Quasi-Reorganization

What Is a Quasi-Reorganization?

A quasi-reorganization is a relatively obscure provision under generally accepted accounting principles (GAAP), which states that under certain circumstances, a firm may eliminate a deficit in its retained earnings account by restating assets, liabilities, and equity in a manner similar to a bankruptcy. A firm's stockholders must agree to allow the accounting change, which essentially resets the firm's books as though a new company had incurred the assets and liabilities of the old firm.

Understanding a Quasi-Reorganization

Although the idea of a quasi-reorganization has seen some renewed interest, the provision is still rarely applied in practice. The idea of a quasi-reorganization holds appeal for some as it is an idea of a "fresh start" and is more exciting to investors than slowly digging out from a large deficit of retained earnings.

Some also argue that quasi-reorganizations could be an effective method of more accurately resetting the accounting balances of a firm when a serious drop in asset value is not adequately reflected. A quasi-reorganization remains highly controversial, however, since it is not truly a change of economic reality, but rather a method to make books appear more favorable.

Quasi-reorganizations can carry risks to lenders or suppliers that extend credit to firms that have undergone a quasi-reorganization. Because a quasi-reorganization makes a company's balance sheet look stronger, this brings comfort to lenders in extending credit. If the lenders were aware of the actual financial situation of the company, they perhaps would not lend money or would lend at a higher rate to compensate for the actual risk taken. Quasi-reorganizations usually require disclosure in the financial statements, so lenders should make sure to look out for such items.

Benefits of a Quasi-Reorganization

Many new businesses operate at a loss for several years after inception. During this period, the sales team makes contacts, workers are trained, processes are improved on and streamlined, and brand recognition is cultivated. By the time the company turns its first profit, a significant retained earnings deficit may have developed. Additionally, a prolonged recession could turn a profitable company into a company with a retained earnings deficit.

It is often illegal or prohibited by debt covenants to pay a dividend from retained earnings while operating with a retained earnings deficit. In this instance, the equity cost of capital can increase materially as investors demand more return for perceived risk. Here, a quasi-reorganization could make financial sense.

When a company undergoes a quasi-reorganization, it is allowed to continue paying dividends, avoids the costs and time associated with a Chapter 11 bankruptcy, and possibly realizes tax advantages. As a quasi-reorganization does nothing to improve the actual operational aspect of a business, they are usually accompanied by other changes, such as consolidations, eliminating excess, and improving efficiency.

Goals of a Quasi-Reorganization

The main goal of a quasi-reorganization is to bring the retained earnings balance to zero. First, overvalued assets should be written down to fair value with a direct reduction in retained earnings. Although this increases the deficit momentarily, it will reduce future depreciation expenses. Liabilities are also restated to their fair values with any resulting offsets going to the retained earnings deficit.

Once assets have been reduced to fair value, either additional paid-in capital or the par value of common stock is reduced to balance out the elimination of the retained earnings deficit. Companies have some flexibility when deciding how to proceed with the quasi-reorganization; it is possible to reduce par value, increase additional paid-in capital, and zero out retained earnings at the same time.