What Is Accounting Insolvency?
In accounting, insolvency refers to a situation where the total value of a company’s liabilities is greater than the value of total assets. Accounting insolvency is wholly based on balance sheets. This means that insolvency is determined by looking at the balance sheet and calculating net worth. If liabilities surpass assets, the company is considered insolvent on the books.
Or
Accounting insolvency means total liabilities exceed total assets. A firm with a negative net worth is insolvent on the books.
Understanding the Term
In contrast, when a business’s creditors' due exceeds the value of its assets, then the situation is considered accounting insolvency. This is a warning sign for a company to let its management know that the business cannot pay its debts and may be headed for bankruptcy or face financial difficulty.
Accounting insolvency and legal insolvency are both different terms. When the court declares that the company cannot pay its debt, it is called legal insolvency. On the other hand, accounting insolvency is a drastic financial measure, while legal insolvency is an official legal declaration.
Determining the Accounting Insolvency Factors
The primary factor in determining insolvency is the company’s balance sheet. A balance sheet is a company’s financial statement that provides comprehensive information about the company’s financial health.
The balance sheets list the company’s total assets, liabilities, and shareholders’ equity. If the balance sheet shows the total assets are less than the liabilities, the company is considered to be accounting insolvent.
Some other factors can also affect the company’s financial health and take part in determining accounting insolvency.
- Declining revenue and profitability
- Increased operating costs
- Poor management decisions
- Inefficient use of resources
- Lack of access to capital
Examples
Example 1
Suppose a company purchased another business to expand its area of operation with the expectation that the company would attract more customers. However, over time the purchased business becomes obsolete. Now the company cannot sell the business to cover the debts, and customers found better alternatives; this scenario is considered to be accounting insolvent.
Example 2
A company purchased a few pieces of equipment for $10 million with a $7 million bank loan. If the value of the equipment drops to $5 million, the company would now have $7 million in liabilities and only $5 million in assets, resulting in a negative net worth and making it accounting insolvent.
In Sentences
- Accounting insolvency is when liabilities surpass assets, resulting in a negative net worth.
- Accounting insolvency is not the same as legal insolvency, which a court of law determines as a company's inability to pay its debts.