Understanding Quasi-Reorganization in Corporate Finance

QUASI-REORGANIZATIONS As noted earlier, a debit balance in the retained earnings account is called a deficit. It may be the result of accumulated losses over a number of years or other significant debits to Retained Earnings. Sometimes a company with a large deficit is forced to discontinue operations and/or enter into bankruptcy proceedings. In some cases, however, where state laws permit, a company may eliminate a deficit through a restatement of investedcapital balances. This provides, in effect, a fresh start for the company with a zeroretained earnings balance. This is known as a quasireorganization. The advantage of aquasi-reorganization is that the procedure does not require recourse to the courts as in aformal reorganization or bankruptcy, and there is no change in the legal corporate entityor interruption of business activity. Quasi-reorganizations are not common, but they may be appropriate for companies operating under circumstances that are quite different from those of the past, for example, a company with new management. Even if operated profitably, the company may take years to eliminate the deficit that was created under a prior management. In the meantime, the corporation generally cannot pay dividends to stockholders. With a quasi-reorganization, however, the accumulated deficit is eliminated. Performance from the reorganization date forward can then be measured and reported without having past mistakes and negative results reflecting unfavorably on the “new” company. Normally in a quasi-reorganization, assets are revalued to reflect their current market values. This may require significant write-downs of assets against Retained Earnings, thus increasing the deficit. The total deficit is then written off (Retained Earnings is adjusted to a zero balance) against paid-in capital balances, giving the company a new capital structure.1 The SEC requires that any anticipated accounting changes should be an integral part of the quasi-reorganization and that the reorganization should not result in a write-up of net assets of the company.2 To illustrate the nature of a quasi-reorganization, assume TSS Corporation has suffered operating losses for some time but is now operating profitably and expects to continue to do so. Current and projected income, however, will not be sufficient to eliminate the deficit in the near-term. It also appears that plant assets are overstated considering current prices and economic conditions. After receiving permission from state authorities and approval from the shareholders, the board of directors of TSS Corporation decides to restate company assets and paid-in capital balances in order to remove the deficit and make possible the declaration of dividends from profitable operations. A balance sheet for the company just prior to this action follows. Eliminate a retained earnings deficit through a quasi-reorganization. TSS Corporation Balance Sheet June 30, 2002 Assets Liabilities and Stockholders’ Equity Liabilities......................................... $ 300,000 Current assets .......................$ 250,000 Property, plant, Common stock, $10 par, and equipment......$1,500,000 100,000 shares ..................$1,000,000 Less: A/D 600,000 900,000 Less: Deficit ................ 150,000 850,000 Total assets ...........................$1,150,000 Total liabilities and Equity.. $1,150,000 The quasi-reorganization is to be accomplished as follows: 1. Property, plant, and equipment are to be reduced to their present fair market value of $600,000 by reducing the asset and accumulated depreciation balances by 331⁄3%. 2. Common stock is to be reduced to a par value of $5; $500,000 in capital stock thus being converted into “additional paid-in capital.” 3. The deficit of $450,000 ($150,000 as reported on the balance sheet increased by $300,000 arising from the write-down of property, plant, and equipment) is to be applied against the capital from the reduction of the par value of stock. Entries to record the changes follow. Transaction Entry (1) To write down property, plant, and equipment and accumulated depreciation balances by 331⁄3%: Dr. Retained Earnings .................................... 300,000 Dr. Accumulated Depreciation ...................... 200,000 Cr. Property, Plant, and Equipment........... 500,000 (2) To reduce the common stock balance from $10 par to $5 par and to establish the paid-in capital from reduction in stock par value account: Dr. Common Stock, $10 par ........................ 1,000,000 Cr. Common Stock, $5 par ...................... 500,000 Cr. Paid-In Capital From Reduction in Stock Par Value ..............................500,000 (3) To apply the deficit after asset devaluation against the paid-in capital from reduction in stock par value account. Dr. Paid-In Capital From Reduction in Stock Par Value ....................................... 450,000 Cr. Retained Earnings ............................... 450,000 The balance sheet after the quasi-reorganization is shown below. TSS Corporation Balance Sheet June 30, 2002 Assets Liabilities and Stockholders’ Equity Current assets ..................... $250,000 Liabilities................. $300,000 Property, and equipment ......$1,000,000 Common stock, $5 par, Less: A/D ...... 400,000 600,000 100,000 shares...................500,000 Paid-in capital........ 50,000 Total assets ........................................... $850,000 Total liabilities and equity..$850,000 After the quasi-reorganization, the accounting for the company’s operations is similar to that for a new company. Earnings subsequent to the quasi-reorganization, however, should be ccumulated in a dated retained earnings account. On future balance sheets, retained earnings dated as of the time of account readjustment will inform readers of the date of such action and of the fresh start in earnings accumulation. Exhibit 11–12 describes the quasi-reorganization undertaken by ILLINOVA, the holding company for Illinois Power. E X H I B I T 1 1 – 1 2 Illinova—Note Disclosure of Quasi-Reorganization NOTE 2 — CLINTON IMPAIRMENT AND QUASI-REORGANIZATION IP [Illinois Power] owns one nuclear generating station, Clinton, a 930-megawatt unit that represents approximately 20 percent of IP’s generating capacity. Significant Clinton write-offs have weakened earnings and led to a 10-year decline in Illinova’s and IP’s retained earnings balances. Clinton has not operated since September 1996. In December 1998, Illinova’s and IP’s Boards of Directors voted to exit Clinton operations, resulting in an impairment of Clinton-related assets and accrual of exit-related costs. The impairment and accrual of costs resulted in a $1,327.2 million, net of income taxes, charge against earnings. Concurrent with the decision to exit Clinton, Illinova’s and IP’s Boards of Directors also voted to effect a quasi-reorganization, in which Illinova’s consolidated accumulated deficit in retained earnings of $1,419.5 million was eliminated. . . . In conjunction with effecting its quasi-reorganization, IP reviewed its assets and liabilities to determine whether the book value of such items needed to be adjusted to reflect their fair value. IP determined that its fossil generation assets were not stated at fair value. With the help of a third-party consultant, management conducted an economic assessment of its fossil generation assets to determine their fair value. The assessment was based on projections of on-going operating costs, future prices for fossil fuels, and market prices of electricity in IP’s service area. Management concluded that IP’s fossil generation assets have a fair value of $2,867.0 million. This fair value was determined using the after-tax cash flows of the fossil assets. Prior to the quasi-reorganization, the fossil generation assets’ book value, net of accumulated depreciation, was $631.7 million. The adjustment to fair value resulted in a write-up of $1,348.6 million, net of income taxes, which was recognized as an increase in retained earnings.