Accounting insolvency definition

Accounting insolvency is an event where the value of a company’s liabilities exceeds the value of its assets. Liabilities of a company can include short-term and long-term debts, accounts payable, accrued expenses and bonds. Assets of a company can include cash, debt securities, accounts receivables, inventories, properties, goodwill and deferred income.

In this article we will learn what accounting insolvency is and read some examples of accounting insolvency events.

Accounting insolvency explained

To fully grasp what accounting insolvency means, we will first have to learn the definition of insolvency. Insolvency is a state of being insolvent, which is declared when a company or a person is unable to pay debts.

Accounting insolvency is also known as technical insolvency as it only looks at a company’s balance sheet. It differs from actual insolvency or cash flow insolvency which occurs when a company is unable to make debt payments on time.

According to Cornell Law School, the definition of insolvency is “notoriously difficult to define and often leads to litigation”. It added that under the Bankruptcy code, insolvency is “essentially a balance sheet test” and that the code defines insolvency as “financial condition such that the sum of such entity’s debts is greater than all such entity’s property, at a fair valuation”.

In contrast, cash flow insolvency is also known as “ability to pay” test. Cornell Law School said in its report that a firm may be balance-sheet insolvent but may still be “liquid enough” to pay off its debts. The report cited the case of Angelo, Gordon & Co LP vs Allied Riser Communications Corp, where the debtor, although balance sheet insolvent, was able to meet its maturing debt obligations by liquidating all of its assets.

It is also important to note the distinction between insolvency and bankruptcy. The two are not equivalent. Bankruptcy is a legal status declared by judicial decree that imposes court supervision over the financial affairs of a company.

According to Cornell Law School: “In modern legislation, insolvency is often a necessary but not sufficient condition for bankruptcy.”

Factors affecting accounting insolvency

There are many factors that can cause the deterioration of a company’s financial health leading to accounting insolvency and potential bankruptcy. Cash shortfalls due to factors including increased competition and unfavourable macro environments, among others, can lead to insufficient levels of cash flows within a company to cover its debt obligations. Subsequent selloff of company assets to fund working capital and debt payments can trigger accounting insolvency.

Technological obsolescence can cause the fair value of a company’s assets to drop significantly, which could lead to a negative net worth. Impending lawsuits, government interventions and fraud cases can cause significant damage to a company’s financial health, potentially leading to both cash flow and accounting insolvency.