What Is 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.
Also known as technical insolvency, a company can have the value of its liabilities rise at a faster rate than its assets due to increased debts or borrowings. However, actual insolvency–also called cash-flow insolvency–occurs when a company is unable to make promised payments to vendors or lenders.
- 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.
- If accounting insolvency persists, creditors and lenders might force the company to sell assets or declare bankruptcy.
Understanding Accounting Insolvency
Accounting insolvency is declared exclusively upon examination of the firm's balance sheet regardless of its ability to continue its operations. An increased amount of borrowings while revenue has declined could lead to accounting insolvency. Also, companies that have assets that fall in value while the value of liabilities remains unchanged or increase could experience accounting insolvency.
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 creditors.
Cash-flow insolvency is different than accounting insolvency because a company might have the assets to cover the liabilities, but not the cash flow. In other words, there's not enough of the revenue from sales being collected in the form of cash. As a result, the company doesn't have the cash available to meet its short-term debt obligations such as loan payments.
Cash flow insolvency could occur, for example, if a company had accounts payables–money owed to suppliers–coming due in the short term. However, the accounts receivables–money owed by customers–are not being paid in time to pay the company's payables. In some cases, cash-flow insolvency can be corrected by opening a short-term borrowing facility from a bank. Companies can also negotiating better terms with suppliers, so they accept later payments on their accounts payables. In other words, just because a company becomes cash-flow insolvent, doesn't necessarily mean that bankruptcy is the only option.
However, accounting insolvency can be a much bigger issue for companies to navigate through since it often involves long-term issues. If fixed assets have declined in value and the company needs to liquidate them to pay debts, it might run into financial issues. Large assets are not easily sold in the market–or liquidated–and oftentimes, the company takes a loss when comparing the sale price versus the initial purchase price.
Factors That Can Lead to Accounting Insolvency
Companies facing possible or impending lawsuits can cause an increasing amount of liabilities in the future that will ultimately exceed the assets. These contingent liabilities can prevent the company from functioning properly and can lead to both accounting and cash-flow insolvency.
Companies with a significant amount of their assets on their balance sheet tied up in fixed assets can run into problems. Fixed assets are typically long-term assets such as property, buildings, and equipment. If the assets become obsolete due to technological innovation, the value of the assets technically declines, causing accounting insolvency.
Companies with negative net assets, meaning the assets don't cover all of the debt obligations can be problematic and lead to negative cash flow. The result can force companies into selling assets or profitable divisions to fund the cash flow shortfalls resulting in accounting insolvency.
Example of Accounting Insolvency
For example, XYZ Company recently took out a loan to purchase a new piece of equipment. The loan value was nearly the entire value of the piece of equipment. Soon after purchasing the equipment, a technological upgrade in the marketplace caused the value of the equipment to drop significantly. As a result, the assets owned by XYZ Company are less than the value of their liabilities. Although the company has positive cash-flow to continue operations, XYZ is technically insolvent, meaning the company has accounting insolvency.