Nextel Mini-Case

Nextel Mini-Case

(Corporate Reorganization)

Nextel Communications, Inc. (NCI) reported an investment relating to a 36% ownership in NII Holdings, Inc.(NII), formerly a wholly-owned subsidiary. NII declared bankruptcy in 2002 as described in the following footnote disclosure from the NCI 2002 10-K:

Corporate reorganizations in bankruptcy typically involve debt forgiveness and/or debt for equity swaps. If the value of the consideration given to debt holders is less than the book value of the debt on the company’s balance sheet, the company recognizes a gain for the book value of the debt given in excess of consideration given.[1]Often, in a debt for equity swap, the value of the new stock is zero, resulting in recognition of a gain equal to the book value of the debt.

Despite the gain on debt forgiveness, bankrupt companies may still report a deficit in retained earnings. This deficit is not viewed favorably by the capital markets. Fortunately for these companies, accounting standards provide for a corporate reorganization, call “fresh start accounting.” The following are required in order for the company to be eligible for fresh start accounting:

• The company must have a deficit retained earnings
• The reorganization plan requires approval of shareholders and creditors
• The company must have the expectation of profitable operations in immediate future (i.e., first quarter following reorganization)
• The retained earnings balance must be dated (beginning as of the reorganization) for10 years and dollar amount of eliminated deficit disclosed on the face of the balance sheet for 3 years.

If these conditions are met, the company can apply fresh start accounting as follows:

1. Assets and liabilities are appraised and marked to market. The resulting loss is reported in the income statement (no write-up of net assets is allowed)
2. The deficit in retained earnings is transferred to paid-in capital, thus increasing retained earnings to a zero balance and reducing paid-in capital by the deficit. There must be sufficient paid-in capital to absorb the loss. Additional paid-in capital can be created via stock sale or debt to equity conversion.

The financial statements of the NII subsidiary pre and post-bankruptcy are provided in Appendix A. Using these statements, please answer the following questions:

1. What opinion is Deloitte & Touche rendering on the statements? What qualifications are they making to the opinion? Is fresh start accounting in conformity with GAAP?
2. NII reports a gain relating to reorganization items in the amount of $2.18 billion. What are the components of this gain?
3. How did the parent company’s (Nextel Communications’) ownership in the NII subsidiary decline from 100% to 36%?
4. NII reports a decline in PPE from 2001 to 2002 despite CAPEX of $25,683 (see SCF). What caused this decline?
5. Why is all of NII’s long-term debt reported as a current liability in 2001? Explain the process leading to the reporting of long-term debt in the amount of $432,157 in 2002.
6. Why did paid-in capital decline from $934,948 in 2001 to $49,178 in 2002?
7. Explain the reporting of $42,566 in retained earnings for 2002.

Appendix A

NII Holdings 2002 Financial Statements

Excerpts from footnote #1:

[1]This is similar to the accounting for early extinguishment of debt (e.g. book value of debt repaid - proceeds paid = gain on extinguishment). This gain is often a large amount and can result in significant profitability upon emergence from bankruptcy (not to mention the competitive advantage afforded to the bankrupt company resulting from extinguishment of debt, leases, pensions, etc.).