DEFINITION of Accounting Insolvency
Accounting insolvency refers to a situation where the value of a company's liabilities exceeds the value of its assets. Accounting insolvency looks only at the firm's balance sheet, deeming a company "insolvent on the books" when its net worth appears negative. This is also known as technical insolvency. Actual insolvency is also known as cash-flow insolvency and occurs when a company is unable to make promised payments to vendors or lenders.
BREAKING DOWN Accounting Insolvency
Accounting insolvency is a different approach to insolvency than cash-flow insolvency. The latter involves a firm missing or being unable to make a debt-servicing or other payment, while the former is declared exclusively upon examination of the firm's balance sheet regardless of its ability to continue its operations. When a firm appears to be insolvent on the books, it is likely the debt holders will force a response. The company may attempt to restructure the business to alleviate its debt obligations, or be placed in bankruptcy by the debt holders.
Example of Accounting Insolvency
For example, XYZ Company recently took out a loan to purchase a new piece of equipment. The loan was very large, almost the entire value of the piece of equipment. Soon after purchasing the equipment, a technological upgrade in the marketplace caused the equipment XYZ Company purchased to drop significantly in value. Currently, the assets possessed by XYZ Company are less than the value of their liabilities. Although they have plenty of cash-flow on hand to continue operations, they are said to be technically insolvent, or they have an accounting insolvency.