Financial Accounting Valuation – Fresh Start Reporting

Key takeaways:

• Understand how reorganization value determines recoveries and influences business valuation during Chapter 11 emergence.
• You must develop DCF-based forecasts reflecting restructuring costs, tax attributes, market share, seasonality, and working capital.
• Fresh start reporting requires fair value measurement under ASC 852 and court scrutiny of valuation conclusions.
• You should quantify post-petition liabilities and allowed claims to determine shareholder interest recovery prospects.
• Engage valuation professionals experienced in Chapter 11 fresh start reporting to support defensible business valuation.

Increasing numbers of businesses are turning to the U.S. Bankruptcy Code for economic survival. Bankruptcy filings for the year ending June 30, 2022 were 35% higher than the previous year-to-year period ending June 30, 2021. The ongoing challenges in the economy continue to impact individuals and businesses significantly. Within that same time span, Chapter 11 bankruptcies alone witnessed a five percent increase. To successfully navigate the Chapter 11 process, a business is required to present a reorganization plan for court approval. Market participant valuation perspectives can strengthen a reorganization plan's estimates of the emerging entity's value. Emerging from Chapter 11 involves addressing numerous critical issues, such as determining the company's "reorganization value."

Reorganization value generally approximates fair value of the entity before considering liabilities, and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring Reorganization value also addresses the amount of resources currently and potentially available to satisfy post-petition liabilities and allowed claims. It encompasses the sum of the value attributed to the reconstituted entity and other assets of the debtor not included in the reconstituted entity.

The Absolute Priority Doctrine

The Absolute Priority Doctrine provides that if an impaired class does not vote in favor of a plan, the court may confirm the plan under the cram-down provisions of the Bankruptcy Code. The doctrine states that all members of a senior class of creditors must be satisfied in full before the next senior class of creditors can receive anything and, in turn, the next senior class must be fully satisfied before the third senior class receives any value, and so on. In addition, if the amount of post-petition liabilities and allowed claims exceeds the reorganization value of the emerging entity, existing shareholders lose their legal right to any economic interest. That right can only be reinstated with the consent of creditors. Consequently, upon emergence from Chapter 11, the entity is required to adopt fresh start reporting.

Fair value measurement techniques are typically applied to quantify reorganization value for comparison with post-petition liabilities.

Financial Reporting Consequences Under ASC 852

Accounting Standards Codification (ASC) 852 addresses the financial reporting requirements required by U.S. GAAP for fresh start reporting. It requires that the value of the emerging entity be determined using the Fair Value standard and specifically discusses use of the Discounted Cash Flow (DCF) method of valuation.

Key DCF inputs include restructuring costs, tax attribute limitations, terminal residual value, market position, competition, sales growth, profitability, seasonality, and working capital needs.

One of the primary components of the DCF method is the development of forecasted financial statements. When forecasting the outcome of an emerging entity, it would not be good to rely on pre-petition financial statements. A structured valuation process provides practical steps for converting business drivers into forecasted financial statements. The pre-petition entity is likely to be radically different from the emerging entity. Instead, the following elements should be considered:

• • • The costs of corporate restructuring and other operating program changes
    • Limitations on the use of available net operating loss carryovers and other tax attributes resulting from the reorganization plan and other events
    • The anticipated discounted residual value at the end of the forecast period based on the capitalized cash flows for the final year of the period
    • Market share and position
    • Competition and general economic considerations
    • Forecasted sales growth
    • Potential profitability
    • Seasonality and working capital requirements

Fresh start reporting is not an altogether typical appraisal process. It requires technical ability in the form of understanding the value drivers of a business, the ability to translate those drivers into meaningful relationships and, ultimately, the use of those factors to forecast financial statements of a business while taking the GAAP treatment of the issues into consideration. The ultimate determination of value is subject to the scrutiny of the Bankruptcy Court, as it must be measured against the post-petition debts and claims of the petitioner.

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Frequently Asked Questions

Q: What is reorganization value in the context of Chapter 11?
A: Reorganization value approximates the fair value of the entity's assets immediately after restructuring and represents the resources available to satisfy post-petition liabilities and allowed claims; it includes the value of the reconstituted entity plus other debtor assets not part of the reconstituted entity.

Q: When is fresh start reporting required after Chapter 11?
A: Fresh start reporting is required upon emergence from Chapter 11 when the reorganization results in a new capitalization or when existing owners no longer retain legal economic interests; the requirement follows the confirmation and implementation of the reorganization plan.

Q: What does ASC 852 require for fresh start reporting valuation?
A: ASC 852 requires measurement of the emerging entity's value using the Fair Value standard under U.S. GAAP and discusses the use of valuation techniques such as discounted cash flow analysis to determine that value.

Q: Which valuation method does the article specifically discuss for determining value?
A: The article specifically discusses the Discounted Cash Flow (DCF) method as a primary approach for measuring the fair value of an emerging entity, emphasizing the development of forecasted financial statements as a key component.

Q: What elements should be considered when developing forecasted financial statements for a DCF?
A: Forecast inputs include the costs of corporate restructuring and program changes, limitations on use of net operating loss carryovers and tax attributes, anticipated residual value, market share and competitive position, forecasted sales growth, potential profitability, seasonality, and working capital requirements.

Paul Vogt

Paul Vogt is a Managing Director at PCE and leads the firm’s valuation practice from its Atlanta office. With over 20 years of experience, he specializes in business valuations for financial reporting, tax planning, litigation support, and corporate strategy across a wide range of industries.

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