A corporation may not be insolvent and yet may have accumulated a relatively large deficit as a result of such problems as an excessive investment in plant assets or inventory, or management’s inability to recognize and influence market demands. If management is replaced and if profits result from new policies, most state laws still will not permit declaration of dividends until the deficit is eliminated. The turnabout period and deficit elimination may take so long that the investors’ interest in the company vanishes, and capital acquisition becomes difficult. To overcome such a handicap, the corporation might seek a quasi-reorganization.
Quasi-reorganization does not require court action, nor does it require the consent of creditors since creditor interests are not altered. However, the procedure is described in state laws, many of which require a quasi-reorganization to be approved by two-thirds of the stockholders. The accounting literature is not specific regarding the conditions under which a quasi reorganization can occur. However, it was most frequently viewed as an approach which would allow for net assets to be reduced to lower fair values and a deficit in retained earnings to be eliminated. The Securities and Exchange Commission has set forth specific criteria which must be satisfied before a quasi-reorganization is accepted. Furthermore, SEC Staff Accounting Bulletin (SAB) No. 78 does not allow registrants to use this procedure just to eliminate a deficit in retained earnings. Net assets must also be restated, and the net result must be a write-down in value versus a write-up.
The primary purpose of a quasi-reorganization is to eliminate a large deficit and take such action as will permit successful operations in the future. Excessive plant capacity and equipment may be sold, and remaining assets and liabilities will be revalued to reflect their fair values. For example, long-lived assets will be written down to reflect an impairment in their value.2 Such revaluations most often increase the deficit in retained earnings. The deficit remaining after these revaluations must be reduced to zero.
It should be noted that the write-down of the assets increases the deficit, which then will be eliminated by subsequent changes in the capital structure. The deficit is eliminated by charges against the existing paid-in capital in excess of par or stated values. If no such paid-in capital exists, it may be created by altering the capital structure and substituting stock with lower par value or lower stated value for existing shares.