Many advanced accounting texts provide some background and the specialized accounting for bankruptcy situations. Bankruptcy advisory services have become a large and lucrative practice for many accounting firms in the United States, so some additional information about bankruptcy might be useful for those who with to seek employment in that arena.  This article does not purport to give a complete overview of bankruptcy, but merely fills in and supplements the material presented in textbooks. As such, this article needs to be read in conjunction with the text.

Bankruptcy is the exclusive domain of the federal government. Article 1, Section 8, clause 4 of the United States Constitution gives Congress the sole power to enact uniform bankruptcy laws across the country. [1] Therefore, bankruptcy is always handled through agencies of the federal and not the state government.

Besides the petitioner for bankruptcy, who are the key players in a bankruptcy?

  • The Bankruptcy Court—All bankruptcy cases are heard in the federal court system. Bankruptcy judges are appointed by the federal Circuit Courts of Appeals and serve a fourteen-year term. They are under the jurisdiction of the federal District Courts. which would ordinarily hear the first appeal. As such, bankruptcy judges operate at the lowest level of the federal judiciary.  Further appeals would then be to the Circuit Court of Appeals and eventually to the United States Supreme Court.[2]
  • The Trustee—A trustee is appointed by the Court to oversee the bankruptcy.[3]  His job is to protect the interests of creditors.
  • Debtor in possession-The petitioner continues to operate the business but must now run it with the creditors in mind. Normal activities such as paying employees and filing tax returns continue, but the debtor in possession must obtain the consent of the court for any out of the ordinary actions.
  • Debtor in possession lender—Often known as DIP financing, this is a highly specialized form of bank lending. DIP financing is placed ahead of all outstanding debt for repayment in the bankruptcy. It is often used to fund the petitioner until it can resume profitable operations or be sold.
  • Receiver-Receivers are relatively rare in bankruptcy courts. Their power exceeds the powers of the trustee in bankruptcy as the receiver steps in to run the business.  States may have insolvency laws that are separate and distinct from bankruptcy laws. Receivers are typically appointed in those situations[4]. It should be noted federal bankruptcy law always supersedes state insolvency laws.

Some other bankruptcy considerations:

  • From a practical standpoint, it is important for a company to enter into bankruptcy with as much cash as possible since there is no guarantee it can obtain trade credit or DIP financing. One sign of an imminent bankruptcy filing is a company has ceased paying all of its vendors for an extended period of time. It may be accumulating funds for the bankruptcy.
  • Some vendors will continue to work with the company after bankruptcy, knowing debts incurred after the bankruptcy filing are enforceable.  Others simply will require “cash on delivery” terms or not work with the petitioner at all.  The latter decision can result from anger or frustration from the situation. This is simply irrational, as the past sales and receivables are “sunk costs”.  Decisions must be made going forward.  If there is profit to be made, the vendor should consider continuing sales to the petitioner.
  • Bankruptcy can eliminate federal income tax liability under certain circumstances, but it will not eliminate a federal tax lien. If a lien has attached to the company’s assets, the IRS will prevail.  Therefore, filing for bankruptcy needs to be timed so it occurs before an IRS lien attaches to the company’s property. The bankruptcy filing will stop IRS collection efforts unless there is a line in place. If the petitioner has been negotiating an offer in compromise with the IRS, negotiations will be halted by the filing of the bankruptcy petition.
  • Similarly, liens arising from purchase money lending arrangements will also eventually prevail against the bankruptcy.  For instance, auto loans or home mortgages may be discharged in bankruptcy, but the lender will always be entitled to recover the collateral to the loan. (This makes perfect sense of course since lenders would not fund purchases knowing they could not foreclose on the pledged assets.)
  • Discharge of indebtedness is a taxable event unless it is done in conjunction with a bankruptcy.  If you default on a loan you must report discharge of indebtedness income on your tax return. If the loan is discharged in bankruptcy, there is no taxable income.
  • Child support and alimony are not discharged in bankruptcy.
  • Fines and penalties levied by government agencies and courts are also generally not dismissed in the bankruptcy
  • The bankruptcy system in the United States is dominated by the legal profession.  This is not the case in some other English-speaking countries.

[1] A significant improvement of the debtor prison system. There were years there were no bankruptcy laws in the United States.  Consequently, debtor issues were handled through state insolvency and collection laws.

[2] Although U.S. Supreme Court review of a bankruptcy case would be extremely unlikely given the number of cases the Supreme Court hears in a year.

[3] Qualifying and acting as a trustee in bankruptcy is also a very lucrative profession and something accountants should be more involved in.

[4] Many attorneys believe state insolvency laws are a less expensive method of dealing with a troubled company. Large bankruptcy cases can involve large professional fees.