers, and establishing new reporting entities are some additional challenges companies may face. Fresh-start revaluation is applied to the entire corporation, including subsidiaries that may not be part of the bankruptcy filing. The fair value of assets and liabilities would be “pushed down” to those subsidiaries for purposes of consolidation with the new entity. The individual subsidiaries, however, may still have statutory and other reporting requirements, which may require that they keep two sets of books: one for the new consolidated entity, and one for the subsidiary’s own legal reporting requirements.

A bankrupt company will look much different from the emerging company. Fresh-start accounting gives companies coming out of a Chapter 11 a chance to continue business with a newly valued balance sheet and less debt. Coordinating all of the elements that need to come together as of the fresh-start reporting date is very complex. Timelines are usually very tight, so it is critical to coordinate all of the pieces that need to come together on the fresh start reporting date. These include ongoing valuation, systems, tax, process, and control and reporting issues. Disclosures are numerous and detailed. Additionally, as the fair values are determined, companies may be continually “re-testing” prior to the reorganization date, to determine that they still meet the insolvency test and qualify for fresh-start accounting. Further complicating this effort is that the reorganization value is generally “negotiated” among the various constituents, including the creditors and holders of equity interests, and rests on ultimate court approval of the reorganization value.

Estimates must be made for those claims that remain contingent, unliquidated, or disputed. The process for determining these estimates must be well documented and controlled. Subsequent changes in estimates would be included in net income for the period when the adjustment is determined. Therefore, accurate estimates of these claims are critical to the opening balance sheet.

Disclosures are required for all financial statements presented in a four-column format. First come the predecessor entity balances, then the adjustments for the reorganization plan, followed by fresh-start reporting adjustments, and finally the successor entity balances. Each column must be audited.

The past few years have been a “perfect storm” in creating as much complexity as possible for companies emerging from bankruptcy and applying the concepts for fresh-start accounting. These companies are already likely in distress, making the valuation issues associated with the new fair-value measurements requirements that much harder. None of this is easy—but then, going bankrupt and emerging anew isn’t supposed to be.

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