In accounting, insolvency is the state of being unable to pay the debts, by a person or company (debtor), at maturity; those in a state of insolvency are said to be insolvent. There are two forms: cash-flow insolvency and balance-sheet insolvency.
Cash-flow insolvency is when a person or company has enough assets to pay what is owed, but does not have the appropriate form of payment. For example, a person may own a large house and a valuable car, but not have enough liquid assets to pay a debt when it falls due. Cash-flow insolvency can usually be resolved by negotiation. For example, the bill collector may wait until the car is sold and the debtor agrees to pay a penalty.
Balance-sheet insolvency is when a person or company does not have enough assets to pay all of their debts. The person or company might enter bankruptcy, but not necessarily. Once a loss is accepted by all parties, negotiation is often able to resolve the situation without bankruptcy. A company that is balance-sheet insolvent may still have enough cash to pay its next bill on time. However, most laws will not let the company pay that bill unless it will directly help all their creditors. For example, an insolvent farmer may be allowed to hire people to help harvest the crop, because not harvesting and selling the crop would be even worse for his creditors.
It has been suggested that the speaker or writer should either say technical insolvency or actual insolvency in order to always be clear – where technical insolvency is a synonym for balance sheet insolvency, which means that its liabilities are greater than its assets, and actual insolvency is a synonym for the first definition of insolvency (“Insolvency is the inability of a debtor to pay their debt.”). While technical insolvency is a synonym for balance-sheet insolvency, cash-flow insolvency and actual insolvency are not synonyms. The term “cash-flow insolvent” carries a strong (but perhaps not absolute) connotation that the debtor is balance-sheet solvent, whereas the term “actually insolvent” does not.
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.
When a Person / Entity can be Declared Insolvent
Before declaring an entity or a person as insolvent, a competent court defines two conditions:
- A person or entity should be debtor and
- He/it should had done any act of insolvency.
- Act of insolvency means, when a person (debtor) shows that he is not able to pay his liabilities.
An order of adjudication must be passed by the court of law, before legally declaring any person insolvent. To pass an order of adjudication by the court of law, a petition should be filed by any of the creditor or creditors or by the debtor himself. Petition by the creditor may be filled only in following conditions;
- Debt should be at least for Rs. 500/- or more
- Within three months of petition, an act of insolvency should be done by debtors.
After filing the petition, the competent court will fix date of hearing and then it may declare that the debtor is insolvent or not. If insolvency of a person starts from an earlier date, and not from the date of adjudication passed by the court. This is known as Doctrine of Relation Back.
Under Presidency Towns Act, to conduct the insolvency proceedings, an official is appointed by the court is known as Official Assignee and in case of Provincial Insolvency Act, known as Official Receiver. The property of the insolvent vests in the official assignee or receiver to realize the assets and distribute the sale proceeds of the assets in the manner given below:
- Secured creditors will be paid in full.
- Remuneration and expenses of the official receiver.
- To Preferential Creditors.
- To unsecured creditors + partly secured creditors to the extent remain un-secured.
The Order of Discharge
Order of discharge is an order issued by the court of law to the insolvent. Normally, this order releases the insolvent from all current and provable debts and liberates him from the legal obligations imposed on as insolvent. The order of discharge is issued on the basis of the report submitted by the official receiver and on the application of the insolvent.
An interest @ 6% pa will be paid to the creditors for the period, after the order of adjudication, if, any surplus remains, after full payment to the creditors.
As per the Presidency Towns Insolvency Act, any property transferred by the insolvent without any consideration during the two years preceding the order of adjudication shall be void. Under the Provincial Insolvency Act, such transfer became inoperative, if made with two years of petition of the insolvency except followings:
For consideration of marriage and made before
To purchase valuable consideration in good faith.
The Insolvency Act in India is based on English Bankruptcy Act and following two acts are applicable on the Indian Territory:
- The Provisional Insolvency Act, 1920; Applicable to the rest of India except Mumbai, Kolkata, and Chennai.
- The Presidency Towns Insolvency Act, 1909; Applicable to Mumbai, Kolkata, and Chennai.
Above Insolvency Acts are applicable to any Individual, Partnership Firm, and Hindu Undivided Family only. Companies Act, 1956 applies to Joint stock companies and the term liquidation is used instead of Insolvency. In case of insolvency, a person is not able to pay his liabilities but in case of liquidation, company may be liquidated even it has the sufficient amount to pay its liabilities.
Under the Presidency Towns Insolvency Act, insolvent has to submit following documents to the court of law:
- Statement of Affairs as on date of order and
- Deficiency Account.