Accounting Insolvency - Explained
What is Accounting Insolvency?
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Table of ContentsWhat is Accounting Insolvency?How to determine Accounting Insolvency?Example of Accounting InsolvencyAcademic Research on Accounting Insolvency
What is Accounting Insolvency?
Accounting insolvency is a situation when the value of an organization's liabilities to its creditors exceeds the total value of its asset. It is different from the actual insolvency or cash flow insolvency. Actual insolvency is a situation when a company becomes unable to meet its immediate debt obligations and other liabilities. Whereas, the accounting insolvency is strictly based on its balance sheet. A company is deemed "insolvent on books" when the net worth of the firm appears negative on its balance sheet. The same is also called technical insolvency.
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How to determine Accounting Insolvency?
Accounting insolvency of a firm is declared upon the examination of its balance sheet. If on the balance sheet, the company's net worth is negative, accounting insolvency is declared, even if it can continue its operations. On the occasion of accounting insolvency, the creditors generally demand a response from the firm. The firm may have to restructure the business to come out of its debt obligations or the creditor may place them in bankruptcy.
Example of Accounting Insolvency
Let's assume Company X takes a loan of significant amount from the bank to purchase new machinery. Soon after they procure the machinery, due to technological up-gradation, the value of the machinery reduced significantly. Thus, the value of the assets currently owned by X company is less than their liabilities. If their balance sheet is examined, their net worth would be negative at this point of time, even if they have plenty of cash flow to run the operations. So, the firm will be declared technically insolvent, and the situation is accounting insolvency.
Academic Research on Accounting Insolvency
- The high cost of incompletely funding the FSLIC shortage of explicit capital, Kane, E. J. (1989). The high cost of incompletely funding the FSLIC shortage of explicit capital. Journal of Economic Perspectives, 3(4), 31-47. A useful parallel can be drawn between the Alaskan oil spill of 1989 and the flood of red ink spilled in recent years by U.S. thrift institutions (savings and loan associations and savings banks). In each case, initial damage from the spill was severely compounded by delaying and mishandling the clean-up required. For more than a decade, federal officials refused to acknowledge that the thrift ink spill had compromised the integrity of the supporting deposit-insurance fund. Instead of promptly shoring up the finances of this fund, officials used accounting smoke and mirrors to cover up the fund's secularly increasing capital shortage. This prolonged refusal to face up to the magnitude of the underfunding imposed enormous costs on society as a whole.
- The federal deposit insurance fund that didn't put a bite on US taxpayers, Kane, E. J., & Hendershott, R. (1996). The federal deposit insurance fund that didn't put a bite on US taxpayers. Journal of Banking & Finance, 20(8), 1305-1327. Unlike the Federal Savings and Loan Insurance Corporation and the Bank Insurance Fund, the National Credit Union Share Insurance Fund (NCUSIF) survived the 1980s without falling into a state of accounting insolvency. This paper analyzes how differences in incentive structure constrain the attractiveness of interest-rate speculation and other risk-taking opportunities to managers and regulators of credit unions. Despite these better incentives, robust present-value calculations establish that NCUSIF fell into economicinsolvency during the mid-1980s. Besides calculating the extent of this insolvency, the paper also seeks to explain why, after NCUSIF became insolvent, it could rebuild its reserves without an explicit or implicit taxpayer bailout. Our explanation turns on cross-industry coinsurance responsibilities and the shallowness of the fund's observed insolvency relative to industry net worth. We identify forces in the decisionmaking environment tending to limit the depth and duration of unresolved insolvencies at individual credit unions. Managerial opportunities to benefit personally from taking risks that would flow through to NCUSIF are constrained by difficulties in converting a credit union to stockholder form and by the intensity of proactive monitoring of troubled credit unions by sister institutions and other private coinsurers. We conjecture that expanded use of coinsurance and private monitoring could reduce taxpayer loss exposure elsewhere in government deposit insurance systems.
- A theory of how and why central-bank culture supports predatory risk-taking at megabanks, Kane, E. J. (2016). A theory of how and why central-bank culture supports predatory risk-taking at megabanks. Atlantic Economic Journal, 44(1), 51-71. This paper applies Scheins model of organizational culture to financial firms and their prudential regulators. It identifies a series of hard-to-change cultural norms and assumptions that support go-for-broke risk-taking by megabanks that meets the everyday definition of theft. The problem is not to find new ways to constrain this behavior, but to change the norms that support it by establishing that managers of megabanks owe duties of loyalty, competence, and care directly to taxpayers
- Principles of accounting advanced, Finney, H. A. (1945). Principles of accounting advanced.
- Complaints Handling in the UK Insolvency Practitioner Profession, Walters, A., & Seneviratne, M. (2008). Complaints Handling in the UK Insolvency Practitioner Profession. Available at SSRN 1094757. Since the mid-1980s it has been a requirement of UK law that any person who acts as a bankruptcy trustee or as a liquidator of an insolvent corporation must be a licensed insolvency practitioner. In 2007 there were around 1,700 practitioners licensed to practice by eight different regulators. Complaints about the conduct of insolvency practitioners may arise in a wide variety of contexts. Moreover, as insolvency processes affect a range of stakeholders, including debtors, creditors and the wider public, complaints may derive from several possible sources. In recent years, public concern has been expressed about issues such as the level of practitioner remuneration, pre-packaged asset sales, retail insolvencies and the provision of appropriate advice to consumer debtors. In the light of these concerns, and given also the increasing volume of individual insolvencies in the UK driven by consumer debt, there is every reason to suppose that complaints against insolvency practitioners (whether well-founded or not) will continue to rise. This study, which was commissioned and funded by the UK Insolvency Practices Council, is the first to consider how complaints about insolvency practitioners are handled both within insolvency practitioner firms and by the various regulators. Drawing on a series of semi-structured interviews with insolvency practitioners, senior compliance officers and officials, we provide a comprehensive account of the functioning of complaints handling processes within the UK insolvency profession and a case study in the workings of professional self-regulation. Our principal finding is that firms' in-house complaints handling procedures are generally conceived of as tools for the centralized management of risk rather than as alternative systems of dispute resolution and redress, although there is evidence of an increasing emphasis on customer care and redress within those firms that concentrate on volume provision of debt relief services to consumer debtors. Within the regulators, we find, perhaps not unsurprisingly, a clear bias towards discipline and sanction rather than complainant redress.
- Accounting variables and bankruptcy risk for non-listed firms, Pramborg, B. (2012). Accounting variables and bankruptcy risk for non-listed firms. Available at SSRN 1482998. In this paper I investigate the relation between accounting based variables and bankruptcy risk, using information available for non-listed firms. I use a large sample of firms and find that many of the variables suggested earlier in the literature seem to provide little explanatory power. Further, I find that industry classification does not add much explanatory power of bankruptcy risk not captured by other variables. I suggest a seven-factor model including accounting variables and firm age which performs well out-of-sample. The results suggest that estimated coefficients are unstable, but that the variables are consistently strong determinants of bankruptcy risk.