Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation

ISSUES IN ACCOUNTING EDUCATION American Accounting Association

Vol. 26, No. 2 DOI: 10.2308/iace-10017

2011

pp. 391–419

Kmart: Predicting Bankruptcy, Fresh Start

Reporting, and Valuation of Distressed

Securities

Reuven Lehavy and Suneel Udpa

ABSTRACT: On January 22, 2002, Kmart Corporation filed voluntary petitions for

reorganization under Chapter 11 of the federal bankruptcy laws. While under Chapter 11

protection, Kmart renegotiated its debt, shed some of its non-performing assets, and

issued new equity. Financier Eddie Lampert of ESL Investments bought much of Kmart’s

debt for less than $1 billion while it was in bankruptcy. As part of the reorganization plan,

virtually all of Kmart’s debt was converted into shares, and ESL Investments emerged as

Kmart’s largest shareholder. Subsequent to its emergence from bankruptcy on May 6,

2003, Kmart’s stock has gone up from around $15/share to nearly $80/share over a period

of one year. The case requires students to analyze Kmart’s financial performance prior to

the bankruptcy, identify the circumstances leading to the bankruptcy, use projected

financial statements to derive Kmart’s value post-bankruptcy, and explore issues related

to Kmart’s adoption of Fresh Start reporting upon its emergence from bankruptcy. The

case questions fall into five categories: (1) pre-bankruptcy evaluation, (2) reorganization

plan and Kmart in bankruptcy, (3) Fresh Start reporting, (4) bankruptcy valuation analysis,

and (5) post-bankruptcy performance. The questions are largely independent, allowing

instructors the flexibility to adopt only the sections relevant to their courses.

Keywords: bankruptcy; valuation; Kmart; Chapter 11; corporate distress; ﬁnancial

distress; prediction; Fresh Start reporting.

COMPANY HISTORY

mart was incorporated under the laws of the State of Michigan on March 9, 1916, as the

successor to the business developed by its founder, Sebastian S. Kresge. Mr. Kresge

opened his ﬁrst store in 1893 where he sold everything for ﬁve or ten cents. By 1912, he

had expanded to 85 stores with annual sales of more than $10 million. After operating the Kresge

department stores for more than 45 years, the company opened its ﬁrst Kmart discount department

store in 1962. By 1977, nearly 95 percent of the Kresge company sales were generated by Kmart

stores. To reﬂect this new thrust, the company ofﬁcially changed its name to Kmart Corporation.

Reuven Lehavy is an Associate Professor at the University of Michigan, and Suneel Udpa is a Professor at

Saint Mary’s College of California and a Lecturer at the University of California, Berkeley.

We acknowledge the comments and suggestions of Andresto Budijanto, Russell Lundholm, Bill Pasewark (the Editor), the

Associate Editor, and two reviewers. Professor Lehavy acknowledges the support of the Michael and Joan Sakkinen

Scholarship.

Published Online: May 2011

391

In 1962, the same year Kmart opened its ﬁrst discount department store; Wal-Mart opened its

ﬁrst, no-frills, discount store in Roger, Arkansas. In less than 30 years, Wal-Mart had become the

number-one retailer in the country. As of 2001, Wal-Mart was operating 2,732 stores, with sales per

square foot of $446, total sales of $217 billion, and net income of $6.7 billion. In contrast, as of

2001, Kmart was operating 2,113 stores, with sales per square foot of $227, total sales of $36

billion, and a net loss of $1.3 billion.

In response to severe competition from Wal-Mart in the discount retail space, between 1984

and 1992 Kmart attempted to diversify and expand its business by acquiring several specialty

stores, including Walden Book Company, Home Centers of America (later renamed Builder’s

Square), the Sports Authority, Ofﬁce Max, and Borders. In 1996, in an effort to compete with

Wal-Mart Supercenters, Kmart unveiled a ﬁve-year, $35 billion new-store opening plan, and an

enlargement and modernization program. These actions signiﬁcantly increased the amount of debt

on Kmart’s balance sheet. By 1997 Kmart had divested its interests in all of its specialty stores to

focus on its core business as a discount merchandise retailer.

By 1997, however, Wal-Mart had gained an almost insurmountable advantage over Kmart in

the discount merchandise space by investing heavily in its core competencies—logistics, store

management, and information technologies. Kmart, on the other hand, was, at best, lukewarm in its

adoption of information technology. Lack of integration in its supply chain frequently led to

stock-outs, inventory pile-ups and resulting write-offs, and low margins.

In August 2000, the new Chairman and CEO, Charles Conway, outlined three strategic

imperatives and ‘‘Big 5’’ initiatives to improve the ﬁnancial performance and competitive position

of Kmart. The three strategic initiatives were: (1) achieve world-class execution by making

end-to-end improvements and investments in the supply chain; to this end, Kmart announced a

massive $1.4 billion investment in technology; (2) create a customer-centric culture to link

day-to-day activities to better serve Kmart customers; and (3) become a marketing- and sales-driven

organization with a deﬁned and differentiated market position. The ‘‘Big 5’’ initiatives included: (1)

ﬁx the ﬂow of goods and streamline supply chain management, (2) increase marketing effectiveness

with less advertising costs, (3) ﬁx the food department and grow the SuperKmart concept, (4)

reduce SG&A expenses through process engineering, and (5) give assistance to develop and

increase proﬁtability of the bottom 250 stores.

In spite of these initiatives and investments, Kmart’s supply chain troubles continued, and it

struggled to keep pace with its rival discount chains, Target Corporation and Wal-Mart. See

Appendix A for Kmart, Target, and Wal-Mart’s condensed ﬁnancial statements for the ﬁscal years

1997–2002. In addition, Kmart made a fateful decision for the holiday season of 2001 to compete

head-to-head with Wal-Mart’s ‘‘Always Low Prices’’ with its own version of everyday low prices

called ‘‘BlueLight Specials.’’ In preparation for the 2001 fourth-quarter holiday season, Kmart had

signiﬁcantly increased its inventories, ﬁnanced by cash ﬂow from operations, bank lines of credit,

and trade credit from vendors. Like all retailers, Kmart’s ﬁnancial performance depended heavily

on the sales volume generated in the fourth-quarter holiday season. Wal-Mart responded to the

‘‘BlueLight Specials’’ by further slashing its prices. Kmart’s fourth-quarter sales and earnings

performance were disappointing.

Due to the deterioration in Kmart’s ﬁnancial health, Moody’s Investor Services downgraded

Kmart’s unsecured debt to junk status in December 2001 by lowering its rating from Baa3 to Ba2.

Standard & Poor’s had downgraded its debt from ‘‘BB-plus’’ to ‘‘BB’’ in November 2001. On

January 2, 2002, Prudential analyst Wayne Hood lowered his rating for the company to ‘‘sell’’ from

‘‘hold’’ and cut earnings per share estimates for the fourth quarter as well as the ﬁscal year, citing

disappointing fourth-quarter sales and earnings. In addition, Hood noted that the company might

choose to ﬁle for Chapter 11 protection within the next six months if its sales and proﬁts don’t get

better (Patsuris 2002).

392 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

Kmart’s precarious credit situation drove it to rely on special, surety bonds to guarantee

payments to its creditors and employees. A surety bond is a contract in which the surety agrees to

pay the debts or guarantee the contract performance of a principal to a third party, if the principal

fails to pay its debt or perform on a contract. Kmart used surety bonds to guarantee payments of its

self-insured worker’s compensation claims and other liabilities, and to comply with government

regulations requiring merchants who sell alcohol and ﬁrearms to post bonds. Enron also

signiﬁcantly relied on surety bonds, using them to back an estimated $2.5 billion of its fuel delivery

and other contracts. Following Enron’s bankruptcy, sureties became more cautious and reportedly

required Kmart to put between $300 million and $600 million in supplemental security to back its

bonds. Given its disappointing sales during the 2001 holiday season, Kmart was unable to come up

with the money (Goodwin 2002). Further, on January 21, 2002, Kmart failed to make its weekly

payment of $78 million to Fleming, a major food distributor and grocery wholesaler, and Fleming

stopped its shipments to Kmart.

Consequently, on January 22, 2002, Kmart Corporation ﬁled a voluntary petition for

reorganization under Chapter 11 of the federal bankruptcy laws in the United States Bankruptcy

Court for the Northern District of Illinois (in re. Kmart Corporation, et al. 2003). On January 24,

2003, Kmart (called debtor-in-possession while in bankruptcy) ﬁled a Plan of Reorganization with

the Court, and on February 25, 2003, ﬁled an amended Joint Plan of Reorganization with the Court.

The Joint Plan of Reorganization received the formal endorsement of the statutory creditors’

committees and was conﬁrmed by the Court on April 23, 2003. On May 6, 2003, Kmart emerged

from reorganization and became a wholly owned subsidiary of a newly created holding company,

Kmart Holding Corporation (ticker: KMRT).

AN OVERVIEW OF CHAPTER 11 REORGANIZATION

Under Chapter 11, a ﬁrm is allowed to continue its operations under the supervision of the

bankruptcy court while a plan of reorganization is prepared and negotiated with its creditors. The

ﬁrm has an exclusive right to propose a plan of reorganization for a period of 120 days after the initial

ﬁling of bankruptcy. Another advantage of ﬁling for Chapter 11 is that an automatic stay is imposed:

all payments of interest and principal on debt ceases, and creditors are prevented from taking any

action against the ﬁrm to collect claims or seize assets. The reorganization plan assigns claimholders

into classes according to the characteristics of their claims (broadly based on seniority) and proposes

a distribution to these claimholders. After the reorganization plan is submitted to the Court, the ﬁrm

and the creditors enter into negotiations on the speciﬁc terms of the plan.

The Bankruptcy Code requires the bankruptcy court to determine that the plan is in the ‘‘best

interests’’ of all holders of claims that are impaired by the Plan and that have not accepted the plan.

The ‘‘best interests’’ test, as set forth in Section 1129(a)(7) of the Bankruptcy Code, requires the

bankruptcy court to ﬁnd either that (1) all members of an impaired class of claims have accepted the

plan, or (2) the plan will provide a member that has not accepted the plan with a recovery that is no

less than the amount that such holder would recover if the ﬁrm were liquidated under Chapter 7 of

the Bankruptcy Code (called ‘‘liquidation analysis’’).

Further, under Section 1129(a)(11) of the Bankruptcy Code, the ﬁrm must demonstrate to the

bankruptcy court (typically by submitting projected ﬁnancial statements and value estimates of the

reorganized entity) the feasibility of the plan to ensure that the conﬁrmation of the plan will not be

followed by liquidation or a need for further ﬁnancial reorganization.

Clearly, the estimated value of a reorganized ﬁrm is critical for the different classes of

claimants, especially the classes that are impaired in the reorganization. Since the value of the

reorganized ﬁrm affects the recoveries of the different classes of claimants, it is a contentious issue.

All interested parties understand that the value of the ﬁrm is estimated based on unaudited

projections of operations, cash ﬂow, and related balance sheets. These projections reﬂect numerous

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 393

Issues in Accounting Education

Volume 26, No. 2, 2011

assumptions and estimates about the future performance of the ﬁrm and the industry, as well as

general business and economic conditions. Furthermore, one needs to choose from a range of

possible valuation models and make subjective judgments about the weights to be attached to the

various competing models. In Chapter 11 reorganizations, a claimant’s return depends on two key

values: the ‘‘true’’ value of the ﬁrm’s net assets and the estimated value used in the reorganization

plan to decide on payouts to various claimholders (called ‘‘Plan Value’’).

The bankruptcy court will conﬁrm the reorganization if the following three requirements are met:

(1) A two-thirds majority of each class of impaired claimants accepts the plan (unimpaired

classes are not allowed to vote on the plan).

(2) Each dissenting claimant receives at least the amount it would have received in a

liquidation (called the Best Interests test).

(3) The plan is feasible; that is, the conﬁrmation of the plan is not followed by a liquidation

or another request for further restructuring.

Once the bankruptcy court conﬁrms the plan and sets the date for emergence from Chapter 11, it is

binding on all claimants, even those that did not accept the plan or were impaired under the plan.

KMART’S REORGANIZATION

Appendix F provides a summary of the treatment of selected classes of Kmart’s claimholders

under the Joint Plan of Reorganization that was conﬁrmed by the Court on April 23, 2003. As noted

earlier, the estimated value of a reorganized Kmart affects the recoveries of the different classes of

claimants, especially the classes that are impaired in the Reorganization Plan.

Kmart retained the services of Miller, Buckﬁre, Lewis & Co. to do formal valuations of

reorganized Kmart as of the effective date of April 30, 2003. Miller, Buckﬁre, Lewis & Co. used the

following valuation methodologies (source: Kmart’s Reorganization Plan):

(a) Comparable Public Company Analysis

In a comparable public company analysis, a subject company is valued by comparing it to

publicly held companies in reasonably similar lines of business. The comparable public

companies are chosen based on, among other attributes, their similarity to the subject

company’s business, presence in the market, and size. The price that an investor is willing to

pay in the public markets for each company’s publicly traded securities represents that

company’s current and future prospects as well as the rate of return required on the investment.

Numerous ﬁnancial multiples and ratios were developed to measure each company’s valuation

and relative performance. Some of the speciﬁc analyses entailed comparing the enterprise value

(deﬁned as market value of equity plus debt minus excess cash) for each of the comparable

public companies to their sales, EBITDA, and EBIT, as well as comparing their equity values

to net income and book value. Where appropriate, the Financial Advisors applied these

multiples to the projected ﬁnancials of the Reorganized Debtors to determine an implied range

of enterprise and equity values for the Reorganized Debtors.

(b) Discounted Cash Flow Analysis

The discounted cash ﬂow method relates the value of an asset or business to the present value

of expected future cash ﬂows to be generated by that asset or business. Reorganized Kmart’s’

projected cash ﬂows after debt service (as set forth in the Business Plan [see Appendix E]) were

discounted to a present value as of the Effective Date using a discount rate equal to the

weighted average cost of capital for Reorganized Kmart. For purposes of the valuation

394 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

analysis, the Financial Advisors used a range of discount rates between 20 percent and 25

percent, which reﬂects a number of company- and market-speciﬁc factors, including business

execution risk and the nature and derivation of the projections set forth in the Business Plan as

well as the cost of equity for companies that the Financial Advisors deemed comparable.

Using the above methodologies, Miller, Buckﬁre, Lewis & Co. estimated the value of Kmart on

April 30, 2003, to range from approximately $2,250 million to $3,000 million, The value does not

include excess cash, if any, remaining after cash distributions under the plan. The excess cash, if any, is

assumed to be necessary to run the business and not viewed as free cash ﬂow for valuation purposes.

The equity value of reorganized Kmart was estimated to range from approximately $753

million to $1,503 million or from approximately $8.74/share to $17.43/share assuming a total of

86,236,453 common shares issued and outstanding as of April 30, 2003.

Under existing accounting rules, Kmart is required to adopt Fresh Start Reporting upon its

emergence from bankruptcy. Fresh Start Reporting requires ﬁrms in Chapter 11 bankruptcy to

estimate and report assets and liabilities at their reorganization value, which approximates fair value

at the date of emergence from Chapter 11. The Fresh Start Accounting adjustments (see Appendix

B) for Kmart are based in part on the enterprise valuation analysis prepared by Miller, Buckﬁre,

Lewis & Co. Application of Fresh Start Accounting adjustments to reﬂect the fair value of assets

and liabilities and the write-off of the Predecessor Company’s equity resulted in a charge of $5.6

billion. The restructuring of Kmart’s capital structure and resulting discharge of prepetition debt

resulted in a gain of $5.1 billion. The charge for the revaluation of the assets and liabilities and the

gain on the discharge of prepetition debt are recorded in Reorganization Items, not in the

Consolidated Statement of Operations.

As noted in Lehavy (2002), these Fresh Start Accounting adjustments are important for two

reasons. One, management’s reported estimate of the Fresh Start value of assets and liabilities plays

a vital role during bankruptcy negotiations because it determines the allocation among various

bankruptcy claimants. Second, the management of the ﬁrm under bankruptcy has signiﬁcant

discretion in the determination of the estimates, and their choices reveal their biases and objectives.

Since in Chapter 11 reorganization debt held by claimants is frequently exchanged for equity,

claimants who hold sufﬁcient percentages of various classes of outstanding debt can have a strong

bargaining position to inﬂuence the terms of reorganization, including the determination of the

Fresh Start values. This motivates investors, often referred to as vulture investors in the popular

press, to strategically buy debt of a ﬁrm in Chapter 11 reorganization in order to obtain majority

ownership in the reorganized ﬁrm.

VULTURE INVESTING

Vulture investing is essentially investing in distressed securities, which are securities of

companies that are in ﬁnancial trouble and in the process of restructuring, reorganization, or

liquidation under local bankruptcy laws. The basic strategy is to buy securities, usually debt, at a

signiﬁcant discount to its intrinsic value and then exit in one of two ways. Investors can simply

trade out of their positions and sell their securities when the prices are higher. This is possible

because with the increase in the number of large public companies in ﬁnancial distress, an active

market for trading claims of distressed companies has developed (Hotchkiss and Mooradian 1997).

Alternatively, investors can swap their debt claims for cash or equity during reorganization. Vulture

investors strategically purchase a sufﬁcient percentage of various classes of outstanding debt, so

that they have a strong bargaining position to inﬂuence the terms of the reorganization. In Chapter

11 reorganizations, where debt held by vulture investors is exchanged for a majority of the equity of

the company, vulture investors can signiﬁcantly inﬂuence management and/or gain control. By

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 395

Issues in Accounting Education

Volume 26, No. 2, 2011

pushing the ﬁrm to run more proﬁtably, they can increase the value of their holdings as the ﬁrm

emerges from bankruptcy.

Gilson (2001) outlines the simple strategy vulture investors use to purchase securities of ﬁrms

in bankruptcy. Purchasing equity is generally an ineffective way to acquire or exercise control of a

ﬁnancially distressed ﬁrm, since typically equity holders do not enjoy high recovery rates during

bankruptcy. With regard to purchasing debt claims, typically senior claims in the capital structure

receive new senior claims (new debt or cash) in exchange for their pre-bankruptcy debt, whereas

more junior claims receive common stock. Thus, with a view to gaining control of the distressed

ﬁrm as it emerges from bankruptcy, investors prefer to purchase junior claims to senior secured

claims. However, the most junior claims may have very low recovery rates because the ﬁrm’s assets

may not be worth enough to pay all the claims.

Bankruptcy rules inﬂuence the amount of different claims an investor will need to hold during

reorganization. Before the bankruptcy court will approve a reorganization plan, each claimant class

votes for or against the plan. The required percentage of votes required varies with the types of

claims within the class. Typically, a class is deemed to have accepted the plan if at least a majority

(in number) of claimholders in that class and at least two-thirds (in value) vote for the plan. Thus,

an investor needs to hold slightly more than one-third of the claims in a particular class to threaten

to hold up the ﬁrm’s reorganization plan unless that claim class is given a higher recovery rate.

However, an investor’s ability to secure a higher recovery rate is limited by the ‘‘cram down

provision’’ of the bankruptcy code. The ‘‘cram down provision’’ allows the Court to conﬁrm the

reorganization plan over the objections of the claimholders of a particular class, if it ﬁnds that the

plan is fair and equitable to each impaired class, and does not unfairly discriminate with respect to

each claim that has not accepted the plan.

VULTURE INVESTING IN KMART AND POST-BANKRUPTCY PERFORMANCE

ESL Investments purchased approximately $382 million principal amount of Prepetition

Lender Claims, approximately $1,777 million principal amount of Prepetition Note Claims, and

$61 million in Trade Vendor/Lease Rejection Claims and Trust Preferred Obligations. Furthermore,

Third Avenue Trust purchased approximately $99 million principal amount of Prepetition Note

Claims and approximately $79 million in Trade Vendor/Lease Rejection Claims.

Under the Reorganization Plan, the prepetition lenders would be entitled to cash and shares in

reorganized Kmart in satisfaction of the Prepetition Lender Claims (Class 3 Claims). However, under

the settlement agreed to by the parties, the Prepetition Lenders (other than ESL Investments and

Third Avenue Trust) received only cash instead of cash and shares in an amount equal to 45 percent

of the amount of their claims. ESL Investments and Third Avenue Trust received only shares in the

reorganized Kmart instead of cash and shares in satisfaction of their Prepetition Lender Claims. In

addition, they received shares for the other claims they held in Kmart as per the Reorganization Plan.

Based on the above transactions and settlements, ESL Investments and Third Avenue collectively

held slightly in excess of 50 percent of all shares of the newly reorganized Kmart.

During the bankruptcy proceedings, Eddie Lampert, Chairman, Chief Executive Ofﬁcer, and

principal owner of ESL Investments, was appointed Chairman and Director of Kmart. Crucially,

Mr. Lampert sat on the Financial Institutions Committee (FIC), the committee overseeing the

bankruptcy on behalf of the claimholders. Because of his position on the FIC, Mr. Lampert was able

to signiﬁcantly affect the bankruptcy proceedings in addition to being able to appoint six of the nine

Kmart board members. Upon Kmart’s emergence from bankruptcy on May 6, 2003, Mr. Lampert

became Chairman of the company.

Kmart’s performance since emerging from bankruptcy has been remarkable. For the fourth quarter

ended January 2004, Kmart reported net income of $276 million compared to an $834 million loss a

396 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

year earlier, although total sales for the 39 weeks fell 23 percent to $17.07 billion, with same-store sales

sliding 9.5 percent. Commenting on the quarter’s results, Julian Day, president and chief executive

ofﬁcer, said, ‘‘By giving careful thought to the processes of sourcing, logistics, pricing, inventory

management, and in-store presentation, we have signiﬁcantly improved the proﬁtability of our market

basket. Our improved inventory management, along with cash ﬂow from operations and receipts from

sales of surplus real estate, has signiﬁcantly strengthened our cash position.’’

The primary reason for Kmart’s stellar performance since emerging from bankruptcy has been

its real estate transactions. Kmart owned and leased thousands of store locations with extremely

favorable terms with very low ﬁxed lease rates for periods that exceeded 50 years. Although these

lease terms were very valuable, Kmart, using Fresh Start Reporting rules, reported its Property and

Equipment as having a total value of just $10 million (Appendix B). Beginning in mid-2004, Kmart

began selling its valuable real estate holdings. On June 4, 2004, Kmart sold 24 stores to Home

Depot for up to $365 million, or roughly $15 million per store. On June 30, 2004, Kmart announced

the sale of 54 stores for $621 million cash to Sears Roebuck & Co., with each store fetching an

average price of $11.5 million. Again, on September 29, 2004, Kmart announced it had ﬁnalized

the sale of another 50 stores to Sears Roebuck & Co., for $575 million in cash. Based on these store

sales, analysts began to project the value of Kmart’s entire real estate portfolio in excess of $18

billion. Kmart stock price closed on September 29, 2004 at $88.06/share or a market capitalization

of $7.81 billion.

On November 16, 2004, Kmart and Sears Roebuck announced a $12.3 billion cash-and-stock

deal creating the new company, Sears Holding Corporation. The CEOs of Kmart and Sears

Roebuck justiﬁed their decision to merge by asserting that the combined $55 billion retail giant

would produce stronger brands, greater efﬁciencies in operations, and higher returns than either

company could achieve standing alone.

However, the retailing experts and the market offered mixed reviews on the deal. Many

questioned how combining two retailers that were struggling would produce an entity that would

compete with the likes of Wal-Mart and Target. Both Kmart and Sears had impressive strengths and

brands. Kmart was strong in home furnishings and apparel, including such lines as Thalia Sodi,

Jacklyn Smith, Joe Boxer, Martha Stewart Everyday, Route 66, and Sesame Street. Sears was well

known for its appliances and tools, lawn and garden products, and had such key brands as

Kenmore, Craftsman, and DieHard. However, retailing experts noted that while operational

synergies would certainly reduce costs, lack of a merchandise strategy that resonated with

consumers would hinder the merged company from recapturing the power of either brand

(Knowledge@Wharton 2005).

Many observers speculated that Eddie Lampert may have plans to break apart the merged

company and sell the assets. Land’s End, the clothing label that Sears bought for $2 billion and that

had turned out to be a disappointing acquisition, was the obvious choice. Others in the market had the

opposite view and conjectured that Eddie Lampert was using the Sears Holding Company as a

publicly traded vehicle to house a portfolio of private and public companies, much like Warren Buffet

created Berkshire Hathaway to buy lower-valued companies and turn them around (Cramer 2005).

REQUIRED

Part I: Kmart’s Financial Performance Prior to Bankruptcy

(a) Using the information in Appendix A, evaluate Kmart’s critical growth, proﬁtability, and

efﬁciency (turnover) ratios for the years 1998–2002 and compare Kmart’s performance to

that of Wal-Mart and Target. How do the different business strategies of these retailers

manifest themselves in the ratios?

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 397

Issues in Accounting Education

Volume 26, No. 2, 2011

(b) Using the information in Appendix A, analyze Kmart’s credit risk and its ability to pay its

bills using common solvency and liquidity ratios for the period of 1998 to 2002. Do these

ratios indicate that debt-rating agencies are likely to downgrade Kmart’s debt? Explain.

been the best predictor of Kmart’s deteriorating ﬁnancial health (if any)?

Part II: In Bankruptcy

Based on the information provided in the case, what are the primary factors that led Kmart to

ﬁle for bankruptcy on January 22, 2002? Was the bankruptcy caused by short-term market effects,

management shortcomings, or simply bad luck? Are there components of Kmart’s operations that

might have value in the future?

Part III: Fresh Start Reporting

Appendix B provides information regarding the adoption of Fresh Start reporting by Kmart.

Using this information, provide the necessary journal entries used to record the following Fresh

Start Reporting Adjustments:



Record the discharge of debt; eliminate the existing liabilities subject to compromise,

record the payment of liabilities, and the issue of new debt.



Cancel the old equity and establish the issue of new equity.



Record the asset value adjustments so as to adjust the assets to the fair values as determined

in the allocation of the reorganization value. Record the amount of goodwill, if any, for the

reorganization value in excess of the value assigned to the speciﬁc assets.

Part IV: Kmart’s Bankruptcy Valuation Analysis

(a) Appendix C provides details of the liquidation analysis including the estimated recovery

rates for Accounts Receivables, Inventories, Prepaid Expenses, and Net Property and

Equipment. The company does not provide details on how the estimated recovery rates

were derived. However, given your knowledge of Kmart and the retail industry, answer the

following questions: (1) What factors would you consider in evaluating the reasonability of

the Estimated Recovery Rates? (2) What assumptions could be challenged by the claimants

and on what grounds? (3) What other information would you request from management in

order to evaluate the plausibility of the Estimated Recovery Rates?

(b) One of the bankruptcy valuation methodologies described in the case is the ‘‘Comparable

Public Company Analysis.’’ Based on the information in the case as well as the data in

Appendix D (which provides information on Kmart’s relative valuation) derive the set of

multiples used by the valuation experts and approximate the range of Kmart’s reorganized

value as of April 30, 2003, by using the Comparable Public Company methodology.

Given your analysis, comment on the reasonability of this valuation.

Analysis method. Based on the information in the case as well as the ﬁnancial projections

provided as part of the reorganization plan and used as the basis for the DCF Analysis

(Appendix E), approximate the range of Kmart’s reorganized value as of April 30, 2003,

using the DCF Analysis method. Make necessary assumptions and clearly state them.

Given your analysis, comment on the reasonability of this valuation.

(d) Based on the information in the case and your analysis in Part IV of the case, do you

believe that the Fresh Start Accounting equity value provided by Kmart while in Chapter

11 bankruptcy is understated or overstated? Given that Kmart’s management has

398 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

discretion in the determination of Fresh Start values, what does it suggest about Kmart

management’s biases and objectives during and after reorganization? While you can rely

on the calculations in questions (a)–(c) of Part IV of this case, this question asks for your

opinion and does not require new computations.

Part V: Post-Bankruptcy Performance

Subsequent to its emergence from bankruptcy, Kmart’s stock price (traded as Kmart Holding

Corp: KMRT) had soared from $15 to $25 in a month, and to $65 (or a market cap of $5.8B) a year

after the bankruptcy. Given this stellar post-bankruptcy stock performance, why was the bankruptcy

valuation so grossly understated? What explains this amazing turnaround? Did one group of

bankruptcy claimants gain wealth at the expense of other groups?

REFERENCES

Cramer, J. J. 2005. Blue light special: Or why Kmart, the downscale, beleaguered retailer everyone loves to

hate, is the next Berkshire Hathaway. New York Magazine (May 21).

Gilson, S. C. 2001. Creating Value through Corporate Restructuring. New York, NY: John Wiley & Sons.

Goodwin, D. 2002. Surety bonds: What they are, why they matter—and how they edged Kmart into the

abyss. Cal Law (April 17). Available at http://www.law.com

Hotchkiss, E., and R. Mooradian. 1997. Vulture investors and the market for control of distressed ﬁrms.

Journal of Financial Economics 43: 401–432.

In Re. Kmart Corporation, et al., in the United States Bankruptcy Court for the Northern District of

Illinois, Eastern Division. 2003. Disclosure statement with respect to ﬁrst amended joint plan

of reorganization of Kmart Corporation and its afﬁliated debtors and debtors-in-possession.

February 25. Available at: http://www.ilnb.uscourts.gov/opinions/JudgeSonderby/Kmart-JDA_

completeopinion.pdf

Knowledge@Wharton. 2005. Sears-Kmart Merger: Is it a tough sell. (January 14). Available at http://

knowledge.wharton.upenn.edu/article.cfm?articleid=1081

Lehavy, R. 2002. Reporting discretion and the choice of fresh start values in companies emerging from

Chapter 11 bankruptcy. Review of Accounting Studies 7: 53–73.

Patsuris, P. 2002. For Kmart, bankruptcy may be best. Forbes (January 3). Available at: http://www.forbes.

com/2002/01/03/0103kmart.html

APPENDIX A

Historical Financial Statements—Kmart, Target, and Wal-Mart (in millions)

Panel A: Kmart (Condensed Financial Statements)

Fiscal Year-End 1/30/1997 1/27/1998 1/27/1999 1/26/2000 1/31/2001 1/30/2002

Income Statement

Sales (Net) 31,437 32,183 33,674 35,925 37,028 36,151

Cost of Goods Sold (23,736) (24,492) (25,648) (28,111) (29,658) (29,936)

Gross Proﬁt 7,701 7,691 8,026 7,814 7,370 6,215

SG&A Expense (6,274) (6,136) (6,245) (5,788) (6,625) (6,764)

EBITDA 1,427 1,555 1,781 2,026 745 (549)

Depreciation and Amortization (654) (660) (671) (770) (777) (824)

EBIT 773 895 1,110 1,256 (32) (1,373)

Interest Expense (538) (412) (343) (330) (333) (414)

Non-Operating Income (Loss) 64 (114) (19) 44 (13) (915)

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 399

Issues in Accounting Education

Volume 26, No. 2, 2011

EBT 299 369 748 970 (378) (2,702)

Income Taxes (68) (120) (230) (337) 134 115

Net Income Before Ext. Items 231 249 518 633 (244) (2,587)

Ext. Items and Disc. Ops. (451) — — (230) — 169

Net Income (available to common) (220) 249 518 403 (244) (2,418)

Balance Sheet

Operating Cash and Market. Sec. 406 498 710 344 401 1,245

Inventories 6,354 6,367 6,536 7,101 6,412 5,822

Other Current Assets 973 611 584 715 939 817

Total Current Assets 7,733 7,476 7,830 8,160 7,752 7,884

PP&E (Net) 5,740 5,472 5,914 6,410 6,557 6,161

Other Assets 813 610 422 534 523 253

Total Assets 14,286 13,558 14,166 15,104 14,832 14,298

Current Debt 156 165 77 66 68 —

Accounts Payable 2,009 1,923 2,047 2,204 2,159 103

Income Taxes Payable — — — 249 187 143

Other Current Liabilities 1,437 1,186 1,567 1,557 1,587 378

Total Current Liabilities 3,602 3,274 3,691 4,076 4,001 624

Long-Term Debt 3,599 2,904 2,629 2,773 3,027 1,187

Other Liabilities* 1,013 965 883 965 834 8,139

Total Liabilities 8,214 7,143 7,203 7,814 7,862 9,950

Preferred Stock ——————

Paid In Common Capital (Net) 3,037 3,075 3,144 3,022 2,952 3,087

Retained Earnings 3,035 3,340 3,819 4,268 4,018 1,261

Total Common Equity 6,072 6,415 6,963 7,290 6,970 4,348

Total Liabilities and Equity 14,286 13,558 14,166 15,104 14,832 14,298

Statement of Cash Flows

Operating:

Net Income 249 518 403 (244) (2,418)

þ Depreciation and Amortization 660 671 770 777 824

Working Capital Adjustments (36) 281 (218) 257 4,708

= Cash From Operations 873 1,470 955 790 3,114

Investing:

 Capital Expenditures (392) (1,113) (1,266) (924) (428)

 Increase in Other Assets 203 188 (112) 11 270

= Cash From Investing (189) (925) (1,378) (913) (158)

Financing:

þ Increase in Debt 295 (363) 133 256 (1,908)

 Dividends Paid on Common — — (80) (73) —

þ/ Net Issuance of Common Stock (887) 30 4 (3) (204)

= Cash From Financing (592) (333) 57 180 (2,112)

Net Change in Cash 92 212 (366) 57 844

þ Beginning Cash Balance 406 498 710 344 401

= Ending Cash Balance 498 710 344 401 1,245

* Other liabilities in 1/30/2002 comprise of ‘‘liabilities subject to compromise’’ in Chapter 11 as follows:

Accounts payable $3,058

Short-term debt $84

Long-term debt $3,262

Other liabilities

$1,735

$8,139

400 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

Panel B: Target Corp (Condensed Financial Statements)

Fiscal Year-End 1/31/1997 1/31/1998 1/31/1999 1/31/2000 1/31/2001 1/31/2002

Income Statement

Sales (Net) 25,092 27,487 30,662 33,702 36,851 39,826

Cost of Goods Sold (17,128) (18,944) (21,085) (23,029) (25,504) (27,606)

Gross Proﬁt 7,964 8,543 9,577 10,673 11,347 12,220

SG&A Expense (6,089) (6,108) (6,843) (7,490) (7,928) (8,924)

EBITDA 1,875 2,435 2,734 3,183 3,419 3,296

Depreciation and Amortization (650) (693) (780) (854) (940) (1,079)

EBIT 1,225 1,742 1,954 2,329 2,479 2,217

Interest Expense (442) (416) (398) (393) (426) (473)

Non-Operating Income (Loss) — ———— 463

EBT 783 1,326 1,556 1,936 2,053 2,207

Income Taxes (309) (524) (594) (751) (789) (839)

Net Income Before Ext. Items 474 802 962 1,185 1,264 1,368

Ext. Items and Disc. Ops. (11) (51) (27) (41) — —

Net Income (available to common) 463 751 935 1,144 1,264 1,368

Balance Sheet

Operating Cash and Market. Sec. 201 211 255 220 356 499

Receivables 1,720 1,555 1,656 1,724 1,941 3,831

Inventories 3,031 3,251 3,475 3,798 4,248 4,449

Other Current Assets 488 544 619 741 759 869

Total Current Assets 5,440 5,561 6,005 6,483 7,304 9,648

PP&E (Net) 7,467 8,125 8,969 9,899 11,418 13,533

Intangibles — ———— 250

Other Assets 482 505 692 761 768 723

Total Assets 13,389 14,191 15,666 17,143 19,490 24,154

Current Debt 233 273 256 498 857 905

Accounts Payable 2,528 2,727 3,150 3,514 3,576 4,160

Income Taxes Payable 182 210 207 318 361 423

Other Current Liabilities 1,168 1,346 1,444 1,520 1,507 1,566

Total Current Liabilities 4,111 4,556 5,057 5,850 6,301 7,054

Long-Term Debt 4,808 4,425 4,452 4,521 5,634 8,088

Deferred Taxes 630 720 822 910 1,036 1,152

Total Liabilities 9,549 9,701 10,331 11,281 12,971 16,294

Preferred Stock 321 310 292 — — —

Paid In Common Capital (Net) 171 250 360 806 977 1,173

Retained Earnings 3,348 3,930 4,683 5,056 5,542 6,687

Total Common Equity 3,519 4,180 5,043 5,862 6,519 7,860

Total Liabilities and Equity 13,389 14,191 15,666 17,143 19,490 24,154

Statement of Cash Flows

Operating:

Net Income 751 935 1,144 1,264 1,368

þ Depreciation and Amortization 693 780 854 940 1,079

Working Capital Adjustments 384 220 126 (467) (1,380)

= Cash From Operations 1,828 1,935 2,124 1,737 1,067

Investing:

 Capital Expenditures (1,351) (1,624) (1,784) (2,459) (3,194)

 Purchases of Intangibles ————(250)

 Increase in Other Assets (23) (187) (69) (7) 45

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 401

Issues in Accounting Education

Volume 26, No. 2, 2011

= Cash From Investing (1,374) (1,811) (1,853) (2,466) (3,399)

Financing:

þ Increase in Debt (343) 10 311 1,472 2,502

þ Increase in Pref. Stock (11) (18) (292) — —

 Dividends Paid on Common — (195) (190) (203) (203)

þ/ Net Issuance of Common Stock (90) 123 (135) (404) 176

= Cash From Financing (444) (80) (306) 865 2,475

Net Change in Cash 10 44 (35) 136 143

þ Beginning Cash Balance 201 211 255 220 356

= Ending Cash Balance 211 255 220 356 499

Panel C: Wal-Mart Stores Inc (Condensed Financial Statements)

Fiscal Year-End 1/31/1997 1/31/1998 1/31/1999 1/31/2000 1/31/2001 1/31/2002

Income Statement

Sales (Net) 104,859 117,958 137,634 165,013 191,329 217,799

Cost of Goods Sold (83,510) (93,438) (108,725) (129,664) (150,255) (171,562)

Gross Proﬁt 21,349 24,520 28,909 35,349 41,074 46,237

SG&A Expense (15,483) (17,724) (20,491) (24,665) (28,682) (32,883)

EBITDA 5,866 6,796 8,418 10,684 12,392 13,354

Depreciation and Amortization (1,463) (1,634) (1,872) (2,375) (2,868) (3,290)

EBIT 4,403 5,162 6,546 8,309 9,524 10,064

Interest Expense (845) (784) (797) (1,022) (1,383) (1,357)

Non-Operating Income (Loss) 1,319 1,341 1,574 1,796 1,975 2,044

EBT 4,877 5,719 7,323 9,083 10,116 10,751

Income Taxes (1,794) (2,115) (2,740) (3,338) (3,692) (3,897)

Minority Interest in Earnings (27) (78) (153) (170) (129) (183)

Net Income Before Ext. Items 3,056 3,526 4,430 5,575 6,295 6,671

Ext. Items and Disc. Ops. — — — (198) — —

Net Income (available to common) 3,056 3,526 4,430 5,377 6,295 6,671

Balance Sheet

Operating Cash and Market. Sec. 883 1,447 1,879 1,856 2,054 2,161

Receivables 845 976 1,118 1,341 1,768 2,000

Inventories 15,897 16,497 17,076 19,793 21,442 22,614

Other Current Assets 368 432 1,059 1,366 1,291 1,103

Total Current Assets 17,993 19,352 21,132 24,356 26,555 27,878

PP&E (Net) 20,324 23,606 25,973 35,969 40,934 45,750

Intangibles 1,037 2,126 2,538 9,392 9,059 8,566

Other Assets 250 300 353 632 1,582 1,333

Total Assets 39,604 45,384 49,996 70,349 78,130 83,527

Current Debt 618 1,141 1,006 5,408 6,661 3,148

Accounts Payable 7,628 9,126 10,257 13,105 15,092 15,617

Income Taxes Payable 298 565 501 1,129 841 1,343

Other Current Liabilities 2,413 3,628 4,998 6,161 6,355 7,174

Total Current Liabilities 10,957 14,460 16,762 25,803 28,949 27,282

Long-Term Debt 10,016 9,674 9,607 16,674 15,655 18,732

Deferred Taxes 463 809 716 759 1,043 1,204

Minority Interest 1,025 1,938 1,799 1,279 1,140 1,207

Total Liabilities 22,461 26,881 28,884 44,515 46,787 48,425

Paid In Common Capital (Net) 375 336 371 705 1,174 661

Retained Earnings 16,768 18,167 20,741 25,129 30,169 34,441

402 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

Total Common Equity 17,143 18,503 21,112 25,834 31,343 35,102

Total Liabilities and Equity 39,604 45,384 49,996 70,349 78,130 83,527

Statement of Cash Flows

Operating:

Net Income 3,526 4,430 5,377 6,295 6,671

þ Depreciation and Amortization 1,634 1,872 2,375 2,868 3,290

Working Capital Adjustments 3,444 857 915 37 858

= Cash From Operations 8,604 7,159 8,667 9,200 10,819

Investing:

 Capital Expenditures (4,916) (4,239) (12,371) (7,833) (8,106)

Purchases of Intangibles (1,089) (412) (6,854) 333 493

 Increase in Other Assets (50) (53) (279) (950) 249

= Cash From Investing (6,055) (4,704) (19,504) (8,450) (7,364)

Financing:

þ Increase in Debt 181 (202) 11,469 234 (436)

 Dividends Paid on Common — (693) (890) (1,070) (1,249)

þ/ Net Issuance of Common Stock (2,166) (1,128) 235 284 (1,663)

= Cash From Financing (1,985) (2,023) 10,814 (552) (3,348)

Net Change in Cash 564 432 (23) 198 107

þ Beginning Cash Balance 883 1,447 1,879 1,856 2,054

= Ending Cash Balance 1,447 1,879 1,856 2,054 2,161

APPENDIX B

Fresh Start Reporting

Kmart Holding Corp

Form 10-Q (Partial)

April 30, 2003

(Filed: June 16, 2003)

2. Basis of Presentation

The unaudited Condensed Consolidated Balance Sheet distinguishes pre-petition liabilities

subject to compromise from both those pre-petition liabilities that are not subject to compromise and

from post-petition liabilities. Liabilities subject to compromise are reported at the amounts expected

to be allowed, even if they may be settled for lesser amounts. In accordance with SOP 90–7, we

adopted Fresh Start accounting as of the Conﬁrmation Date. However, in light of the proximity of

such date to our quarter end, for accounting purposes, the effects of Fresh Start accounting and the

Plan of Reorganization, including the cancellation of the existing common stock and the issuance of

the new common stock, have been reported ‘‘as if’’ they occurred on April 30, 2003.

3. Fresh-Start Accounting

Fresh-Start Adjustments

In accordance with Fresh Start accounting, all assets and liabilities are recorded at their

respective fair market values. Such fair values represent our best estimates based on independent

appraisals and valuations. To facilitate the calculation of the enterprise value of the Successor

Company, we developed a set of ﬁnancial projections. Based on these ﬁnancial projections, the

enterprise value was determined by the Company, with assistance of a ﬁnancial advisor, using

various valuation methods, including (i) a comparison of the Company and its projected

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 403

Issues in Accounting Education

Volume 26, No. 2, 2011

performance to the market values of comparable companies, (ii ) a review and analysis of several

recent transactions of companies in similar industries to the Company, and (iii ) a calculation of the

present value of the future cash ﬂows under the projections. Table B1 reﬂects the reorganization

adjustments to Kmart’s unaudited Condensed Consolidated Balance Sheet as of April 30, 2003.

TABLE B1

Kmart Reorganization Adjustments

Predecessor

Company

April 30,

2003

Fresh

Start

Adjustments Recapitalization

Successor

Company

April 30,

2003

Assets

Current assets

Cash and cash equivalents $1,232 $— $— $1,232

Merchandise inventories 4,446 (15) — 4,431

Other current assets 528 168

195

891

Total current assets $6,206 $153 $195 $6,554

Property and equipment, net 4,623 (4,613)

—10

Other assets and deferred charges 212 (154)

Total assets $11,041 $(4,614) $233 $6,660

Liabilities and Shareholders’ Equity (Deﬁcit)

Current Liabilities

Long-term debt due within one year $— $— $8

Accounts payable 1,151 — 9

1,160

Other current liabilities 915 117

563

1,595

Total Current Liabilities $2,066 $117 $580 $2,763

Long-term debt — — 108

108

Capital lease obligations 415 — — 415

Other long-term liabilities 174 279

1,208

1,661

Total Liabilities Not Subject to

Compromise

2,655 396 1,896 4,947

Liabilities Subject to Compromise 8,896 114

(9,010)

—

Trust convertible securities 387 (387)

——

Other comprehensive income (908) 908

——

Common stock 537 (537)

Other equity (526) (5,108)

7,346

1,712

Total Liabilities and Shareholders’

Equity (Deﬁcit)

$11,041 $(4,614) $233 $6,660

To adjust assets and liabilities to fair market value (‘‘FMV’’), and reﬂect the write-off of Predecessor Company’s equity

and the application of negative goodwill to long-lived assets.

To record assumption or discharge of Liabilities subject to compromise and cash to be received from the Plan Investors.

To record par value of new common stock for the Successor Company.

To record gain on discharge of liabilities subject to compromise and additional paid-in-capital of new common stock

for the Successor Company.

404 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

APPENDIX C

Liquidation Analysis (Source: Kmart’s Plan of Reorganization)

Liquidation Analysis

($ in 000s)

V. Selected Notes to Liquidation Analysis

Note 1 Overview and Liquidation Period

This Best Interests Analysis was prepared as if the Debtors were substantively consolidated.

The Analysis is based on the Company’s projected balance sheet as of April 30, 2003 (except as

indicated), and the actual amount of assets available to the estates as of the date of liquidation may

differ from the amount of assets used in this Analysis (see Table C1).

TABLE C1

I. Calculation of Net Estimated Proceeds Available for Allocation

Projected

Balances

@ 4/30/03

Estimated

Recovery

Rate Range

Impact on

Unsecured

Creditor Recoveries

See NoteLow High Low High

A. Statement of Assets

Cash and Equivalents $820,550

100% 100% $820,550 $820,550

Accounts Receivable 414,894 25% 40% 104,512 164,185 2

Inventories 4,581,433

53% 62% 2,447,229 2,845,873 3

Prepaid Expenses and

Other Current Assets

166,223 45% 53% 74,032 88,465 4

Net P&E 4,633,995 13% 19% 593,359 878,996 5

Other Assets and Deferrals 182,989 19% 37% 53,607 70,462 6

Total Assets 10,800,084 38% 45% 4,093,290 4,868,531

B. Recoveries from Exercise of Avoiding Powers 240,000 405,000 7

C. Recoveries from Claims Against Certain Directors,

Ofﬁcers, and Advisors of Debtors

——

D. Other Proceeds—Sale of Pharmacy Lists 152,000 192,000

E. Gross Proceeds 4,485,290 5,465,531

F. Creditor Recovery Expenses

Corporate Expenses (400,000) (450,000) 8

Six months’ store rent and occupancy following completion

of GOB sale

(498,668) (498,668)

Employee retention and severance (92,624) (92,624)

Chapter 7 Trustee fees (3% of gross proceeds) (134,559) (163,966)

Other professional fees (80,000) (100,000)

(1,205,852) (1,305,259)

Net Estimated Proceeds Available for Allocation $3,279,438 $4,160,272

Cash and Equivalents is projected balance of cash (net of checks outstanding) and marketable securities at 4/30/03

reduced for payment of estimated professional fees of approximately $37.3 million.

Inventories is projected balance of inventories at 4/30/03 increased for estimated inventories secured by Trade Letters

of Credit outstanding as of the projected ﬁling date (See Note 3—Inventories).

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 405

Issues in Accounting Education

Volume 26, No. 2, 2011

Management of the Company, with the assistance of AlixPartners LLC, prepared the Analysis.

The Analysis presents management’s estimated net value of the Company’s assets if the Debtors

were to be liquidated under the provisions of Chapter 7 of the United States Bankruptcy Code (the

‘‘Code’’), and the net proceeds of the liquidation were to be applied in strict priority to satisfy

claims against the debtors.

The Analysis is limited to presenting information that was the representation of management

and does not include an evaluation of the support for the underlying assumptions. The Analysis has

not been examined or reviewed by independent accountants in accordance with standards

promulgated by the American Institute of Certiﬁed Public Accountants. The estimates and

assumptions, although considered reasonable by management, are inherently subject to signiﬁcant

uncertainties and contingencies beyond the control of management. Accordingly, there can be no

assurance that the results shown would be realized if the Company were liquidated and actual

results in such case could vary materially from those presented.

For purposes of this Analysis, management assumes a liquidation would require three phases

and would take place over 18 months. Phase I would comprise a three-month period during which

inventories would be sold in a going-out-of-business sale (‘‘GOB Sale’’) conducted by a third-

party. By the end of the GOB Sale substantially all store, distribution center, and ﬁeld associates

would be terminated. During Phase I, certain headquarters associates would be terminated

including, for instance, staff of merchandising, merchandise ﬁnance, advertising, stores

organization, loss prevention, maintenance, accounts payable, training, communications, and

purchasing.

Phase II would comprise the next six-month period (and would actually have started during

Phase I). During Phase II, the Company’s real estate and most of the Company’s non-real estate

ﬁxed assets would be marketed. In addition, headquarters operations would continue to wind down,

and most remaining headquarters associates would be terminated. Certain headquarters personnel,

such as staff in legal, ﬁnance and accounting, and information technology would be retained as

necessary to support Phase III. Phase III would comprise a nine-month period after completion of

the real estate marketing efforts during which any remaining litigation would be pursued, ﬁnal tax

returns ﬁled, bankruptcy court reports and schedules ﬁled, and remaining assets disposed.

While the Analysis assumes an 18-month liquidation time frame, ﬁnal resolution of all

preference actions is expected to extend 12 months beyond the 18-month liquidation time frame.

All professional fees associated with resolution of such matters are contemplated in the estimated

net recoveries from preferences actions.

Note 2 Accounts Receivable

Accounts receivable comprises a variety of accounts, the most sizeable being Pharmacy

Receivables, Store Receivables, and Merchandise Allowance Receivables.

Pharmacy Receivables are receivables from third-party insurance companies in connection

with the ﬁlling of prescriptions. All accounts aged past 60 days are fully reserved. Historical

experience indicates that the Company’s reserve policy has been sufﬁcient in estimating losses

incurred with this account.

Store Receivables are a combination of layaway receivables and credit extended at the store

level by store management to customers. For purposes of the Analysis, the account is assumed to be

primarily comprised of credit extended to customers and would be, in all likelihood, uncollectable.

Merchandise Allowance Receivables are allowances generated in connection with food

products purchased through Fleming.

Other Receivables are comprised of a number of miscellaneous accounts such as rent due from

subtenants and former subsidiaries, amounts due from landlords for repairs and maintenance, and

amounts due from bad checks, etc. and have varying degrees of estimated collectability (see Table C2).

406 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

Note 3 Inventories

Merchandise inventories are assumed to be disposed of through a lawful ‘‘going-out-of-

business sale’’ commencing May 1, 2003, with no restrictions on the Company’s ability to

aggressively advertise the sale as a ‘‘going-out-of-business sale’’ (‘‘GOB Sale’’). The GOB Sale

assumptions reﬂect the Company’s experience in 2002 when it closed 283 stores over a ten-week

time period and are adjusted where considered appropriate for the scale and timing of a mass

liquidation, as well as for the projected composition of Company inventory at the commencement

of a mass liquidation. The Low Recovery scenario assumes that the sale takes 13 weeks and reﬂects

a lowered net recovery resulting from deeper discounts and increased direct expense. The High

Recovery scenario assumes a ten-week sale period and is more reﬂective of the results achieved in

the 2002 store closings. For purposes of the Analysis, GOB Sale Merchandise Inventory is the sum

of perpetual inventories, imports paid not received, and merchandise letters of credit outstanding

under the Company’s projections as of April 30, 2003 (see Table C3).

Note 5 Net P&E—Owned and Leased

Net P&E includes owned land, buildings, furniture, ﬁxtures, and equipment at the stores,

distribution center, and corporate resource center, net of depreciation. Certain P&E is recorded as

capitalized lease assets. Proceeds from the disposition of owned real estate and real estate leasehold

interests were established using estimates provided by Rockwood Gemini Advisors.

Proceeds from the sale of furniture, ﬁxtures, and equipment are estimated based on

management’s experience with store closings (see Table C4).

TABLE C2

Accounts Receivable

Projected

Balance

@ 4/30/03

Recovery

Rate Range

Estimated

Proceeds Range

Low High Low High

Pharmacy Receivables (net) $100,000 90% 100% $90,000 $100,000

Store Receivables 86,000 0% 0% — —

Merchandise Allowance Receivables (net) 61,353 10% 35% 6,135 30,677

Other Receivables 167,540 5% 20% 8,377 33,508

Total Accounts Receivable $414,894 25% 40% $104,512 $164,185

25% 40%

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 407

Issues in Accounting Education

Volume 26, No. 2, 2011

TABLE C3

Projected Merchandise Inventories at Cost @ 4/30/03 $4,322,229

Add: Inventory Received after 4/30/03

259,204

GOB Sale Merchandise Inventories at Cost 4,581,433

Assumed Selling Value of Merchandise Inventories $6,737,402

Assumed Selling Value Gross Margin 32%

2002

GOB Sale Percentage

Low

Recovery Percentage

High

Recovery Percentage

Merchandise Inventory

@ Retail

$1,415,469 $6,737,402 $6,737,402

Sales (Gross Recovery) 890,303 62.9% 4,042,312 60.0% 4,237,696 62.9%

Store Direct Expenses

Total Employment

Expense

118,479 8.4% 777,183 11.5% 603,774 9.0%

Rent & Occupancy 47,132 3.3% 320,279 4.8% 320,279 4.8%

Advertising 31,100 2.2% 204,005 3.0% 158,486 2.4%

Other SG&A 4,435 0.3% 82,667 1.2% 64,222 1.0%

Total Store Direct Expenses 201,146 14.2% 1,384,134 20.5% 1,146,761 17.0%

Royalty Expense

NA 8,826 0.1% 9,252 0.1%

Liquidation Fees 58,423 4.1% 202,122 3.0% 235,809 3.5%

Total GOB Expenses 259,569 18.3% 1,595,082 23.7% 1,391,823 20.7%

Estimated Cash Proceeds $630,734 44.6% $2,447,229 36.3% $2,845,873 42.2%

from Sale

Projected Trade Letters of Credit at 4/30/03 ($216 million) are grossed-up by 20 percent for insurance, freight, and

import fees and are assumed, for purposes of this Analysis, to be issued to foreign vendors and that all goods secured by

Letters of Credit are shipped and paid in the normal course. Additionally, it is assumed that all purchase orders for

goods not secured by Trade Letters of Credit would be cancelled as of the hypothetical ﬁling date. While it may be

possible to cancel certain Trade Letters of Credit, it is assumed that any potential cancellation would be offset by any

goods on a non-secured purchase order that are FOB. Accordingly, the estimated Trade Letter of Credit balance is

considered a reasonable estimate of the value of goods that would ﬂow into a GOB sale subsequent to the sale

commencement date.

Royalty Expense on Licensed Inventory is estimated using projected balances of licensed inventories as of 4/30/03.

Expense is calculated on those lines where royalties are determined by sales. Royalty expense calculated on purchases

or receipts are assumed to have been booked prior to commencement of the GOB Sale. Results of the 2002 GOB Sale

were tracked only on a direct store expense basis. Consequently, comparable information for royalty expense is not

available.

408 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

APPENDIX D

Data for Relative Valuation

Kmart Corporation

Relative Valuation

(Dollars in Millions, Except Per Share Data)

Kmart

Wal-Mart

Target

Filing Date Jan 2003 Jan 2004 Jan 2003 Jan 2004 Jan 2003 Jan 2004

Fiscal Year 2002 2003 2002 2003 2002 2003

Number of Outstanding

Shares (millions)

519.12 89.59 4,395.00 4,311.00 909.80 911.81

Price/Share

0.24 25.31 51.68 52.68 31.04 37.95

Market Value of Equity 126 2,267 227,123 227,099 28,237 34,599

Book Value of Debt 4825 501 37,055 40,322 10,186 10,217

Cash 613 2088 2,736 5,199 758 716

Enterprise Value 4,338 680 261,442 262,222 37,665 44,100

Book Value of Equity 301 2,209 39,461 43,623 9,443 11,065

TABLE C4

Proceeds from the Sale of Furniture, Fixtures, and Equipment

Real Estate Assets

Projected

NBV @

4/30/03

Recovery

Rate Range

Estimated

Proceeds Range

Low High Low High

Owned

Stores $193,529 $234,546

Distribution Centers (DC) 933 11,803

Kmart Resource Centers (KRC) 9,625 19,250

Other 57,020 65,569

1,208,392 22% 27% 261,107 331,168

Leased:

Capitalized Assets and LHI

a,b

1,703,830 17% 27% 293,238 461,536

Non-Real Estate Fixed Assets

Furniture and Fixtures—Stores 1,229,244 3% 5% 36,877 61,462

Furniture and Fixtures—DCs 282,944 0% 5% — 14,147

Furniture and Fixtures—KRC 213,659 1% 5% 2,137 10,683

Other (4,074) 0% 0% — —

Totals $4,633,995 13% 19% $593,359 $878,996

Per discussions with the Company’s real estate advisor, Rockwood Gemini Advisors, appraised values have been

reduced by 50 percent to reﬂect the liquidation assumptions contemplated by this Analysis.

For purposed of the Analysis, Capitalized Assets are considered to be principally real estate assets and Leasehold

Improvements are considered as part of those assets. Anticipated recoveries on Capitalized Assets and Leasehold

Improvements are assumed to be through the sale of designation rights.

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 409

Issues in Accounting Education

Volume 26, No. 2, 2011

Revenue 30,762 23,253 229,616 256,329 42,722 46,781

EBITDA 12 639 13,295 15,025 4,476 4,839

Square Feet of Stores

(millions)

154 454 193

Kmart ﬁnancial data was taken from Compustat.

Wal-Mart ﬁnancial data was taken from Bloomberg.

Target ﬁnancial data was taken from Bloomberg.

Price per share data was taken from Bloomberg.

Kmart’s square feet of stores data was taken from http://www.bizstats.com/whyspf.htm.

Wal Mart’s square feet of store data were taken from http://www.buildings.com/Articles/detail.asp?ArticleID=1525

Target’s square feet of stores data were taken from http://pressroom.target.com/pr/news/target-stores/fastfacts.aspx

APPENDIX E

Projected Financial Statements (Source: Kmart’s Plan of Reorganization)

Panel A: Projected Consolidated Statements of Operations

Kmart Corporation

(Debtors-in-Possession)

(Dollars in millions)

Fiscal Year

2004

(Ending

Jan. 2005)

2005

(Ending

Jan. 2006)

2006

(Ending

Jan. 2007)

2007

(Ending

Jan. 2008)

Net sales 25,614 26,981 28,478 30,170

Cost of sales, buying and occupancy 20,423 21,308 22,407 23,669

Gross margin 5,191 5,673 6,071 6,501

Selling, general and administrative expenses 4,814 5,066 5,258 5,409

Earnings before interest and income taxes 377 607 813 1,092

Interest expense, net 89 73 61 51

Earnings before income taxes 288 534 752 1,041

Income taxes 109 202 287 397

Net earnings 179 332 465 644

Depreciation and amortization 47 93 142 192

EBITDA 424 700 955 1,284

410 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

Panel B: Projected Consolidated Balance Sheets

Kmart Corporation

(Debtors-in-Possession)

(Dollars in millions)

Fiscal Year

2003

(Ending

Jan. 2004)

2004

(Ending

Jan. 2005)

2005

(Ending

Jan. 2006)

2006

(Ending

Jan. 2007)

2007

(Ending

Jan. 2008)

Assets

Current Assets

Cash and cash equivalents 300 300 312 468 807

Merchandise inventories 4,048 3,995 3,925 3,910 3,872

Other current assets 739 657 681 708 740

Total current assets 5,087 4,952 4,918 5,086 5,419

Property and equipment, net 273 676 1,083 1,491 1,899

Other assets and deferred charges 14 13 14 15 16

Total Assets 5,374 5,641 6,015 6,592 7,334

Liabilities and Shareholders’ Equity

Current Liabilities

Long-term debt due within one year 8 8 8 8 8

Accounts payable 1,026 1,357 1,505 1,570 1,684

Other current liabilities 828 966 1,159 1,470 1,720

Total Current Liabilities 1,862 2,331 2,672 3,048 3,412

Long-term debt 251 115 73 68 63

Other long-term liabilities* 1,993 1,750 1,492 1,233 972

Total liabilities not subject to

compromise

4,106 4,196 4,237 4,349 4,447

Shareholders’ equity 1,268 1,445 1,778 2,243 2,887

Total Liabilities and Equity 5,374 5,641 6,015 6,592 7,334

* ‘‘Other long-term liabilities’’ include capital lease obligations as can be inferred from the payment of $52 in the

statement of cash ﬂows on the next page.

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 411

Issues in Accounting Education

Volume 26, No. 2, 2011

Panel C: Projected Consolidated Statements of Cash Flow

Kmart Corporation

(Debtors-in-Possession)

(Dollars in millions)

Fiscal Year

2004

(Ending

Jan. 2005)

2005

(Ending

Jan. 2006)

2006

(Ending

Jan. 2007)

2007

(Ending

Jan. 2008)

Operating Activities

Net Earnings $179 $332 $465 $644

Adjustments to reconcile net earnings to net cash used for operating activities:

Depreciation and amortization 50 93 142 191

Equity income in unconsolidated subsidiaries (47) (48) (49) (50)

Dividends received from Meldisco 46 47 48 49

Changes in operating assets and liabilities:

Inventories 52 71 15 38

Accounts payable 331 148 65 114

Deferred income taxes and taxes payable 110 202 287 271

Other assets 82 (24) (27) (31)

Other liabilities (164) (215) (183) (230)

Net cash provided by operating activities 639 606 763 996

Investing Activities

Capital expenditures (450) (500) (550) (600)

Net cash used for investing activities (450) (500) (550) (600)

Financing Activities

Payments on debt, net (137) (42) (5) (5)

Payments on capital lease obligations (52) (52) (52) (52)

Net cash used for ﬁnancing activities (189) (94) (57) (57)

Net change in cash and cash equivalents — 12 156 339

Cash and cash equivalents, beginning of year 300 300 312 468

Cash and cash equivalents, end of year $300 $312 $468 $807

Summary of Signiﬁcant Assumptions

The ﬁnancial projections included in this Disclosure Statement are dependent on successful

implementation of the business plan of Kmart Corporation and its subsidiaries and the accuracy of

the assumptions contained therein. The Projections have not been prepared to comply with the

guidelines established by the American Institute of Certiﬁed Public Accountants (AICPA).

Fresh Start Accounting and Enterprise Value

The Projections assume that Kmart will emerge from Chapter 11 on or about April 30, 2003, and

as required, adopt the principles of Fresh Start Accounting prior thereto. Adoption of Fresh Start

Accounting requires that assets and liabilities be stated at their reorganization value, which

approximates fair value at the date of emergence from Chapter 11. Adjustments to reﬂect the fair value

of assets and liabilities, on a net basis, result in an excess of fair value of net assets over reorganization

value (‘‘negative goodwill’’) of approximately $4.2 billion. This negative goodwill will be allocated on

412 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

a pro rata basis and serve to reduce the basis of our non-current assets. The remaining negative

goodwill of $0.1 billion will be recorded in the income statement as an extraordinary gain.

Net Sales

Net sales for 2003 as compared to 2002 are projected to decrease by 17.5 percent due to the

closure of 283 stores in May 2002 and additional stores by March 2003. Net sales are expected to

increase 0.7 percent in 2004, 5.3 percent in 2005, 5.5 percent in 2006, and 5.9 percent in 2007. The

increases in net sales for 2004 through 2007 are partially the result of 70 new store openings, which

are planned as follows: 10 each in 2004 and 2005, 20 in 2006, and 30 in 2007. On a same-store

basis, the Projections assume that same-store sales will increase over prior years by 1.1 percent, 3.8

percent, 4.5 percent, 4.3 percent, and 4.0 percent for 2003 through 2007, respectively. The primary

drivers of the same-store sales increases include the continued improvement in operational

execution, increased promotional productivity and improved product ﬂow. As a result of improved

product ﬂow and allocation, inventory turns are expected to improve from 4.0 in 2002 to 4.2 in

2003. Inventory turnover is expected to further improve to 5.0 by 2007 as a result of right-size

purchasing and ﬂow path optimization.

Gross Margin

Gross margin as a percentage of net sales is projected to improve from 18.0 percent in 2002 to

21.5 percent in 2007. This improvement is driven by improved promotional productivity and

favorable product mix. In addition, the Projections assume lower depreciation of buildings and

leasehold improvements as a result of the write-down of assets for Fresh Start Accounting.

SG&A

Selling, general, and administrative expenses (‘‘SG&A’’), as a percentage of net sales, are

projected to remain relatively ﬂat at approximately 20 percent from 2002 to 2003 as lower

depreciation expense generated by Fresh Start Accounting adjustments is mostly offset by the

effects of store closings and the resulting lower sales base. Thereafter, SG&A is expected to

improve to 17.9 percent of net sales by 2007. This improvement is primarily due to improved

operating procedures and cost control initiatives at Kmart’s headquarters.

Income Taxes

The Projections assume that Kmart will substantially offset its unused net loss carryforwards

against the Company’s cancellation of debt income at emergence. The effective tax rate going

forward is estimated at 38.0 percent. Tax beneﬁts will be fully reserved until utilization.

Capital Expenditures

The Projections assume that annual capital expenditures build from $350 million in 2003 to

$600 million in 2007. The increase is primarily related to new store openings (a total of 70 through

2007) and updating the existing stores.

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 413

Issues in Accounting Education

Volume 26, No. 2, 2011

APPENDIX F

Treatment of Selected Classes of Kmart’s Claimholders

(Source: Kmart’s Plan of Reorganization)

Below is the summary of the treatment of selected classes of Kmart’s claimholders under the

Reorganization Plan:

Class Description Treatment

Class 3: Prepetition Lender Claims

These are unsecured creditors of Kmart Issued 18,723,735 shares of new com-

mon stock of Kmart Corporation and

cash recovery of $243 million

Estimated Amount of Claim: $1,076,156,647.02

Estimated Percentage Recovery: 45.0 percent

According to the valuation analysis prepared by Kmart’s investment bankers and ﬁnancial

advisors, the estimated mid-range value of Kmart’s equity is approximately $1.128 billion (average

of $753 million and $1,503 million) or $13.09/share (average of $8.75/share and $17.43/share)

assuming a total of 86,236,453 shares. A cash recovery of $243 million and the 18,723,775 shares

at an average of $13.09/share totals a recovery of $488 million, which is approximately 45 percent

of total estimated amount of claims of $1,076,156,647.

Class 4: Prepetition Note Claims

These are comprised of unsecured deben-

tures and notes issued by Kmart over the

course of several years

Issued 25,008,573 shares of new com-

mon stock of Kmart Corporation

Allowed Amount of Claims: $2,277,384,986.97

Estimated Percentage Recovery: 14.4 percent

Class 5: Trade Vendor/Lease Rejection Claims (amounts over $30,000)

These are claims arising as a result of re-

tail merchandise or services provided by

trade vendors or service providers, rejec-

tion of executory contracts and unexpired

leases, guarantees with respect to indus-

trial revenue bonds, and unsecured defi-

ciency claims

Issued 31,945,161 shares of new com-

mon stock of Kmart Corporation

Estimated Amount of Claims: $4,300,000,000

Estimated Percentage of Recovery: 9.7 percent

414 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

Class 6: Other Unsecured Claims (claims greater than $30,000)

These comprise personal injury and other

litigation claimants and claims by gov-

ernment entities on account of anything

other than taxes. Note that a large per-

centage of these claims are of unknown

amounts and disputed.

Claimholders will receive their pro rata

share of common stock on the third anni-

versary of the effective date of the Plan

of Reorganization

Estimated Amount of Claim: $200,000,000

Estimated Percentage of Recovery: NA

Class 7: General Unsecured Convenience Claims

These are claims held by persons who

would otherwise qualify for treatment as

Class 5 or Class 6 creditors, but whose

claims are in amounts equal to or less than

$30,000

Under the Plan, these claimants will

receive cash in an amount equal to 6.25

percent of the amount of their claim.

Estimated Amount of Claim: $5,000,000

Estimated Percentage Recovery: 6.25 percent

Class 1: Secured Claims and Class 2: Priority Claims were not impaired and are not listed. Class 8:

Trust Preferred Obligations, Class 10: Subordinated Securities, Class 11: Existing Common Stock,

and Class 12: Other Interests were cancelled and not entitled to any distribution. Class 9:

Intercompany Claims are purely accounting transactions and are eliminated.

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 415

Issues in Accounting Education

Volume 26, No. 2, 2011

CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE

Overview

This is a comprehensive case that requires students to analyze Kmart Corporation’s ﬁnancial

information, investigate the circumstances leading to its bankruptcy, and analyze accounting and

valuation issues as it emerged from its Chapter 11 reorganization. The case has been prepared from

publicly available information, including Kmart’s 10-K and 10-Q ﬁlings, Joint Plan of

Reorganization ﬁled with the United States Bankruptcy Court for the Northern District of Illinois,

and news items in the business press. This case is targeted primarily at graduate-level courses in

Financial Statement Analysis as well as Forecasting and Valuation.

Incremental Contribution of the Case

This teaching case provides several opportunities for the instructor to contribute to the

students’ learning experience in a typical ﬁnancial statement analysis and/or forecasting and

valuation courses. First, the case demonstrates the ability of a detailed ﬁnancial ratio analysis (over

time and compared to other ﬁrms) to predict bankruptcy. Second, the case introduces and

demonstrates the implementation of Fresh Start Reporting for ﬁrms emerging from bankruptcy.

Third, the case familiarizes the students with the institutional background of a Chapter 11

bankruptcy, and, in particular, the requirements for a liquidation analysis that demonstrates the

value of the ﬁrm if it were to liquidate instead of reorganize. This is a fascinating part of the case

because it illustrates possible methods to compute assets’ liquidation values as well as a discussion

of the effect of management incentives on the determination of these ﬁgures. Fourth, while there are

many teaching cases whose objective is to derive equity values based on various valuation models,

this case requires students to derive equity values based on the ﬁrm’s own release of projected

ﬁnancial statements during bankruptcy, and discusses the potential for these forecasted statements

and the resulting valuation to be biased. Finally, the case discusses the incentives of the various

groups that are a part of a typical bankruptcy (e.g., management, creditors, and vulture investors)

and demonstrates the effect of these incentives on the reported ﬁnancial numbers (both on the

projections provided during the bankruptcy and on the fresh start numbers). This provides students

with a unique and clear-cut example of the use of reporting discretion in ﬁnancial reporting.

There are a number of existing cases (primarily Harvard Business School cases) relating to

bankruptcy and Chapter 11 reorganization. Some of these cases, such as Bankruptcy and

Restructuring at Marvel Entertainment Group (Esty and Auerbach 2007) and Flagstar Companies

Inc. (Gilson 2007) focus on the valuation of a company in a corporate restructuring. Other cases

deal with the details of the restructuring process. For instance, Scott Paper Company (Gilson and

Cott 1997) requires students to evaluate the optimal level of layoffs in a corporate downsizing

program.

Two other cases deal with topics similar to the issues discussed in the Kmart case. In ‘‘TWA:

The Second Bankruptcy’’ (Barth and Yildiz 2001) students are required to act as the holders of

TWA’s 8 percent secured notes and to analyze the information in the proxy statement in order to

decide how to cast the vote on the ﬁrm’s reorganization proposal. The second is ‘‘Eddie Bauer’’

(Healy et al. 2009), which is a comprehensive valuation case in a setting in which the ﬁrm is

emerging from bankruptcy protection and later plans to go private. While both the TWA and the

Eddie Bauer cases rely on details that are similar to those provided in the Kmart case, they primarily

address valuation issues and do not focus on the same set of issues as the ones in the Kmart case

(e.g., understanding the mechanics of the Fresh Start adjustments, the analysis of the ﬁnancial

performance of the ﬁrm prior to bankruptcy, and the assessment of the reasonableness of the

416 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

Estimated Recovery rates vis-a`-vis Kmart’s post-bankruptcy performance). As such, we believe that

the Kmart case provides incremental contribution over and above existing published cases.

Case Learning Objectives

Following are the speciﬁc learning objectives of the case:

i. Analyze the ﬁnancial statements of Kmart Corporation through the computation of

appropriate ratios with a view to ascertaining its potential bankruptcy. In addition to

assessing the ﬁnancial position and performance of the ﬁrm, students have to understand

and evaluate the business risks that confronted Kmart and its management actions prior to

its bankruptcy.

ii. Understand Kmart’s Reorganization Plan, speciﬁcally, the treatment of its various

claimholders and the details of the liquidation analysis as set forth in the Bankruptcy Code.

iii. Learn to value Kmart as it emerges from reorganization using appropriate valuation

methodologies and based on the unaudited projections that Kmart’s management

provided in the Reorganization Plan.

iv. Understand the use of Fresh Start Reporting by Kmart and examine the consequences of

Kmart’s management discretion in the determination of Fresh Start values.

v. Understand the reasons and consequences of Kmart’s stellar stock performance after it

emerged from bankruptcy.

Implementation Guidance

The case is most suitable for a graduate-level course in Financial Statement Analysis as well as

a Forecasting and Valuation course. In Financial Statement Analysis, the case can be used

concurrently with lectures on Credit Analysis and Distress Prediction—for instance, Chapter 10 of

Business Analysis and Valuation, Palepu and Healy (2007). In a Forecasting and Valuation course

the case can be used to demonstrate the forecasting process (using the Kmart-provided ﬁnancial

projections) as well as the various valuation techniques used by bankruptcy valuation experts. The

categories of case questions are largely independent allowing instructors the ﬂexibility to adopt only

sections that are relevant to their courses. For a Financial Statement Analysis course, the instructor

could assign questions in Part I, II, and III. For a Forecasting and Valuation course, Parts IV and V

would be appropriate.

The case is challenging and broad in scope, but manageable if the instructor reviews the

underlying topics prior to assigning the case to allow students with limited knowledge and

background to tackle the case. For instance, prior to assigning Part III questions, the instructor

should provide an overview of Fresh Start Reporting, including the allocation of reorganization

value to identiﬁable assets, reporting of liabilities, and required disclosures in ﬁnancial statements of

the new entity. The main body of the case provides an overview of Chapter 11 reorganizations and a

description of the various approaches for valuing ﬁrms in ﬁnancial distress. In addition, the

instructor could provide supplemental handouts on various valuation methodologies and Fresh Start

Reporting.

The case is computationally intensive. However, instructors can obtain electronic spreadsheets

of the condensed ﬁnancial statements of Kmart, Target, and Wal-Mart and the projected ﬁnancial

statements of Kmart from the journal’s website. This will signiﬁcantly reduce students’ preparation

time, allowing them to focus on analysis and interpretation. Also, the case is best used as a

collaborative project in which groups of three to four students submit written analyses of the case. A

lead time of at least two weeks is suggested before the case analyses are required.

Instructors should schedule a class discussion after students submit their projects. For optimal

class discussion, two class sessions of 1.5 hours each should be devoted to the case. The ﬁrst class

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 417

Issues in Accounting Education

Volume 26, No. 2, 2011

session would cover the company history leading to its bankruptcy ﬁling on January 22, 2002;

comparative ratio analysis of Kmart, Wal-Mart, and Target’s growth, proﬁtability, efﬁciency, and

credit risk; Kmart’s Reorganization Plan; and an introduction to Fresh Start Reporting

(Requirements in Parts I, II, and III). The second session would cover the valuation methodologies

in detail, liquidation analysis, post-bankruptcy performance, and vulture investing in Kmart

(Requirements in Parts IV and V). The valuation spreadsheets and PowerPoint slides for the two

class sessions described above are available on the journal’s website.

Student Feedback

The authors have used the case in a graduate ﬁnancial statement analysis course. It was

assigned as a collaborative project with a group size of between 3–4 students accounting for 10–15

percent of the course grade. Students were asked to provide feedback on the following questions,

using a ﬁve-point scale with the following response categories: (1) Strongly Disagree, (2) Disagree,

(3) Neither agree or disagree, (4) Agree, and (5) Strongly Agree. Mean response for the 58 students

(or 45 percent) completing the survey are reported in Table 1.

Responses to the ‘‘Other Comments’’ section of the student feedback forms indicate that the

students found the case very interesting and a useful tool to discuss Chapter 11 reorganization.

On average, the students spent between 1–2 hours on each part with the instructors spending

between 2–3 hours preparing for each part of the case. The case generated considerable discussion

and interest among the students on the topics of Fresh Start Reporting, valuation, and the strategies

for investing in distressed securities. The case has signiﬁcant real-life relevance because many

graduate students had heard about Mr. Eddie Lampert and the returns he generated for ESL

Investments from his investment in the distressed bonds of Kmart.

TEACHING NOTES

Teaching Notes are available only to full-member subscribers to Issues in Accounting

Education through the American Accounting Association’s electronic publications system at http://

aaapubs.org/. Full-member subscribers should use their usernames and passwords for entry into the

system where the Teaching Notes can be reviewed and printed. Please do not make the Teaching

Notes available to students or post them on websites.

TABLE 1

Student Feedback

Mean Response

1. The case content was realistic. 4.38

2. The Kmart case and class discussion enhanced my understanding of how to

analyze the ﬁnancial performance of a ﬁrm prior to bankruptcy.

4.10

3. The Kmart case and class discussion helped me understand the accounting rules

for companies emerging from a Chapter 11 bankruptcy (Fresh Start Reporting).

4.14

4. The case incorporated many of the analysis techniques (strategy analysis,

accounting analysis, etc.) taught in the course.

4.10

5. Overall, the Kmart case and class discussion enhanced my understanding of the

Chapter 11 reorganization process.

4.21

5. Overall, I found the Kmart case and class discussion interesting and useful. 4.22

6. I would recommend that the Kmart case be used as part of this course in the

future.

4.47

418 Lehavy and Udpa

Issues in Accounting Education

Volume 26, No. 2, 2011

If you are a full member of AAA with a subscription to Issues in Accounting Education and

have any trouble accessing this material, then please contact the AAA headquarters ofﬁce at info@

aaahq.org or (941) 921-7747.

REFERENCES

Barth, M. E., and N. Yildiz. 2001. TWA: The Second Bankruptcy. Stanford Graduate Business School Case.

Product Number: A178-PDF-ENG. Palo Alton, CA: Stanford University.

Esty, B. E., and J. C. Auerbach. 2007. Bankruptcy and Restructuring at Marvel Entertainment Group.

Product Number: 298059-PDF-ENG. Cambridge, MA: Harvard Business School Publishing.

Gilson, S. C. 2007. Flagstar Companies Inc. (Abridged). Product Number 206076-PDF-ENG. Cambridge,

MA: Harvard Business School Publishing.

Gilson, S. C., and J. Cott. 1997. Scott Paper Company. Product No: 296048-PDF-ENG. Cambridge, MA:

Harvard Business School Publishing.

Healy, P. M., S. Katz, and A. Sesia 2009. Eddie Bauer (A). Product Number: 1100008_PDF-ENG.

Cambridge, MA: Harvard Business School Publishing.

Palepu, K. G., and P. Healy. 2007. Business Analysis and Valuation: Using Financial Statements, Text, and

Cases. Kentucky: South-Western College Publishing.

Kmart: Predicting Bankruptcy, Fresh Start Reporting, and Valuation Of Distressed Securities 419

Issues in Accounting Education

Volume 26, No. 2, 2011