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Accounting for and Audit of Liabilities
Reorganization By CNAO

SAI- China

Liabilities reorganization is the concession items made by a creditor in accordance with the agreement made with a debtor in financial difficulty or rules of the court. There are four major forms of liabilities reorganization:

1.    Using assets to pay off

The debtor transfers his ownership of assets such as cash, inventory, short term investments, fixed assets, long term investments and intangible assets to the creditor to pay off its liabilities.

2.    Transforming liabilities into capital

The liabilities of an enterprise are transformed into owner's equity. Such reorganization process shall follow the principle of capital preservation and go through necessary legal procedures.

3.    Modification of other liability conditions

The liability conditions excluding the above two are modified, for example, reducing the principal of liabilities or the interest of liabilities.

4.    Mixed reorganization

For mixed reorganization, the above stated forms of reorganization are combined. For example, part of the liabilities is paid off through assets and other parts are transformed into capital, or a part of a specific liability is transformed into capital and the other part is reorganized by modifying other liability conditions.

Accounting for Liabilities Reorganization

Accounting for different forms of liabilities reorganization forms varies from each other. Even under the same reorganization, accounting for the debtor differs from that for the creditor. The valuation of the profits generated and the losses arising in the process of reorganization and the accounting for contingent expenditures or contingent incomes are the key issues in liabilities reorganization.

1    Accounting for the debtor

When assets are used to pay off liabilities, debit accounts payable and credit assets accounts. The difference between the book value of the liabilities and the fair value of the assets is accounted as gains of liabilities reorganization and is posted to the profit & Loss account of the current period. When liabilities are being transformed into capital, off-set book value of liabilities and debit accrual accounts. The amount of shareholder's equity gained by creditors after giving up their credit is recognized as capital received and is credited as capital received. The difference between the fair value of shareholder's equity and the capital received constitutes capital reserve, therefore credit capital reserve. The difference between the book value of liabilities reorganized and the fair value of shareholder's equity is the gains from liabilities reorganization and posted to profit & Loss account of the current period. If the liabilities are reorganized by modifying other liability conditions, the debtor reduces the book value of the reorganized liabilities to the amount payable in the future. The reduced amount is gains from liabilities reorganization and posted to profit & loss account of the current period. If the modified cause for liabilities involves contingent expenditures, the contingent expenditure should be included in future accounts payable and thereafter gains from liabilities reorganization should be determined.

2    Accounting for the Creditor

When the debtor pays off his liabilities by assets, he debits the asset account to be sold to off-set the accounts receivable and provisions for bad debts of the credit. The difference between the net value of the reorganized credit (book balance less provision for bad debts) and the fair value of the assets to be sold is posted to profit & loss account of the current period as losses of the liabilities reorganization. When the creditor is transformed into capital, the fair value of the shareholder's equity is recognized as long term investment, the accounting process of which is the same as the above case. When modifying other liability conditions to make the liability reorganization, the book balance value of the creditor is reduced to the accounts of future receivables with the amount reduced recognized as losses of reorganization. If any of the modified causes for liabilities involves contingent incomes, the contingent income is not included in future receivables. It is recognized and accounted as profits and losses of the current period only when it takes place.

Auditing of Liabilities Reorganization

1. To confirm whether the date of liabilities reorganization is accurately defined. The fair market price of assets varies from date to date, the amount of liabilities payable with interest also varies from each other. Consequently, the profits and losses of liabilities reorganization and the relevant records of assets and liabilities recognized in different dates vary from each other. In addition, the date of liabilities reorganization is also the basis for defining the accounting period. No matter when the assets transactions were conducted, the reorganization date should be the accounting cut-off date. Auditors, in carrying out auditing, shall obtain the asset reorganization agreement files in the first place to identify the date of reorganization. They should then review the accounting information to check whether the valuation of the assets and liabilities are based on the reorganization date and the accounting information prepared are within the corresponding accounting period.
2. To check whether the accounting of the liabilities reorganization is proper. Major tool of such auditing is to examine on a sample basis the accounting vouchers of liabilities reorganization. These vouchers are verified against relevant agreement to make sure (1) relevant assets, liabilities and capital items are consistent with the agreement,- (2) proper accounting items have been applied and (3) accurate amounts have been recorded. Special attention shall be paid to see if the capital received and the capital reserve have been classified accurately, if the bad debt provision of the creditor has been written off and if contingent expenditures have been given due consideration?
3. To check whether the calculation and recognition of the profits and losses of liabilities reorganization has been conducted in accordance with relevant requirements. Review of the calculation of the profits and losses of liabilities reorganization is done through consulting and examining such information as the reorganization agreement, information provided by intermediary institutions and market information, the book value of debtor's liabilities, book value of assets, fair value of assets, fair value of shareholder's equity, future payables, the creditor's net credit value, future receivables. The calculation of the profits and losses of the enterprise is then reviewed to make sure data has been applied correctly and correct calculation has been conducted. Special attention shall be paid to see if the fair market value of assets, shareholder's equity and the amount of contingent liabilities have been accurately defined on proper basis and, whether the accounting period of the profits and losses is appropriate.
4. To audit whether the disclosure of reorganization is sufficient. Accounting standards require that liabilities reorganization be disclosed in the footnotes of the financial statements at the end of an accounting period, explaining the contents and impact of the reorganization. Such disclosure aims to make the user of financial statements better informed of the financial condition of the enterprise. The user of the financial statements will not be able to understand the full impact of the reorganization on the assets and liabilities, profits and losses of the enterprise, nor can they study the value for money of the enterprise correctly if the disclosure is not properly made. It is therefore necessary to observe carefully if complete disclosure has been made by the enterprise through examining the disclosure of the process of liabilities reorganization.