Unwinding A Tangled Web: Substantive Consolidation, Solvency Analysis And The Forensic Accountant's Contribution

Friday, December 1, 2006 - 01:00
Ivan Lehon

In complex Chapter 11 bankruptcy cases, a debtor may have hundreds of subsidiary legal entities, each with its own articles of incorporation and contractual agreements. With multiple claims against assets and with creditors clamoring for fairness in being made fully or even just partly whole, the debtor in possession faces an onslaught of filings, actions, and claims against its separate entities - especially if it has business units with a history of financial cooperation or has a practice of inter-company financial dealings.

In the chaotic days and weeks leading up to the filing, determining whether the company should adopt substantive consolidation for the purposes of bankruptcy proceedings is therefore an important one. Segregating the assets and liabilities of multiple legal entities for the purpose of settling claims with creditors is difficult; recreating financial statements for them can be even more burdensome, especially if each individual entity has not compiled comprehensive financial statements.

When a solvency analysis of individual subsidiaries is required, companies that choose not to consolidate for the purposes of a workout can find themselves mired in a frustratingly complex and expensive process of reconstructing subsidiary debtor statements before proceedings can move forward. Whether the company's financials are to be substantively consolidated or not, however, the solvency of the debtor(s) will need to be analyzed.

From the perspective of accounting professionals who have performed this type of reconstruction of subsidiary financial statements during bankruptcy proceedings, deliberations about substantive consolidation should occur sooner than they typically do - and should be conducted with more rigor. Instances of premature decisions to effect a substantive consolidation also arise: In some cases, the work of forensic accountants in a bankruptcy proceeding is to effectively deconsolidate financials that are under review.

This article reviews the intent and potential benefit of substantive consolidation. It clarifies issues that the debtor in possession should be aware of when considering such a consolidation, introduces questions that should be asked during a solvency analysis, and explains what company leadership can expect the process to look like. In addition, this article describes the type of financial analysis that must be undertaken and the role of the forensic accountant in performing such work.

Equitable Treatment vs. Simplified Obligations

A fundamental objective in any bankruptcy proceeding is to balance restructuring a company with treating creditors as equitably and fairly as the law and financial situation allows.

In line with this objective, substantive consolidation is a process in which bankruptcy courts combine the assets and liabilities of two or more separate but related legal entities into a single entity. Secured and unsecured creditors' claims against the separate debtors are combined into claims against the consolidated entity, and duplicate claims against multiple debtors and inter-company claims, including debt guarantees among debtors, are eliminated.

In principle, substantive consolidation aims to treat all creditors equitably relative to one another. By consolidating business units, divisions, or operations, a debtor is essentially pooling assets to simplify how it settles with all its creditors. In practice, substantive consolidation can result in inequity for certain parties. If the assets in one subsidiary are greater than those of others with which it is consolidated, creditors of certain entities receive less from the consolidated debtor than they would have from the entity that originally owed them.

Creditors that stand to benefit from substantive consolidation will therefore obviously argue for it; those harmed by it will argue against. Neither approach can satisfy everyone.

Should We Or Shouldn't We?

The decision whether to effect a substantive consolidation should rest on a review of the company's structure, its inter-company accounting practices, and the solvency of different units. That determination requires a clear understanding of the actual and implied financial relationships between business entities involved, and an in-depth analysis of the financial condition of each entity involved.

Achieving such an understanding entails thoroughly analyzing the debtors' books and records, reviewing public filings, assessing the quality and value of assets, reviewing liabilities and the extent to which they are collateralized, interviewing management and accounting personnel, and reviewing key contracts and inter-company guarantees. Generally, the more a company operated as one intertwined and tangled unit is the company substantively consolidated. Corporate managers and their bankruptcy advisors must consider several questions:

Did the organization's individual legal entities maintain separate books and records prior to bankruptcy, or did the companies have consolidated financial records? Do books and records or financial statements even exist for the smaller legal entities?

Did the debtors have common directors or officers?

Did the debtors participate in a centralized cash management system? If so, are cash balances at each entity accurate?

Did the parent company allocate costs to the legal entities, or did it absorb overhead? Were these appropriately accounted for? Were inter-company allocations eliminated upon consolidation?

Did the entities share their assets and liabilities? If so, does proper documentation exist to accurately identify the assets and liabilities of each entity?

Did the entities share centralized services, including human resources, risk management, etc.? If so, do the books reflect that?

Were individual state tax returns prepared for the entities, if applicable?

How were financial records archived and who can help retrieve the support for records that must be reconstructed? Who will archive the support once the reconstructions are complete?

Because many companies operate by business unit and not by legal entity, reconstruction may have to account for a myriad of inter-company transactions. This is a delicate and time-consuming process. Financial relationships among subsidiaries are often complex. The books, records and financial statements of subsidiaries are often insufficient or nonexistent; and employees with the most knowledge of the inter-company relationships and transactions may no longer be accessible.

Moreover, the process of reconstruction becomes more difficult the further back in time the financial statements are needed. Generally, the more difficult reconstruction will be, the longer it will take and more it will cost to reconstruct financial statements. In such cases, the debtor can weigh the cost benefit to consolidation.

Reconstruction & Solvency Analysis

It would be a perfect world if every bankruptcy proceeding resulted in a single figure for the value of a company's assets - and its obligations. Unfortunately, that world does not exist. Unwinding complex corporate structures entails dealing with limited information, scattered records, and financial statements reflecting different and sometimes conflicting accounting treatments across entities. Coming to reasonable and equitable settlement requires judgments - albeit informed ones - at every turn.

One way to protect the assets of the debtor(s) involves a solvency analysis of respective entities. This analysis is comprised of three tests - each of which should result in a "yes" or "no" answer. These are (1) the balance sheet test, which determines if the debtor's assets exceeded its liabilities at the time of transfer; (2) the cash flow test, which establishes whether the debtor can pay its debts as they come due; and (3) the adequate capital test, which assesses whether the debtor is left with reasonable capital.

In order to complete a robust solvency analysis that will withstand a potential trial, the debtor needs full financial statements for each separate entity, and accountants need to prepare cash flow statements in addition to income and revenue statements. A specific legal entity may not have an accounting ledger; in certain cases, it may have more than one. The forensic accountant must also determine how to treat companies in which the ultimate holding company holds less than a 100% interest. Further, they need to address errors found in previous financial statements.

If it is necessary to reconstruct financial statements, several concerns arise at the outset. The company must decide which subsidiaries should be included in the analysis. Sometimes, no chart of ownership exists for the legal entity; agreements at subsidiaries may be inconsistent, out of date, or simply incomplete. In a multi-tier ownership structure, it may be difficult or extremely burdensome to clearly establish the legal ownership at each tier. Materiality is the benchmark for management in setting the cut-off point for review of the legal ownership.

Forensic Investigation In Reconstructions

Solvency analysis can be assisted by a forensic accounting team well-versed in unwinding the complex financial history of large organizations in bankruptcy. Forensic accountants assist the debtors' legal and financial advisors in properly accounting for the assets and liabilities of each individual entity.

Using a company's contemporaneous accounting and financial data, the forensic team assembles information in a meaningful way so as to reconstruct historical financial statements. Their investigation requires locating data in both paper and electronic form, conducting interviews to gain institutional knowledge of the business and its systems at the time, identifying key transactions and entries to ensure proper recording, and using professional judgment to determine the purpose of transactions and entries. All these contribute to the completeness and accuracy of the business's reconstructed financial statements.

In attempting to reconstruct financial statements, a forensic accountant identifies where assets and liabilities for different entities may have been co-mingled. For example, were prepayments or accruals posted correctly with respect to subsidiaries? From an accounting perspective, this might not have been an issue when looking at the entire corporation structure because all subsidiaries consolidated to the ultimate corporation's financial statements. However, when analyzing individual subsidiaries, these entries may be significant due to the size of the accruals and the size of the subsidiary.

Other challenges arise simply due to the unforeseen nature of a bankruptcy proceeding in the first place. Statements may look correct when considering a corporation as a consolidated entity, but the reconstruction of financial statements for specific entities means deconsolidating the single entity. Once the proper financial structure is revealed, certain entries may not appear correctly on both sides of the transaction. For example, a company accountant at a subsidiary might never consider the possibility that a journal entry that is substantially correct on the consolidated financials at the parent may come under scrutiny later during a reconstruction. Based on knowledge of the correct corporate structure, the forensic specialist seeks to ascertain whether entries were posted correctly or if mistakes were made or shortcuts taken, and seeks to establish their financial impact.

Tough Judgments In Forensic Work

These are not the only issues that forensic accountants face. As they move through the process, they need to determine how profits are rolled from subsidiaries to the parent and if that roll-up has been done consistently in the past. If, as with most accounting systems, the roll-up is done at year-end based on the ownership at that point, the investigating accountant must decide how to treat the mid-year purchase or sale of subsidiaries. Similarly, if the financial statements are being prepared mid-year, the forensic team needs to determine the accuracy of accrual postings in the period, must account for the parent's share of profits, and must determine how to properly allocate costs between the parent and the subsidiaries for centralized services and other overhead.

A centralized cash management system also presents challenges. While the inter-company account may not have much value in the context of a bankruptcy, the practice of central cash management results in many inter-company payables and receivables among brother, sister and parent entities. The presentation of inter-company cash flow may need to reflect the substance of the transactions. One solution is to treat all or part of the inter-company balances as cash/debt balances; in any event, the accountants must determine how each subsidiary recorded inter-company asset transfers and make sure they match on both sides of the transaction.

Once all these issues have been addressed and resolved, one final task remains for the company: documentation needs to be compiled to support the reconstructed financial statements. Analytical procedure and other tests are performed to make sure the financials are consistent as a whole. Additionally, the balance sheet, income statement and statement of cash flow are examined to ensure they fairly describe the operations of the business.


Whatever the cause of bankruptcy, declaring Chapter 11 is a decision compelled by financial reality. Such a decision involves an understanding of the company's outstanding debts, operating cash and cash flows, and assets and liabilities, as well as market conditions affecting business prospects going forward. As company management scrambles to effect a financial and operational turnaround, they must also find time to meet with creditors, entertain suitors for a merger or company sale, and communicate meaningfully about the company's situation with investors, employees, customers - even regulators and the press.

Decisions during this period are serious and consequential. The determination as to whether or not to consolidate can be controversial and management must inform itself as quickly as possible as to whether substantive consolidation is the best choice. Having this information early in the process could prove invaluable in a large, complex filing. Whether substantive consolidation might benefit those involved - or whether it is better to face the possibility of performing individual solvency analyses down the line for each legal entity - is a question that should be addressed earlier in the process than it typically is.

Brought into the process sooner, a forensic accounting team can advise on the possible consequences of consolidation, and can begin the work of reviewing the legal entities' books and related financial information while company executives focus on other pressing concerns. The forensic team can give management an idea of potential complexities in the restructuring process, help determine the approach that will most satisfy their creditors and other stakeholders, and identify the resources they will need to have on hand to accomplish the task.

By looking out for creditors' and others' interests and managing their expectations from the start, debtors will be more likely to mitigate their risks for disputes on a reorganization plan or other negative effects lasting beyond the bankruptcy itself.

Ivan Lehon is a Partner in the Fraud Investigation and Dispute Services Department of Ernst & Young. Ernst & Young senior managers Brian Browne and Rick Yarger assisted in writing this article.

Please email the author at ivan.lehon@ey.com with questions about this article.