Under the Framework, financial statements are normally prepared on the going concern basis. However, when an entity appears no longer viable in its present state, that basis will not present reliable and relevant information.
Not every company is successful; many make losses or find themselves in a net liability position. Many such companies will ultimately end up being liquidated if there is no way to return them to profitability.
Indications that a company is struggling may include the following:
Negative cash flows
Poor or even adverse financial ratios such as ROCE
Loss of major market or customer
High staff turnover
Pending legal claim against the company
Disasters such as fire or flood.
Not all struggling companies will be forced into liquidation; if a profitable future appears possible, some form of reconstruction will be used to get the company back on a level footing.*
The various stakeholders must therefore compare what their position will be if the company is liquidated against their position if a reconstruction scheme goes ahead.
2. Forms of Reconstruction
For all forms of reconstruction, it is important that all stakeholders are consulted and treated in a fair and equitable manner. However, the ordinary shareholders bear the major risk and so will suffer the greater proportion of any losses, compared with secured creditors (for example).
In all reconstructions, the protection of the creditors is crucial. Although this stakeholder group will be required to share in any losses this will be proportionately less than that of the equity shareholders.
3. Exam Approach
There are two types of scheme that may be examined:
Internal reorganisation-a restructuring of the statement of financial position; and
─ winding up of a company;
─ setting up of a new company to take over trade/assets.
You may be required to:
Prepare the financial statements after the reorganization has taken place:
─ this may involve a bookkeeping exercise;
─ i.e. process the scheme of reorganisation.
Appraise the scheme, either in general or for a specified stakeholder:
─ For this there will be no single correct answer;
─ It is more important to apply principles.