Quasi Reorganization: Fresh or False Start

This article looks at quasi reorganizations by summarizing current generally accepted accounting principles, evaluating the theoretical underpinnings and reporting on a survey of quasi reorganizations in practice. It is our conclusion that the quasi reorganization concept has little theoretical validity, and we urge the Financial Accounting Standards Board to delete it from GAAP. If retained, the concept's intended significance in an entity's history demands strengthening the related accounting procedures and financial statement disclosures. Hard Times Company has weathered some difficult years; losses have not only wiped out retained earnings but also have created a large deficit. Hard Times has slashed personnel and has identified unprofitable divisions and subsidiaries it could sell. Management is convinced the company can turn the corner and return to profitability. One problem remains: Although stockholders' equity is positive, the large deficit in retained earnings will take years to wipe out, preventing the company from paying dividends and possibly hampering its ability to raise new capital. What can Hard Times do? An infrequently used provision of Accounting Research Bulletin no. 43, Restatement and Revision of Accounting Research Bulletins, may offer a solution. Cited in the 1991 FASB discussion memorandum (DM), New Basis Accounting, ARB no. 43 reinforced an earlier rule permitting an accounting procedure known as a corporate readjustment--or more commonly, a quasi reorganization. FRESH-START ACCOUNTING The FASB DM, which examines situations that may require companies to adopt a new basis for assets and liabilities, says AP-B no. 43 allows the company to "accomplish, in its books of account, substantially what might be accomplished in a reorganization by legal proceedings--that is, elimination of a deficit in retained earnings and establishment of a new basis of accounting for its assets and liabilities. " The new basis results from adjusting assets and liabilities to their current fair value. Adjusting the books in this way has led to the notion of fresh-start accounting, as it allows a company to "wipe clean its prior accounting records and start anew," according to the DM. Because of the limited incidence of quasi reorganizations in practice and the fact the underlying concepts are far from pervasive, relatively little literature on the subject has appeared since a comprehensive study by James S. Schindler in 1958. (See exhibit 1, page 80, for a review of selected quasi reorganization literature. The renewed interest in quasi reorganizations that followed a 1988 American Institute of CPAs issues paper, Quasi-Reorganizations, is both reinforced and challenged in the FASB DM. On the one hand the DM acknowledges that quasi reorganizations provide a reference point for exploring the appropriateness of new basis accounting. On the other, the DM says some observers question whether a quasi reorganization is good accounting and whether it should result in a new basis of accounting. APPROPRIATE OR NOT? Although APB no. 43 provides guidance for the accounting procedures in a quasi reorganization, it does not specify the conditions under which one is appropriate. Instead, section 210 of the Securities and Exchange Commission Codification of Financial Reporting Policies requires that, at a minimum, these four conditions exist before a quasi reorganization can be considered effective. 1. Retained earnings are exhausted. 2. No capital account has a deficit after the quasi reorganization. 3. Parties entitled to vote on corporate policy are informed of the quasi reorganization and approvals required by state law and corporate charter are obtained. 4. The accounting for the quasi reorganization reflects substantially what might be accomplished in a reorganization by legal proceedings. " This includes restating assets to current value and making appropriate modifications to the capital accounts, such as eliminating a deficit in retained earnings to minimize the need for similar reorganizations in the future. …