The Nuances of Fair Value in Fresh-Start Accounting
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The Nuances of Fair Value in Fresh-Start Accounting
October 09, 2013
Organizations filing for protection under Chapter 11 of the U.S. Bankruptcy Code are subject to Accounting Standards Codification (ASC) 852, Reorganizations. Under this guidance, certain companies emerging from bankruptcy are required to adopt fresh-start accounting, which calls for the measurement of the fair value of assets and liabilities for the post-emergence entity. Determining the fair value of assets and liabilities for fresh-start accounting can be complex and requires a thorough understanding of the business, its assets and liabilities, industry / economic conditions, as well as the latest best practices in valuation.
While many of the accounting and valuation concepts contained within ASC 852 are similar to those used under the acquisition method for a business combination under ASC 805 (Business Combinations), certain aspects of fresh-start accounting require specific consideration. Such nuances require close coordination among management, independent valuation professionals, external auditors and tax professionals.
Determining Reorganization Value
One of the major differences between accounting for a business combination and fresh-start accounting is the starting point for the analysis. A business combination considers the purchase price as negotiated between unrelated third parties, while fresh-start accounting relies on the concept of reorganization value. ASC 852 defines reorganization value as: the value of the entity before considering liabilities [that] approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring.[1] The reorganization value used in a bankruptcy proceeding is different from business enterprise value. A company's enterprise value represents the fair value of its interest-bearing debt and equity capital, while the reorganization value can be derived from the enterprise value by adding back liabilities non-interest bearing debt.
Capital Structure Considerations
Once the reorganization value has been established, consideration should be given to the capital structure of the entity upon emergence. The restructuring process often gives rise to multiple classes of securities (stock options, warrants, etc.), each with different rights and privileges. As such, the fair value of each security should be determined in the context of the company's overall value. Determining the fair value of share-based payment awards, such as stock options for a company emerging from bankruptcy, presents some unique challenges. This detail is important because the accounting for subsequent equity transactions could be influenced by the initial determination of fair value. Valuation assumptions used in option-pricing models for share options and similar instruments measured on, and subsequent to emergence should be carefully analyzed and evaluated.
Asset Valuations
The approaches and techniques to value intangible and tangible assets for fresh-start accounting are generally similar to those used in accounting for business combinations. The primary intangible assets of a company are generally valued using some form of the income approach, with certain secondary intangible assets valued using an income and / or cost-based approach. Intangible assets commonly valued using the income approach include, but are not limited to, the following: customer relationships, patents and trademarks. The cost approach tends to be used to value such intangible assets as internally developed software and assembled workforce.
Tangible assets are generally valued using either the market approach and / or cost approach. In applying the cost approach, it is common to make adjustments for physical and functional obsolescence for both fresh-start accounting and business combination valuations. However, the existence of economic obsolescence tends to be more prevalent in fresh-start accounting projects given the circumstances surrounding entities filing for bankruptcy. Appropriate quantification of economic obsolescence can require significant input from senior management and operations personnel. Valuation professionals knowledgeable of both financial valuation theory and tangible asset valuation concepts should be actively involved in the process to address this issue.
Assessing Liabilities and Contractual Obligations
Consistent with the accounting for business combinations, the liabilities to be assumed by the new entity also need to be valued as part of the fresh-start process. Any liabilities not settled as part of the bankruptcy process must be recorded at fair value in the application of fresh-start accounting. Certain contractual obligations of the new entity may arise from negotiations between debtors and creditors during the bankruptcy process. In these instances, negotiated terms may not necessarily be reflective of market conditions, and therefore should be adjusted to reflect fair value.
Tax Matters
It is common for companies emerging from bankruptcy to have net operating losses (NOLs). Section 382 of the U.S. Tax Code imposes an annual limitation on a company's use of NOLs if there has been more than a 50 percent change in ownership. Generally, the Section 382 limitations for a company emerging from bankruptcy are calculated using the equity value of the company after reduction of creditors’ claims in the reorganization. Under certain circumstances, the annual limitation of Section 382 can be modified for a corporation emerging from bankruptcy.
Companies emerging from bankruptcy also frequently encounter issues related to cancellation of indebtedness (COD). For tax purposes, a company generally realizes income from COD when the indebtedness is satisfied for less than the face amount of the debt. COD income is excluded from gross income if the cancellation is granted in a bankruptcy.[2] Any COD income excluded from gross income under these exceptions is generally applied to reduce certain tax attributes (NOLs, general business credits, capital loss carry-overs, minimum tax credits, basis in property).
Conclusion
Emergence from bankruptcy provides management a unique opportunity for a “fresh start” with regard to how to operate and manage its business. However, the complexities of the fresh-start accounting process can result in challenges for management, particularly after going through the stresses of a potentially prolonged and contentious bankruptcy process. These factors, along with staff resource constraints and diminished employee morale, can present difficult challenges to overcome in emerging from bankruptcy. Proactive planning and close coordination among management, valuation professionals, independent auditors and tax professionals can help contribute to an efficient process, resulting in supportable and defendable conclusions.
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