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 that of its assets due to increased debts or borrowings. This differs from actual insolvency, or cash flow insolvency, which occurs when a company is unable to make promised payments to vendors or lenders.
Key Takeaways
- 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 company'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. Companies that have assets that fall in value while the value of liabilities remains unchanged or increase also might fall into this category.
When a company 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.
Factors That Affect Accounting Insolvency
Possible or impending lawsuits can cause an increasing amount of liabilities in the future that may ultimately exceed a company's assets. These contingent liabilities can prevent the subject from functioning properly and can lead to both accounting and cash flow insolvency.
Companies with a significant amount of fixed, long-term assets on their balance sheet, such as property, buildings, and equipment, can run into problems, too. If the assets become obsolete due to technological innovation, the value of the assets technically declines, causing accounting insolvency.
Cash flow shortfalls, meaning levelsof cash flows that do not cover all of the debt obligations, can be problematic. This state of liquidity crunch can force companies into selling assets or profitable divisions to fund the cash flow shortfalls, triggering accounting insolvency.
Cash Flow Insolvency vs. Accounting Insolvency
Cash Flow Insolvency
Cash flow insolvency is different than accounting insolvency because a company might have the assets to cover the liabilities, but not the cash flow. When there's not enough of the revenue from sales being collected in the form of cash, the company risks failing 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—due in the short term, and accounts receivables—money owed by customers—not being paid in time to settle these bills.
In some cases, cash flow insolvency can be corrected by opening a short-term borrowing facility from a bank. Companies can also negotiate 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.
Accounting Insolvency
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.
Example of Accounting Insolvency
XYZ Company recently took out a loan to purchase a new piece of equipment, with the loan value nearing the entire value of the piece of equipment. Unfortunately, soon after buying the equipment, a technological upgrade in the marketplace caused its value to drop significantly.
Suddenly, the assets owned by XYZ Company are now worth less than the value of its liabilities. Although the company has a positive cash flow to continue operations, XYZ is technically in accounting insolvency territory.
