Accounting Insolvency: a state where a company's liabilities' value exceeds its assets' value.
Accounting Insolvency Details
Accounting insolvency only accounts for the book value of liabilities and assets of a company. Based on the balance sheet, if total assets minus total liabilities—a.k.a equity or net worth—is negative, then the company is in the state of accounting insolvency. This is different from standard or actual insolvency, which happens when a business fails to settle its outstanding debt payments.
An increase in borrowed money is the most common reason for accounting insolvency. The amount of debt increases while revenue remains stagnant or even decreases. Another cause is the decline in assets' value. Long-term physical assets of a company (e.g., buildings, cars, computers, etc.) may become obsolete as more modern equipment surfaces. This results in an imbalance between the value of total assets and total liabilities.
Even if accounting insolvency doesn't directly affect a business's ability to continue its operations, creditors or lenders can still use it to pressure the company to take certain actions. For instance, a company may still be able to satisfy its periodical debt payments. If the company has an alarming negative net worth value upon closer inspection, creditors may force the business to restructure its assets or even declare bankruptcy.
Accounting Insolvency Example
In 2018, a startup company purchased a dozen computers on credit. These computers have the most cutting-edge components with high-end processors, making each device quite expensive. However, three years later, in 2021, these computers lose much of their original value due to swift advancements in the tech world.
The situation above may force the company to enter a state of accounting insolvency. The value of long-term fixed assets decreases while the debt incurred from buying computers in credit remains the same.
Accounting Insolvency vs. Standard Insolvency
As mentioned before, accounting insolvency is different from standard or actual insolvency. In standard insolvency, a company may have a sufficient amount of assets to cover its debts but not enough revenue. This can cause negative cash flow, meaning that the business shells out more cash than it can make back. Since you cannot convert some assets into cash easily (especially fixed assets), this can result in failure to pay the debt and a state of standard insolvency.
One example is if a company sells its goods or services in credit. During a certain period, customers may not pay their bills in time, resulting in a decrease in accounts receivables. Meanwhile, the company needs to pay for its monthly operational costs, which they cannot settle if the company doesn't receive enough revenue from its customers.
That said, when dealing with standard insolvency, declaring bankruptcy is not the only way out. Companies suffering from standard insolvency can take out short-term loans from banks to pay for their current liabilities. Alternatively, they can also negotiate terms with suppliers for longer due dates to pay for accounts payable. On the contrary, companies typically have a more challenging time dealing with accounting insolvency as long-term assets are generally non-liquid. They can't quickly sell their fixed assets to pay for debts, not to mention that most of them would lose their original value over the years.