Determining Solvency
Why prove insolvency?
Proving the insolvency of a company or of a person (an 'entity') at a particular point in time is usually one of the most difficult and time consuming tasks of an external administrator. But it may be necessary as a majority of the recovery actions and offences prosecutions under the Corporations Act or Bankruptcy Act can only be taken if the event happened at a time when the entity was insolvent.
How is it done?
In its most simple form, the task is mathematical. It is a comparison of "Resources" against "Debts". The first two hurdles are (1) gathering sufficient evidence to prove what resources and debts the entity has, and (2) determining their monetary values at various points in time. This paper gives an overview of the process. The full process and all of the possible variables cannot be explained in such a short paper.
What time period is relevant?
External administrators will try to prove insolvency for a purpose, usually to enable a recovery action. Administrators will try to prove insolvency at a time before the relevant transaction and show insolvency up until the date of the appointment.
What is insolvency?
The definition in the Corporations Act is:
Section 95A - Solvency and Insolvency
(1) A person is solvent if, and only if, the person is able to pay all the person's debts, as and when they become due and payable.
(2) A person who is not solvent is insolvent.
The definitions is almost identical in the Bankruptcy Act. Therefore we can deal with the concept of solvency without having to change the explanation to compensate for differences between the Acts.
What terms do we use?
The terms "Resources" and "Due and Payable Debts" may not be familiar. They are not defined under accounting principles nor in the Acts. They are terms used by Worrells in the process of determining solvency.
Assets
The definition of asset is the same as under accounting principles. It is anything of value owned by or available to the entity, whether current or non-current, tangible or intangible or in any form. Assets are a starting point in determining "Resources".
Resources
Resources are the subset of assets that can be used to satisfy debts, either immediately (cash), or within a reasonable time (trade debtors). If the asset can not be used to pay debt (a piece of plant and equipment) it will not be a resource. It is possible for an asset rich entity to be insolvent, if its assets are not available or cannot be made available to pay debt.
Liabilities
The definition of liability is the same as under accounting principles. It is any obligation of the entity that has a commercial (money value) basis, whether current or non-current, contingent or otherwise. If the entity is financially obligated, it has a liability. Liabilities are the starting point for determining "Due and Payable Debts".
Due and Payable Debts
Due and Payable Debts are the subset of liabilities that are due to be paid at the time at which we are trying to determine solvency. Debts that are not due at that time (e.g. long term liabilities) or debts that have not reached the end of their credit term (current trade creditors) will not be due and payable. It is possible for an entity to have more liabilities than assets but not be insolvent, if its debts are not due for payment.
What is the difference between assets and resources?
External administrators have to distinguish between assets that can be used for debt repayment (resources) and those that cannot (other assets). The first step is to determine if a particular class of asset should be considered as a resource or not. Assets that generally will not be resources at all are:
(i) Plant and Machinery
(ii) Motor Vehicles
(iii) Goodwill
(iv) Intangible Assets
(v) Land and Buildings
(vi) Prepaid Expenses
(vii) Work in Progress
(viii) Deposits Paid
Some liquid assets will usually be resources in their full amounts. These include:
(i) Cash at bank
(ii) Available Overdraft
(iii) Cash Investments
(iv) Shares in Publicly Listed Companies
The last group are assets that as a class are liquid assets and will be resources, but maybe not in their full amount. These assets will need to be realized (liquidated) or collected during the period, and only that realizable or collectable amount can be classified as a resource. These assets include:
(i) Trade Debtors
(ii) Stock on Hand
(iii) Loans to other parties
What is the difference between liabilities and due and payable debt?
External administrators have to distinguish between those liabilities that are due for payment at a particular time, and those that are not.
The most obvious due and payable debts are trade creditors where the credit period has expired. The amount of due and payable debt will be the amount of debt that has passed its credit terms and remains unpaid. Care must be taken to determine whether other liabilities are due, either partially or in their full amount. This will require an examination of the balance sheet items and information on the terms of the credit. Common items examined are:
(i) Loans
(ii) Bank overdraft
(iii) Deposits received that are no able to be drawn
(iv) Provisions for debts that are now due
(v) Tax that may now be due for payment
(vi) Lease or finance payments due
How are the monetary values determined?
The next step is determining monetary values for each class of resource and debt at the relevant times. This can either be difficult or easy. Items like bank balances and values of publicly listed shares are easy to determine at any time. Trade debtors and creditors will require more work and information from third parties. Other assets will have their own requirements.
Some of the information in the entity's records may not be reliable or up to date. Calculation of the values will then be a manual process and can be time consuming. At this point the investigation process will have to be adapted to fit into the requirements of the particular item being examined.
What is the shortfall?
Calculation of a shortfall is purely mathematical. You simply deduct the value of the due and payable debts from the value of the resources at the relevant points in time and determine whether there is a negative (a shortfall) or a positive (a surplus) result.
Available Resources - Due and Payable Debts = Shortfall or Surplus
Balance sheet analysis Vs. Cash flow analysis
Technically and legally, determining Insolvency should be done on a cash flow basis (resources less due and payable debt). Sometimes insolvency can be indicated (if not proved) by looking at the balance sheet.
(a) Net Assets comparison
All assets, including those that are not now or will never be available for debt repayment (e.g. land and buildings), may be compared to all liabilities that would, could or should become due and payable in the future. Comparing these results with the cash flow shortfall may show whether the entity is asset rich but insolvent, or asset poor but solvent.
(b) Working Capital comparison
A better comparison will be current assets to current liabilities and will show whether there is a deficiency in working capital. This is a better indication of solvency or insolvency, but issues like the collectability of trade debtors and the liquidity of stock are not considered.
These extra views are not completely accurate nor have a great legal standing, but will give a view of the potential position over the forthcoming future of the company and the expectation of directors. But it is a reasonable barometer of the potential future.
What are the indicators of insolvency?
The Courts often look into the question of insolvency and indicators that directors and other parties should consider. In a 2003 decision, the Judge referred to a check list of indicators of insolvency. These are all indicators that can be considered by business owners during trading. They are not solely retrospective indications available to insolvency practitioners.
1. Continuing losses
2. Liquidity ratios below 1
3. Overdue Commonwealth and State taxes
4. Poor relationship with present Bank, including inability to borrow further funds
5. No access to alternative finance
6. Inability to raise further equity capital
7. Suppliers going to a COD basis, or otherwise demanding special payments before resuming supply
8. Creditors unpaid outside trading terms
9. Issuing of post-dated cheques
10. Dishonored cheques
11. Special arrangements with selected creditors
12. Solicitors' letters, summonses, judgments or warrants being issued
13. Payments to creditors of rounded sums which are not reconcilable to specific invoices
14. Inability to produce timely and accurate financial information to display the company's trading performance and financial position, and make reliable forecasts
There would be few occasions where all of these indications are present, just as there would be few cases of insolvency where none of these indications were present. Overall, they represent a reasonable set of circumstances that, cumulatively, would indicate insolvency.
What is deemed insolvency?
Section 588E of the Corporations Act provides circumstances where a company may be deemed insolvent. These conditions fall into two major categories:
1. Where it has been proven in court that a company was insolvent within 12 months of the winding up, it may be deemed to be insolvent thereafter. The liquidator can avoid having to reprove matters already proven to the Court.2. A company may be deemed insolvent when it did not keep books and records in compliance with section 286 of the Corporations Act. In Forem Freeway Enterprises Pty Ltd the Judge stated:
"the requirements are that the financial records should both correctly record and explain a company's transactions, financial position and performance and also enable true and fair financial statements to be prepared and audited"
If the company did not comply with these provisions, the liquidator may apply to have the company "deemed" insolvent under section 588E.
There are no parallel provisions to these in the Bankruptcy Act.
For more detailed information:
Disclaimer
The enclosed information is of necessity a brief
overview and it is not intended that readers should rely
wholly on the information contained herein. No warranty
express or implied is given in respect of the information
provided and accordingly no responsibility is taken by
Worrells or any member of the firm for any loss resulting
from any error or omission contained within this
fact sheet.
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Last Updated: 6.2.2008