Authored by Patrick Warch, Matthew O’Rourke and Daniel Altschul
A liquidation may present several obstacles to be navigated by the organization, one such obstacle being the accounting. The proper application of Liquidation Basis of Accounting (LBOA) within financial statements can be quite challenging. The goal behind LBOA is to report the amount that an investor may expect to receive after the completion of the liquidation process. The key objective for management is to communicate to the individual investor what the overall impact of liquidation will be.
The Financial Accounting Standards Board (FASB) addresses this in Accounting Standards Codification (ASC) 205-30, Liquidation Basis of Accounting, which is primarily based on Accounting Standards Update (ASU) 2013-07 Topic 205, Presentation of Financial Statements – Liquidation Basis of Accounting. LBOA is used to comply with U.S. generally accepted accounting principles (GAAP) when applicable situations present themselves.
When liquidation basis of accounting is used
LBOA is used when liquidation is imminent and no plan was specified in the governing documents. The question arises as to when liquidation would be considered imminent in the eyes of FASB. Per ASC 205-30-25-2, it is considered imminent when either of these occur:
- “A plan for liquidation has been approved by the person or persons with the authority to make such a plan effective, and the likelihood is remote that any of the following will occur:
- Execution of the plan will be blocked by other parties (for example, those with shareholder rights) or
- The entity will return from liquidation.
- A plan for liquidation is imposed by other forces (for example, involuntary bankruptcy), and the likelihood is remote that the entity will return from liquidation.”
Determining if LBOA should be applied
There are a few basic questions that need to be answered in determining if LBOA should be applied to conform to GAAP presentation based on liquidation being considered imminent.
Is the entity is considered a “limited-life” entity? This would be if at inception the entity was defined as to when it would enter liquidation.
- YES: If the answer is yes then it would be considered limited-life. In that case, LBOA would not be used as liquidation would have been part of the original planned life of the entity. This would mean that the entity would continue to present their financial statements using the accrual basis of accounting through final liquidation of the entity and there would be no application of LBOA.
- NO: If the entity is not a limited-life entity, then the next factor to be contemplated is if liquidation has been approved or has liquidation been imposed on the entity involuntary.
- NO: If the answer to both of these questions are no, then LBOA would not be used.
- YES: If the answer to either question is yes, then it must be assessed if there is a remote likelihood of blockage or return from liquidation.
- YES: If the answers to either of these questions are yes, then LBOA should not be used, but
- NO: If the answer is no, then LBOA is required for conformity with GAAP.
Relevant financial position
The goal of using LBOA is to present a more relevant financial position on the financial statements. During the liquidation process presenting assets and liabilities at their historical basis is no longer relevant. The investors are primarily concerned with what would be the value of these items in the imminent future when they are sold or settled in the current market conditions. Using the LBOA would present the value of each at their expected liquidation value.
Valuation of assets and liabilities
For assets, net realizable value would equal net liquidation value: Net realizable value is equal to the expected selling price less the expected selling costs. Third party expenses relating to such items as brokerage fees, disposal fees or other such expenses are often required during liquidation and should be considered in the estimated value. Any specialized equipment often times does not have a market for resale. This often times forces the equipment to be sold to another entity in the same industry or if active buyers are not available, it may result in the equipment being sold at scrap value.
For liabilities, net settlement value would equal net liquidation value: This valuation would require more judgment. As a result this often times would result in a specialist who has worked with other liquidating entities being involved in the liquidation process to add additional insight in determining the value of each item.
After estimating the valuation of the assets and liabilities, there may be adjustments necessary to make after the initial recording of the amounts. These adjustments should be recognized when management becomes aware of the changes and not when they are actually realized. All changes should flow through net income.
Costs and income
The entity should also accrue any costs or income that they expect to incur or earn through the end of the liquidation process when it is reasonable to estimate these amounts. This would include such items as payroll costs, income from preexisting orders that will be fulfilled or any other items that could be estimated.
Per ASC 205-30-45-2 LBOA should be applied prospectively from the day that liquidation becomes imminent. The initial statement of changes in net assets in liquidation shall present only changes in net assets that occurred during the period since liquidation became imminent.
Unrecognized or potential assets and liabilities
Additionally during the application of LBOA, the entity should recognize any items that previously were not recorded by the client such as a trademark that they expect to sell during the liquidation process or use in the settlement of liabilities. This way the statement encompasses any potential asset or liability that may exist in the imminent future.
Per ASC 205-30-45 Other Presentation Matters, at a minimum, an entity that applies the LBOA shall prepare a statement of net assets in liquidation and a statement of changes in net assets in liquidation.
It is also noted that within ASC 205-30-50 Disclosures that at a minimum the entity should disclose that the financial statements are being prepared using LBOA and the circumstances surrounding the use of LBOA. The disclosure should include:
- Details in regards to the amount of cash or other consideration that an entity expects to collect and the amount that the entity is obligated or expects to be obligated to pay during the course of the liquidation.
- The circumstances that led to the adoption of LBOA being applied and how the entity determined that the liquidation would be considered imminent.
- The manner in which the entity plans to dispose of its assets, settle its liabilities and the expected date by which liquidation is expected to be completed.
- Any significant assumptions and methods used to measure the entity’s assets and liabilities.
- The type and amount of costs and income accrued in the statement of net assets in liquidation and the period over which those costs are expected to be paid or income earned.
Fair value and ASC 946
Under ASC 205-30-25-3, an entity shall presume that its plan of liquidation does not follow a plan specified in the entity’s governing documents at inception if the entity is forced to dispose of its assets in exchange for consideration that is not commensurate with the fair value of those assets. As an investment company accounted for under ASC Topic 946 – Financial Services, the organization is required to account for its assets at fair value, unless management expects to sell assets in a disorderly or duress situation. This may allow for a broader interpretation that the fund is following a plan of liquidation specified in the entity’s governing documents and thus that the liquidation basis of accounting may not apply.
Special attention should be given by fund management to evaluate whether their ability to dispose of their assets will approximate fair value and whether this qualifies them for this scope exception from the LBOA guidance. Management should still consider disclosing the factual circumstances of its liquidation process including its expected liquidation period as well as under what provisions of its governing documents allowed for them to scope out adoption of the LBOA guidance.
It is important to understand the situations in which LBOA should be applied and those circumstances in which it would not be applicable. Once it is determined if it needs to be applied, making sure that the proper information is included in the financial statements and presented according to LBOA is essential. It is important to remember that these financial statements are being presented to show the most meaningful presentations for the investors in the entity. The goal is to show a clear impact of the liquidation and what the investors can expect to occur over the remaining life of the fund. The entity should ensure all relevant information is included and they are able to present a clear picture as to the impact of liquidation to the investors.
For more information on LBOA, or to learn how Baker Tilly's asset management industry specialists can help, contact our team.