Accounting Insolvency - Explained
What is Accounting Insolvency?
Written by J. Mance Gordon
Updated at April 18th, 2024
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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.
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.
Related Topics
- Managerial Accounting
- Institute of Management Accountants
- Annual Report
- Certified Financial Statement
- Common Size Financial Statement
- Accounting Personnel in an Organization
- Comptroller vs Controller
- Financial Statement Analysis
- Cost Accounting
- Operating Income
- Profit Margin
- Paid in Capital
- Retained Cash Flow
- Book Value (Company)
- Adjusted Book Value
- Book Value (Asset)
- Accounting Insolvency