Accounting for Pre-petition Liabilities Not Always as Easy as It Sounds

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Oct 2004

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For an entity in
bankruptcy, accounting for pre-petition liabilities sounds like it should
be a relatively easy task. However, when one really digs into it, there are
a number of challenges and situations that result in making what seems like
a straightforward task far more challenging.

Why should it be easy? For starters, the accounting
for pre-petition liabilities while in bankruptcy is not very different from accounting
for liabilities in the ordinary course. Companies are required to maintain
systems and procedures to acknowledge obligations when accounting rules
indicate they should. These systems and procedures encompass estimation,
verification and cut-off. To the extent that the accounting for
pre-petition liabilities is different while in bankruptcy, there is
specific but limited guidance in the accounting literature to provide
direction. For example, AICPA Statement of
Position 90-7, "Financial Reporting by
Entities in Reorganization Under the Bankruptcy Code (SOP 90-7),"
specifically states that "pre-petition liabilities, including those
that become known after the petition is filed, should be reported on the
basis of the expected amount of the allowed claims in accordance with FASB Statement No. 5,
'Accounting for Contingencies'...."<a href="#3" name="3a">3</a> In addition,
there is a claims bar date, which is the last day a creditor can file a
proof of claim for a pre-petition liability. The claims bar date should
make things easier because it provides a firm cut-off date, allowing the
company to define the population of pre-petition claimants. The claims bar
date allows the company to reassess the adequacy of its acknowledged
pre-petition liabilities, at least as to identified claimants, if not
amounts. With few exceptions, if a creditor does not file a proof of claim
by the bar date, the creditor is forever barred from asserting a claim for
a pre-petition liability. This applies whether the claim is a
straightforward accounts payable-related claim or a very complex
litigation-related claim.

So one would think that if there is some accounting
guidance and there is a complete population of claims for pre-petition
liabilities, it should not be all that difficult for an experienced
accountant to do the accounting. However,
accounting for pre-petition liabilities is
much easier said than done. In many cases, a debtor will not file for
bankruptcy at a normal month, quarter or fiscal year end. This results in
the need to perform an accounting cut-off mid-month. Significant additional
processes and procedures may need to be developed to distinguish the
liabilities that fall before and after the bankruptcy filing, especially
for larger companies. More importantly, the claims process can quickly
become very data-intensive and complex. The voluminous and complex nature
of the data makes the application of accounting rules challenging, even for
an experienced accountant.

<h4>Where Claims Come From</h4>

Typically, all of a debtor's known creditors
are listed on the debtor's schedules of liabilities: Schedules D, E
and F. Included in the schedules is the debtor's value of the
pre-petition liability owed to each creditor based on the debtor's
books and records. In many cases, the value is listed as contingent,
disputed and/or unliquidated, depending on the circumstances and the
company's relationship with the party. The schedules are filed with
or shortly after the bankruptcy petition is filed. At some point
thereafter, a bar date is set by the court. When the bar date is set, each
creditor listed on the schedules is mailed a bar date notice and a proof of
claim form. In addition, the bar date notice and proof of claim form are
typically mailed to many other parties who are potential creditors. Other
potential creditors may include, but are not limited to, employees and
former employees, customers and former customers as well as vendors and
former vendors. At the same time, in larger cases, some amount of
advertising of the bar date may take place often in widely read newspapers,
such as The Wall Street Journal and USA Today.

During the period prior to the bar date, any creditor
who disagrees with the amount of liability listed on the schedules or any
creditor who is not listed on the schedules, or whose claim is scheduled as
disputed, contingent or unliquidated, must file a proof of claim or forever
forego the opportunity to make a claim against the debtor.

A second source of claims are those proofs of claim
filed as a result of restructuring activities, such as the rejection of
executory contracts. Depending on the circumstances, executory contracts
may be rejected over the entire period of the bankruptcy, including the
period after the bar date. The rejection of executory contracts has the
effect of creating new pre-petition liabilities. Unless the court order
provides otherwise, the counter-party to a rejected contract is allowed to
file a proof of claim after the bar date for rejection damages, resulting
in additional claims being added to the claims population.

<h4>The Complexities of Claims</h4>

So what is so complex about claims? For starters, the
sheer volume of potential claims presents tremendous challenges. The bar
date deadline combined with the widespread mailing and advertising can lead
to a large number of proofs of claim being filed. In larger cases, it would
not be unusual for there to be thousands, if not tens of thousands, of
proofs of claim filed. In one recent case, because the debtor maintained
separate contractual agreements with each location of its many national and
international customers, the claims process addressed more than 300,000
executory contracts.

Included in this claim population are numerous claims
that the company will ultimately find to be invalid. Nevertheless, each
claim must be reviewed before it can be completely dismissed from an
accounting perspective. Examples of likely invalid claims include various
types of redundant or duplicate claims, claims by equity security-holders
solely to record ownership interest or possession of such equity
securities, and claims by creditors whose liabilities have already been
satisfied. Unfortunately, invalid claims must be identified and excluded
from the population of claims to arrive at a population that more closely
resembles the debtor's true liabilities, for which an accounting
analysis and related adjusting entry may be necessary.

In addition to the volume of claims, there are in
many cases a large number of contingent or unliquidated claims. Some of
these claims are valid and may require accounting recognition. However,
many parties file proofs of claim before there is certainty that an
obligation on the company's part actually exists. For example, the
counterparty to an executory contract may file a proof of claim for
rejection damages before knowing if the applicable contract is going to be
rejected, only to find out later that the contract was assumed. In
addition, proofs of claim are filed by issuers of letters of credit, both
drawn and undrawn, as well as issuers of surety bonds. These types of
claims must also be reviewed and analyzed to determine their validity and
the appropriate accounting recognition, if any.

A third group of claims that result in accounting
challenges are simply disputed claims. These range from complex litigation
and tax disputes to what would seemingly be straightforward trade-vendor
disputes. However, even trade-vendor claims can present some complexities.
For a trade vendor, this is the last opportunity to make a claim for any
unpaid pre-petition invoice, no matter how old. This fact, combined with
any number of other reasons, typically results in a high percentage of
trade creditor claims that are in dispute with the debtor's books and
records. As with the other types of claims, these claims must be reviewed
and analyzed to determine their validity and the appropriate accounting
recognition.

Depending on the circumstances, accounting for
pre-petition claims may be complete when the debtor emerges from
bankruptcy. However, emergence (the effective date of the plan) may not
mean the end of the accounting challenges. It is likely that the overall
resolution of claims will continue post-emergence with some aspects of the
claims process continuing to affect the reorganized company. Depending on
timing, bankruptcy circumstances and the size of the case, a number of
claims will probably be unresolved at emergence. In large cases, a large
number of claims may be unresolved.

The form of the reorganization plan is a significant
factor in determining when a company has put its pre-petition liabilities
and the related accounting and financial reporting behind it once and for
all. In the best-case scenario from a debtor's perspective, a
reorganization plan will provide for the transfer of claims and a fixed
"pot" of value to a reorganization trust upon the
company's emergence from bankruptcy. In such a case, the company must
make a final estimation of the claims it has transferred to resolve its
financial reporting obligations. In all likelihood, the company will have
continued obligations to work with the reorganization trust supplying
historic information and assistance to resolve disputes, but the
"pot" plan and trust protect the reorganized company from
having any continued financial reporting obligation if the claims are
ultimately higher (or lower) than estimated when the transfer to the trust
took place.

Under a reorganization plan that provides a fixed
return to creditors regardless of what size the claims pool is or, in the
case of the reorganized company, retaining the obligation to resolve
claims, the ultimate outcome of adjustments to the estimated claims pool at
emergence could result in adjustments that are recorded in the reorganized
company's post-emergence results of operations.

<h4>Conclusion</h4>

One would think that the accounting for pre-petition
liabilities should be a straightforward task, and in many cases, it is
relatively simple. However, because of the numerous factors that can lead
to significant challenges in the accounting for pre-petition liabilities,
even in bankruptcy cases that do not appear to be overly complex, it is
always best to prepare for the complexities that may arise by careful
planning and staying ahead of the curve, even if the case turns out to be
more easily handled than expected.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Steve Burns
is a managing director in Huron Consulting Group LLC's Corporate
Advisory Services practice who leads Huron's bankruptcy claims
management practice. <a href="#1a">Return to article</a>

<a name="2">2</a> Brian
Linscott is a director in Huron Consulting Group LLC's Corporate
Advisory Services bankruptcy claims management practice. <a href="#2a">Return to article</a>

<a name="3">3</a> AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under
the Bankruptcy Code," Nov. 19, 1990, paragraph 24. <a href="#3a">Return to article</a>

Journal Authors

Brian Linscott

Stephen Burns

Journal Date

Friday, October 1, 2004 - 12:00

Bankruptcy Rule

2004