Insolvency and tests of insolvency: An analysis of the “balance sheet” and “cashflow” tests
Margret, Julie A
National and international case law refers to two basic tests of insolvency: the “balance sheet- test and the “cashflow” test. While the former method is argued to be the bona fide test for insolvency, accounting principles fail to provide serviceable data for that function. Hence, the cashflow test is superior to the balance-sheet test principally because it quantifies the market worth of assets. The premise is that a financial test of insolvency requires current money equivalents for assets to be compared against all business debt incurred by the entity.
Chambers (1973) and Clarke et al (1997) have shown that companies sometimes collapse unexpectedly even though they have pubfished financial statements showing a profitable financial position. This is of concern to accountants and others (eg, the investing public and regulators) as these reports contain financial details prepared according to professional accounting standards and statutory requirements. This paper considers the extent to which courts and other parties use conventionally prepared accounting reports to determine an entity’s financial state and establish its level of solvency. The courts may go beyond the content of financial statements for information to help determine an entity’s ability to realise its assets and be granted extension of time for payment by creditors, but if accounting reports are used in insolvency decisions this necessitates examination of those financial reports. Two accounting-reports-based financial tests of insolvency – the balance-sheet test and the cashflow test – are discussed in this paper. Both tests have been used by financial analysts and international courts since the nineteenth century. It is argued that only one financial statement, and hence one financial test, is necessary (albeit not always sufficient) to determine an entity’s solvency.
A major proposition explored is that an entity’s factual financial state at a nominated date can be sought through the process of accounting. Generally accepted accounting principles (GAAP) and procedures will not, however, assist in generating the required information because those financial statements do not necessarily contain the required financial facts.1 Moreover, financial facts are essential in the calculation of an entity’s financial capacity to pay its debts and the community is increasingly demanding quantification of this financial state of an entity.2
This paper proposes that the statement of financial position of a business entity should indicate its financial capacity to pay its debts and still be able to continue its business operations. A statement of financial position has, over time, been referred to as a balance sheet. Such a statement implies knowledge of an entity’s ability to pay its debts, maintain its capital and adapt to ever-changing commercial situations.3 This view accords with the idea of commercial realism.4
JUDICIAL TESTS OF INSOLVENCY
Courts around the world use two main financial tests of insolvency, the balance-sheet test and the cashflow test (Goode 1990, p. 26; Keay 1995). Australian courts, however, use only the cashflow test (ACL 2000, s.95A; Keay 1995, pp. 307, 308). The emphasis in this test is on an entity’s ability to pay its debts as they fall due. This idea suggests a focus on an entity’s level of liquidity or short-term financial state; however, liquidity and solvency are related. For instance, Heath (1978, p. 2) stated that “liquidity is closely related to solvency. The term, liquidity, is used in at least two different ways. First, it is used to describe the nature of a company’s asset holdings, that is their nearness to cash in some (often unspecified) sense … Second, it is used to describe some relationship between a company’s liquid assets and its short term liabilities.” In addition, “liquidity refers to the ability of a firm to meet its short run financial obligations when and as they fall due” (Foster 1978, p. 28). On the other hand, in a purely financial sense, solvency focuses on long-term calculations of an entity’s ability to pay. This is because the concept of solvency includes identifying whether the entity has a short-term financial problem. It is evident that difficulties have arisen for the courts when using the cashflow test of insolvency, particularly in deciding what debt to recognise at a particular time.
The cashflow test of insolvency
The cashflow or commercial test of insolvency is concerned with the entity’s capacity to finance its current operations. The main consideration of the test is whether the entity in question can pay its debts when due and payable (see, eg, Honsberger 1980, pp. 1534). This concern accords with the requirements of s.5 (2) (3) of the Australian Bankruptcy Act and s.95A of the Corporations Law. Essential elements in the use of this test include the entity’s cash on hand, access to cash, items held that have a cash equivalent and the level of debt incurred by the entity. A major problem for the courts has been to decide what debt to include in this method (Keay 1995, pp. 312-22; Duns 2000, p. 27). Mescher (1996) expanded this point when referring to the Standard Chartered Bank v Antico (1995) 18 ACSR 1.(5)
The balance-sheet test of insolvency
The balance-sheet, or asset, test of insolvency in its simplest form deems an entity to be insolvent if the book value of its assets, as listed on the conventional balance sheet, is less than its reported liabilities.6 “If the assets exceed the liabilities, the firm is solvent, that is, able to pay its debts in full. If the total of debts due to creditors … is greater than the liquid assets . . . the position of the firm may be financially unsound” (Carter 1923, p. 43). At issue is the decision on what constitutes an asset, especially when attempting to quantify an entity’s solvency.7 Carter’s reference to liquid assets highlights the fact that not all assets on a balance sheet can be readily exchanged for money. In fact, some assets as defined by conventional accounting wisdom can never be exchanged for money because they are not severally exchangeable, tradable or saleable items – consider bookkeeping constructs such as “Provision for Deferred Taxes”.
Application of the balance-sheet test
To apply the balance-sheet test of insolvency, logically each element of the test should relate to things that are tangible and have a current and observable monetary equivalent. Under these conditions, and contrary to conventional accounting wisdom, exchangeability becomes an essential element in the definition of an asset.8 With exchangeability inherent in the definition of an asset, the current ability of an entity to cover all debt incurred could be objectively ascertained.
On the other hand, debt that is based on a contract or agreement could be immediately due, payable at some future date, or contingent on some possible event occurring (Keay 1995, pp. 319-21). The concept of a liability proffered by the Australian professional accounting bodies is more ambiguous and embodies a sacrifice of economic benefits.9 This definition leads to a presumption about what is likely to happen in the future (an unknown element) and what may constitute an economic benefit to the firm (a subjective decision). Criteria for the recognition of liabilities in an entity’s periodic financial statements emphasise the probability that a future sacrifice of economic benefits is required and that the amount recorded must be able to be reliably measured. At times, the courts also consider contingent liabilities in conjunction with insolvency determination, but frequently these are disregarded.10 Nonetheless, the transcripts of Sandell v Porter and Expo International v Chant, for instance, suggest that contingent liabilities should be taken into account.
Provisions for liabilities associated with environmental factors, such as litigation and restructuring charges, add a further dimension. The Financial Accounting Standards Committee of the American Accounting Association, when commenting on the IASC Exposure Draft E 59 Provisions, Contingent Liabilities and Contingent Assets stated that “such events and activities are typically firm specific in nature and difficult to assess using general information available from sources other than firms’ financial statements … the committee believes that accounting for provisions and contingencies under E 59 would reduce related uncertainty and enrich the information available to financial statement users”.11 Monetary amounts attributed to liabilities (except contingent liabilities), however, are generally based on agreements; contracts and their details are identifiable. But this is not necessarily the case in relation to assets.
Assets are defined by the Australian professional accounting bodies with regard to future economic benefits.12 The nebulous nature of these definitions of assets and liabilities result in unsupportable and unrealistic financial statement entries when, or if, used to determine an entity’s solvent or insolvent state. This has long been a dilemma for interested parties. Moreover, such circumstance may have resulted in a different view from the balance-sheet approach: one based on the notion that when debt is incurred in a money economy, then money sufficient to relinquish that debt will be required at some future time. The cashflow test of insolvency focuses on the availability of money to pay debt that is due and payable.
History of the cashflow test
The cashflow test “has been in equity jurisprudence for hundreds of years and is a classical concept of civil law” (Keay 1995, p. 308). Its focus is on sufficiency of money to pay debts. However, determining when a debt is due for payment is not always an easy task for the courts and myriad case law exists on this point.13 Yet it has been ascertained that “if a company fails the test it means, in effect, that it has insufficient resources available to pay creditors” (Keay 1995, p. 308). Although the cashflow test and balance-sheet test are two separate investigations into an entity’s state of solvency, similarities and links between the tests are demonstrable (Goode 1990, p. 27, Keay 1995, p. 308). According to Keay, the 1869 decision in Re European Life Assurance Co. (1869) LIZ. 9Eq. 122 may be said to have employed the balance-sheet test. But that judgment also emphasised currently due and payable debt as the primary concern when deliberating on solvency and this is a cashflow approach. In that case, specified future liabilities were considered extraneous to the issue of whether the company was in fact meeting its debt obligations when due. Similar decisions have been made in subsequent cases, including Re A Debtor (No.17 of 1966) (1967) 1 All E.R. 668.
The problem of what debt to examine in deciding an entity’s solvency or insolvency is conceptual. When a court decides to recognise only presently payable debt in the calculation of an entity’s financial position, debt to be paid at a future date is ignored, or treated indifferently. Thus, deciding what debt is payable or not payable, and at what time payment is due, is contestable.14 For any entity to meet its obligations, the full amount of its debt must be managed and that entails a continual review of its financial state to ensure sufficient funds are available to meet payments. Where a business has committed itself to bona fide debt contracts that are due and payable at some distant time, regardless of the time factor the obligations are agreed facts and change the financial structure of the enterprise. Arguably, the crucial point in deliberations on solvency (in contrast to liquidity) is not the date that payment is due, but rather the fact that debt has been incurred and must be paid.15
Further, the notion that an entity must have and be seen to have sufficient money available to pay its debts and continue business operations was illustrated in Cornhill Insurance plc v. Improvement Services Ltd. (1986) 1 W.L.R. 114. There it was held that the plaintiff could present a winding-up petition in respect of failure to pay a due debt even though the petition contained no evidence of insolvency, because the defendant, a large public company, ignored repeated demands by the plaintiff’s solicitors for payment of the agreed debt. The circumstances of this case stress that a business entity cannot incur debt in the normal course of its business and then ignore its obligation to pay that debt. Also, unless a prior agreement exists between the parties, creditors may not be willing to wait for payment. Changing business and environmental circumstances could mean that creditors require payment earlier than initially agreed (Keay 1995, pp. 316-19). Such a situation could alter the due date for payment of debts.
This review, confirmed by a more detailed consideration in Mescher (1996, pp. 837-50), serves to illustrate some of the difficulties facing courts in deciding what debt is relevant to a test of insolvency. Short-term and long-term debts are identifiable monetary amounts also referred to in accounting as liabilities, and liabilities include all debt and obligations incurred by a business. Bentley (1911, p. 22) stated that “the liabilities of a business include all debts owed by it, and such other obligations as it is legally liable for”. These responsibilities may at any time impinge on an entity’s state of solvency, but may not necessarily affect its liquidity position. Short-term funds may be readily accessible to pay debt due immediately (liquidity), while the financial capacity to cover present and future debt commitments remains questionable or non-existent. The cashflow test is evidently relevant in deliberations on liquidity but its usefulness in cases of insolvency remains contestable. As Loftus and Miller (2000. p. 35) stated: “A primary concern of many users of a financial report is the ability of the reporting entity to survive–implying an ability to pay present and future debts. Accordingly, financial reports should help users to identify both insolvent entities and those still solvent but experiencing financial distress.”
The balance sheet is arguably the main source of information for users about the financial state of the business and hence its ability to survive.16 The accounting process used to recognise and value an entity’s assets and liabilities will affect the financial information subsequently reported in that financial statement. The following discussion considers the sort of financial information users are likely to view in a balance sheet, given the use of existing accounting methods.
INFORMATION USED TO DETERMINE SOLVENCY
The financial representation of items in the balance sheet is based on the assumption that the entity is a going concern and that the business will continue its operations, in the same style, into the future. This assumption is independent of the financial facts being determined. Much has been written on the idea of a firm as a going concern, but authors such as Storey (1959), Chambers (1966), Fremgen (1968), Sterling (1968) and Yu (1971) have specifically questioned conventional wisdom in accepting the idea of a going concern as an untested assumption underlying practice.17
This notion of an entity as a going concern, is the rationale for numerous accounting procedures, spreading costs over multiple accounting periods, and representing assets periodically by unamortised costs that have no external monetary referent. The products of such cost allocations do not necessarily relate to any real-world referent; they are not indicative of a business firm’s solvency, debt-paying ability or general purchasing power. Yet, it is these real-world entity characteristics which determine whether a business has the financial capacity to continue trading. As Fremgen (1968, p. 650) stated: “The going concern concept may be a valid description of the accounting entity, if it is justified by evidence in the particular case but not if it is offered as an untested general assumption.”
Further, if the basis on which financial statements are compiled is incorrect, then it may be argued that the statements in their entirety are wrong. The conventional balance sheet at times lists assets at historic cost, replacement cost, directors’ or expert’s revaluation or a combination of these or other valuations. In fact, conceptual frameworks around the world endorse this practice (see, for example, Australia’s SAC 4 and the FASB FAC 1). Depreciation by formula of some of an entity’s assets is required in current accounting practice.18 This approach reduces the recorded cost and stated value of the asset in the balance sheet On the other hand, if the depreciated item is actually appreciating in current monetary terms, this change is not recognised unless the business considers a revaluation of a class of its assets, and then the revaluation may or may not relate to current market values. These factors add to previous reservations that the balance-sheet test of insolvency is inadequate in its present form, mainly because too many accounting numbers are discretionary. Of course, such reservations are not new.19
Now, the survival of a business entity depends on its financial capacity to trade and its ability to respond to consumer demands, industry competition, technological improvements and environmental changes. McCracken (1948, p. 28) remarked: “The chief concern of the successful businessman is that of watching daily the moves of his competitors and the possible or prospective changes in mood or habit of prospective customers. Every new move made by a competitor or customer makes imperative some new move or considered adjustment in his own business to meet the new contingency.”
To this end evidence, rather than assumptions, of financial capacity to meet debt obligations, would at least provide some assurance of an entity’s financial solvency and its ability to continue in business. Vickers (1981, p. 174) also supported the necessity for continual change in business when he stated that “the firm today is not the same firm as it was last year … Firms change their technologies, factor intensities, operating structures, financing mix, market penetration, product outputs, activity diversification, and expansion policies.” Conventionally prepared financial statements may be accurately compiled in accordance with guidelines set by the accounting profession and law in the form of accounting standards, but it is doubtful whether they provide evidence that a business entity is solvent or insolvent.
The use of GAAP means that financial statements include a mixture of monetary estimates, speculations, arbitrary allocations and operating outcomes derived by method. They do not provide up-to-date facts concerning an entity’s financial capacity to pay its debts and continue trading. Financial details such as dated solvency, dated debt-to-equity relations and dated rates of return all contribute to the analysis of an entity’s potential to survive as a going concern. These factors are effectively ignored in traditional financial accounts. Jones (1993, p. 135) stated that “the financial statements are, of course, prepared for the shareholders”, but he continued: ” . . . but this argument does not help the court when considering whether or not a company is insolvent”. It seems that conventional financial statements may not help shareholders either when considering whether a company is solvent, mainly because most elements in the statements have no external monetary referent.
Of concern, then, is the extent to which courts may depend on or consider the financial data contained in conventionally prepared accounting statements of an entity’s financial worth, particularly when ascertaining conditions of insolvency. So the previous discussion on the definition of assets and liabilities as well as the above discourse on the elements of financial statements based on GAAP suggest that the courts’ use of these details in tests of insolvency be examined. An analysis follows of how various jurisdictions have interpreted insolvency.20
FINANCIAL TESTS OF INSOLVENCY BY NATIONAL AND OVERSEAS COURTS
Numerous legal cases in Australia and overseas illustrate problems that courts have encountered when dealing with issues of insolvency. An examination of cases can show whether the courts state or imply dissatisfaction with the currently used cashflow test and balance-sheet test of insolvency, and may suggest a model for providing financial information that would be more appropriate in assessing an entity’s ability to pay its debt when due and payable.
According to Goode (1990, p. 39): “In most cases there is little or no doubt as to a company’s insolvency, but in marginal situations the basis of valuation and the assessment of values upon that basis can be crucial. Here lie the seeds of a potentially difficult problem. For the purposes of insolvency legislation the court has to be able to decide whether on a balance of probabilities a particular company is or was at a particular time unable to pay its debts.”
Table 1 depicts areas of interest that have been stressed by courts and highlights similarities between the cases.21 Although many factors may be considered, the cases are specifically relevant to the insolvency test that determines whether the entity is able to pay its debts as they become due, in accordance with the Corporations Law.
Table 1 shows that the courts have concentrated particularly on assets, liabilities and an ability to pay debt. These considerations have gained momentum especially during the latter half of the twentieth century. This is very evident in more recent legal cases. Arguably, the approach incorporates the elements of both cashflow and balance-sheet tests of insolvency. An example is Leslie & Anor v Howship Holding Pty. Ltd. (1997) 133FCA, where proceedings focused on whether Howship would be wound up in insolvency because of failure to comply with a creditor’s demand for payment.
Howship’s failure to pay led to a presumption of insolvency and the onus fell on Howship to show otherwise. The company was found to be solvent Unaudited financial statements for the years ended 30 June 1994, 1995 and 1996 were used in evidence, as well as a profit and loss statement for the six months ending 31 December 1996, and a balance sheet as at 31 December 1996. A cashflow chart was also constructed to reflect Howship’s financial position at 17 January 1997. The court considered the chart “extremely helpful in assessing whether Howship [had] discharged the burden of establishing that it [was] solvent” (p. 19).22 It was the chart that suggested Howship was able to pay its debts when they fell due “at least in the short term”. In addition, cashflow charts were used to try to establish the financial position of Howship into the future, considering the debt it had and would incur and its obligation to pay that debt. The asset and liability valuations used in the chart were at their “Estimated Real Value [for] January 97”, rather than recorded figures in the entity’s accounts.
A crucial observation was made by Loftus and Miller (2000, p. 105): “Users need information on the relative liquidity of the assets (their nature and function in the entity’s activities including whether they are held to increase financial flexibility or for use and recovery in the normal course of operations, and the rate at which specific types of assets turn over). The relative proportion of debt (liabilities) in the capital structure is important as the lower the reliance on debt, other things being equal, the lower the risk of insolvency (through an inability to pay or other amounts falling due) and the greater the capacity to restore a weak cash condition by additional borrowing. Not only is the extent of the debt in the capital structure important but the timing of debt’s required payment (its relative liquidity) is also important. A high proportion of debt with a near due date may result in insolvency, particularly if the entity’s assets are relatively illiquid and economic conditions result in a shortfall in cash flow from operating activities.”
In the case of Howship Holdings, Sackville J found that it was “clearly a company with substantial assets which, on the evidence, exceed its liabilities. However, its principal assets are in the form of land holdings which the company’s directors wish to develop for sale. There is no immediate prospect of the land being sold” (p. 22). This implies recourse to the elements of a balance-sheet test of insolvency. However, the court also considered the entity’s history of raising finance through loans to meet its commitments, along with the evidence that its assets were greater than its liabilities. This is an example of combining the concepts of both the cashflow and balancesheet tests of insolvency when examining financial credibility. Sackville J determined that it was probable Howship would be able to pay all its expenses when due, at least until the end of the current financial year, but he concluded:
“This, of course, is not to say that the company’s future is secure. The evidence suggests that its financial position is precarious and that further delays in developing the land that constitutes its principal asset may well result in the failure of the company. But the question is not whether the company will survive for the foreseeable future. It is whether the company has discharged the burden of showing that it can pay all of its debts as and when they become due and payable” (p. 23).
Supporting the claim made previously that emphasis in Australia is on the cashflow test of insolvency,23 Sackville J remarked: “It follows that the mere fact that the company’s assets exceed its liabilities does not establish solvency” (p. 9, emphasis added).24 It is a necessary but not sufficient condition. Nonetheless, the basic concept of the balance sheet is used in many cases to establish whether an entity’s assets exceed its liabilities. So it seems arguable that elements of the cashflow test and the balance-sheet test ought to be combined to provide the courts and other interested parties with a single, more comprehensive, financial test.
Figure 1 illustrates primary aspects of both financial tests of insolvency and highlights particular problems that have continued to arise for the courts.
As shown in Figure 1, the courts consider the extenuating circumstances of each case.25 Analysis presented here, however, focuses only on the concept, definition and identification of an entity’s assets, liabilities and its financial capacity to pay its debts.
CASES THAT ILLUSTRATE THE CASHFLOW TEST
The following cases are similar in that the main concern is to ascertain the entity’s ability to pay its debts. The situations are different. They cover circumstances such as the financial effect on the entity when payment of debt is made from capital, when dividend payments are made from capital, and when the inability of an entity to pay its debt is due to a non-financial event that restricted the entity’s ability to trade. The link between the cases is the use of the commercial, or cashflow, test of insolvency.
In Jones and Aiken (1994, pp. 196-227), the significance of identifying corporate profit and the methods used to determine profit were discussed with emphasis on an entity’s ability to pay dividends and whether payment was made from surplus funds or capital. Stressing accounting issues such as the categorisation of assets, liabilities and their valuation to be included in the balance sheet when ascertaining corporate profit,26 Jones and Aiken highlighted two main concepts of profit. One method to determine an entity’s profit or loss is to calculate total revenues less all expenses. On the other hand, the emphasis may be placed on the surplus of assets to liabilities, a balancesheet approach. The concept of distributable profit or surplus funds is paramount in deciding an entity’s ability to pay its debts and dividends and its financial capacity to continue in business. Jones and Aiken (p. 201) remarked: “The balance sheet is arguably a more significant document than the profit and loss account depending on the concept of profit accepted.” Deciding what constitutes a relevant concept of profit, or surplus funds, requires recourse to the prevailing circumstances. However, in a test of insolvency an entity’s capacity to access cash is always paramount. This is arguably a view of total assets over total liabilities, valued with regard to their monetary equivalent at a particular time.
In Re Oxford Benefit Building and Investment Society (1886) 35 LR Ch.502 the entity conducted much of its business by lending money to builders on mortgages. It was held that the directors, “having treated estimated profits as realised profits, and having in fact paid dividends out of capital, on the chance that sufficient profits might be made, were jointly and severally liable, as upon a breach of trust, to repay, and must repay, the sums improperly paid as dividends” (p. 146). Technically, conventional accounting practice and Australian Corporations Law s.254T do not permit dividends to be paid out of capital, thus safeguarding the basic capital structure of the business entity. Yet paying debts incurred in the ordinary course of business out of capital could have a more damaging effect on the financial structure of the entity. It is evident from examples to follow that legal thought concentrates on many aspects of the cases brought to trial; but in such situations accounting remains primarily concerned with the financial circumstances of business and how best to determine and report on that financial state.
Other nineteenth-century and early twentieth-century cases that emphasise the ability to pay debts when due include Parker v Gossage (1835) 2 C.M. & R.617;150 E.R. 262; London & Counties Assets Co. Ltd. v Brighton Grand Concert Hall and Picture Palace Ltd. (1915) 2 K.B. 493,501. These cases were cited, in the case of Minion v Graystone Pty. Ltd. (1986) 1 Qd.R 157, 169, as support for the idea that insolvency means commercial insolvency, an inability to pay debts when due. But a major dilemma remained in deciding what debts to consider relevant to the issue of insolvency.
Buckley L.J. in London & Counties Assets Co. Ltd. v Brighton Grand Concert Hall & Picture Palace Ltd cited many authorities with regard to insolvency and stated that it means an “inability to pay certain debts as they become due” (emphasis added). McPherson J. in Minion v Graystone referred to Sandell v Porter (1966) 115 C.L.R. 666, 670 where emphasis was given to utilising all assets to command cash resources to pay debts when due, which is in accord with the reference to certain debt by Buckley L.J., and a selective view of liabilities. McPherson J. stated: “For my part, I am not persuaded that later variations of detail have either added much or detracted from the original basic proposition that insolvency exists where a debtor is not able to pay his debts as they fall due” (p. 157). This opinion implies that the cashflow test of insolvency is adequate because of its emphasis on an entity’s ability to pay its debts when due. However, as previously discussed, this disregards the entity’s fundamental obligation to pay all the debt it has incurred.
The phrase “ability to pay debts as they fall due and payable” draws attention to both the time when payment of debt is due and the entity’s actual ability to repay its debt. In the previous cases the court’s unease centred on the entity’s payment of debt when due, focusing on the entity’s immediate obligations. But in Sandell v Porter one issue was that all assets be utilised as a means of raising cash to pay the entity’s debts and emphasis was given to the financial capacity of the business to pay all its debts.
In Re Australian Co-Operative Development Society (1977) Qd. R66, at 79; (1976) 2 A.C.L.R 207,218 it was held that solvency was proved by the respondent’s ability to pay its debts at the relevant time. The applicant’s claim was based on s.122 of the Bankruptcy Act 1966, which specifically refers to “a person who is unable to pay his debts as they become due”. The society paid its debts out of capital but this was not considered to be of significance; the main point of concern was that payment was made and that payment was made in a timely fashion. Senior counsel for the respondent stated that “on the evidence the Society was at all material times in fact paying its debts with its own money as they fell due, so that it cannot be said that it was ‘unable’ to do this. It was, no doubt, using capital (depositors’ subscriptions) to make payments, but s.122 does not make ability to pay creditors out of revenue the test. It seems tolerably clear – having regard to the Society’s latest failure – that for some time (including the period under consideration) the Society invested other capital improvidently and unwisely” (p. 78).
In such a situation many accounting theorists would argue that payments out of capital erode an entity’s financial basis and that this would in turn adversely affect its long-term financial capacity to trade. Clearly there are different conceptual interpretations of what constitutes a surplus or available funds for an entity to pay dividends or debts. For instance, “different interpretations of the double accounts system were made by nineteenth-century authorities which ultimately undermined the capital maintenance rule in this period” (Jones and Aiken 1994, p. 203). Likewise, legal opinion in the above case was concerned not so much that debts were paid out of capital, but rather that the debts were paid when due. The emphasis in the cashflow test is on the entity’s ability to pay its debts when they are due and not necessarily that the entity will continue to operate into the future. This point is disputed here.
Dunn J. determined that even though the society was actually using capital to pay its debts, this did not mean it was unable to pay its debts. The nature of its business was borrowing and an entity “whose business is borrowing seems to me to be in a category of its own. In such a case, money which is borrowed cannot realistically be regarded as having been borrowed in order to stave off creditors” (p. 79). The court applied the commercial test of insolvency to determine ability to pay debts incurred. Depositors’ subscriptions were considered monetary loans (liabilities) to the society, used by the society in order to conduct business, make money (assets) and increase the rate of return to investors. The investigation focused on the immediate financial ability of the entity to pay its debts and not on its financial capacity to continue to pay debts and operate into the future.
On the other hand, arguably accounting reports should concentrate on determining whether the entity has the financial ability to conduct its business and still keep its capital intact – an essential feature of any going concern.27 In order to continue its business activities the entity must have access to money sufficient to meet its commitments and be able to pay its debts. The role of accounting is to provide these financial details to assist decision-makers. Yet this has not always been achieved. “Conventional accounting practices complying with the prescribed Standards have masked impending failure, exacerbated losses to creditors and shareholders, and provided regulators with a recurring dilemma” (Clarke et al 1997, p. 259).
In Minion v Graystone Pty. Ltd. it was held that “the expression `becoming insolvent’ was prima facie to be taken as meaning an inability to pay debts as and when they fell due, not the doing of something which caused [an inability] to trade without restriction” (p. 157). The respondent had been unable to complete a contractual arrangement because property required to do so had been seized by another party. The entity’s inability to complete the contractual arrangement altered its financial state and its ability to pay debt. Judgment in this case held that inability to pay debt was only part of the requirement to determine insolvency; another consideration was the length of time creditors were willing to wait for payment that was due.
As accounting is primarily a communication system with social and organisational functions, there is a responsibility that the process provides users of accounting statements with financial facts that relate to the type of report issued; for example, an entity’s cashflow, ledger account balances, production capacity, cost of production, environmental responsibilities, periodic accounting profit for taxation or internal management purposes, solvency or financial position. Although the cashflow test of insolvency extends the concept of the balance-sheet test, it seems more precisely to be a test of liquidity. In contrast, the balancesheet test is implemented in a context of data based on a conventionally prepared general-purpose financial statement that does not contain contemporary financial facts. It is questionable, then, whether this accounting report, prepared using prescriptive formulae and discretionary valuations, can serve the purpose of the judiciary or any interested party when determining an entity’s state of solvency. This may be a reason why Australian courts, at least, implement the cashflow test of insolvency and reject the balancesheet approach.
The major work of Canning (1929) detailed a critical analysis of accounting theory and conventional accounting practice. His approach emphasised concepts of economics to link the two disciplines. Tweedie and Whittington (1984, p. 25) stated: “[Canning’s] critique of contemporary accounting practice offered alternatives which were designed to bring the accountant’s practices more in line with the economist’s forward-looking methods of valuation.” Further, Canning observed that accountants were “fully aware of the difference between dollar accounting and a conceivable purchasing power accounting, and would prefer, just as economists do, a purchasing power accounting” (p. 196). His idea was that an entity’s financial position as disclosed in the balance sheet would specify its financial capacity to procure future funds with due regard to its dated valued assets. Zeff (2000, p. 21) explained that Canning was interested “in applying theories of capital and price so that accounting information would yield a more rational basis for business decisions”.
COURTS’ USE OF THE BALANCE SHEET
The following cases indicate a balance-sheet test of an entity’s state of solvency A primary concern is shown to be the concept and definition of assets and liabilities represented in the balance sheet. Further, various adjustments are made to an entity’s reported financial details in order that its financial statements more readily determine factual financial circumstance.
For instance, in Rees v Bank of New South Wales (1964) 111 C.L.R. 210, Bank of Australasia v Hall (1907) 4 C.L.R was cited in relation to the meaning of the phrase “inability to pay debts as they become due” (pp. 1514,1528,1543). Barrister W.B. Campbell stressed that the phrase as they become due “does not mean that simply because a man cannot put his hand on ready cash the day the debts fall due, he is insolvent” (p. 216). Moreover, in Sandell v Porter opinion was that it is “the debtor’s inability, utilizing such cash resources as he has or can command through the use of his assets, to meet his debts as they fall due which indicates insolvency” (p. 670). Barwick C.J. stressed: “It is quite true that a trader, to remain solvent, does not need to have ready cash by him to cover his commitments as they fall for payment, and that in determining whether he can pay his debts as they become due regard must be had to his realizable assets” (p. 218). The accent placed on realisable assets in Re D’Onofrio (1983) 76 F.L.R. 136 implied property with a monetary-equivalent, marketable character.
Such ideas stress the concept of exchangeability in defining assets. Other cases follow that also support this view. The cases emphasise that it is tangible assets that are also readily realisable; in other words, marketable assets that more precisely form part of a bona fide test of insolvency.
In Re Timbatec Pty.Ltd. (1974) 24 F.L.R. the company was held to be hopelessly insolvent from a certain date because it was unable to pay its debts from its own money. The mix of assets and liabilities as listed on the company’s balance sheet was considered in this judgment. The court determined that the company was undercapitalised from its inception and had always carried an inadequate liquidity position. The decision of Barwick C.J. in Sandell v Porter was applied, in that the court extended the cashflow test of insolvency to include realisation of assets by sale, mortgage or pledge in order to determine capacity to pay debts when due. Although the courts specifically relate this move to a cashflow test of insolvency, the further consideration of realisable assets includes the concept of a balance-sheet approach. A further point made in the case was that a business should be able to continue as a going concern after meeting its debt obligations. Barwick C.J. stated that this test “as regards ready realization of cash resources has regard, as I understand it, to the debtor who is conducting a business, and is applying his cash resources, and selling or mortgaging assets readily available to inflate these resources, while continuing his business” (p. 36). This idea asserts that a business will, or should, use all its available resources to survive in a competitive commercial environment as a going concern.
The reference by Barwick C.J. to “assets readily available” is worth considering in some depth because not all assets on the balance sheet are readily available, or available at all, to assist in payment of debt. This is mainly due to the intangible characteristics of conventional balance-sheet assets.28 In Re Timbatec Pty. Ltd. other authorities were cited that show further complications. For instance, in Rees v Bank ofNew South Wales (1964) 111 C.L.R. 210 where Barwick C.J. “emphasized that stock-in-trade in that case was clearly not an asset which was available to be realized to meet current debts except in the ordinary course of the company’s business, a course which had proved itself inadequate” (p. 218), due to the company’s insolvent state.
In Dunn v Shapowloff (1978) 2 N.S.W. L.R.235, an officer of the company knowingly contracted more debt when the company was apparently unable to pay the debt it had already accumulated. This indicates a management problem and at least two separate accounting issues: first, whether the company’s assets were in fact greater than its liabilities, in a monetary sense; and second, was management privy to this financial information and if so, why was it unable to pay its debts? Reynolds J.A. remarked: “The figures in the balance sheet were not a compelling guide to realisable figures” (p. 241). Further, the court discussed the effect of contingent liabilities to the extent, for this entity, of a possible future income tax obligation. The balance sheet and profit and loss statements were submitted as evidence and it was decided that with an adjustment for the contingent debt and valuation of some shares, company assets would exceed its liabilities. Mahoney J.A. said: “The fact that, eg, the company’s obligations, as to payment or otherwise, are contingent, does not, in my opinion, alter the position. If this be so, then the fact that, as the result of the contingency or otherwise, the debt never falls due for payment, does not mean that there was no contracting of it” (p. 243). It seems, at least in this case, the court’s preference was for the inclusion of all debt when deciding the entity’s financial ability to pay. So the term ability to pay would then relate to the amount of money held by the entity, its access to money in the short and long term and its capacity to continue trading into the future. Perhaps if management had this information, or had been given this information earlier, the financial crises may have been avoided.
CORPORATIONS LEGISLATION AND ISSUES OF SOLVENCY
Corporations legislation around the world shares concerns including the need to know whether an entity’s asset accumulation is greater than its liabilities, and ensuring that this knowledge is continuously available. Loftus and Miller (2000, pp. 23-58) explore this topic, noting that financial flexibility directly relates to the concept of solvency.29 The problem for countries, as well as business entities, is how best to value assets, liabilities and equity.
Figure 2 illustrates issues dealt with by courts in the US, UK, Canada, Australia and New Zealand when determining an entity’s state of solvency and identifies relevant sections of the corporations law of these countries. It shows that features emphasised in tests of solvency are similar in all countries.
The figure refers to sections of law in the Uniform Fraudulent Transfer Act (UFTA), Bankruptcy Reform Act (BRA), New York Business Corporations Law (NYBCL), Californian Corporations Code (CCC), the British Insolvency Act (BIA), Canada’s Bankruptcy and Insolvency Act, Australian Corporations Legislation (ACL) and the New Zealand Companies Act (NZCA). Insolvency legislation in the US, UK, Canada and Australia are examined in more detail by Duns (2000, note 2). A comprehensive discussion on New Zealand legislation is provided by Loftus and Miller (1996).
In addition to individual accounting and law concerns, there are overlaps between the two disciplines, in particular with regard to calculating the extent of an entity’s solvent or insolvent position. Figure 3 summarises the issues.
The balance-sheet test of insolvency, which compares an entity’s assets to its reported liabilities, has the potential to be a sound financial test of insolvency but not in its current form, primarily because of the vagaries of the GAAP definition of assets and the monetary equivalents given to them in financial statements. On the other hand, the cashflow test of insolvency has been shown to be better, principally because of its emphasis on ascertaining the current market worth of assets and the exchangeability of assets. It is suggested that only one financial statement is necessary to determine an entity’s financial state and its ability to pay its debts at any time.
Two main premises were examined. The first proposed that a financial statement used to determine an entity’s solvent or insolvent state should be compiled with particular regard to the definition and measurement of its elements. Specifically, the notion of assets with a current realisable market value was considered necessary if assets were to be legitimately aggregated for the purpose of assessing whether an entity can extinguish its debt. Second, it was argued that a financial test of insolvency should include all debt incurred by the entity in the course of its business activities in order to quantify more precisely its financial position. Hence, this paper continues previous debate on how best to determine an entity’s financial position and extends previous argument to include analysis of financial tests of insolvency – an issue with implications for both internal and external users of accounting reports.30
1 This is mainly because conventional financial statements “are not objective statements of reality, as there are clearly many alternatives, assumptions and estimates that are involved in producing financial statements” (Wright 1994, p. 373). See also Canning (1929, eg, pp.199, 319).
2 As evidenced by increases in penalties in the Australian Corporations Law for company directors involved in insolvent trading, particularly s.588. Directors of Australian companies must provide a solvency statement s.301(5), as part of the company’s published financial reports. Reference to particular legal cases with regard to the fiduciary duties of directors is provided by Duns (2000).
3 A premise first expounded by Chambers (1966). 4 For an entity to adapt to changing business cir
cumstances requires that it has money and access to money on a continual basis. Also: “It is relevant to note that the courts have clearly decided that in determining solvency, the money of the company which is taken to be available to pay debts which are due not only indicates cash resources, but can include money which is able to be procured by realising (by sale or by mortgage) its assets within a relatively short time. This is indicative of commercial realism. . .” (Keay 1995, p. 320).
5 Mescher (1996, p.842) argued that the Standard Chartered Bank case expanded this definition of solvency when Hodgson J held it necessary to consider “the company’s financial condition in its entirety, including its activities, assets, liabilities, cash, money which it could procure by sale or on the security of its assets, and its ability to obtain financial assistance by way of loan or subscription for share capital”.
6 See Duns (2000, p. 29) for comment on the importance of applying “an appropriate insolvency concept” especially with regard to employing a net asset test of insolvency.
7 Accounting academics and practitioners have long argued about the definition and concept of an asset. For a variety of opinion see, for example: Lisle (1899, p. 67), Sprague (1908, p. 36), Esquerre (1914, p. 135), Couchman (1924, p. 28), MacNeal (1939, p. 200), Paton (1949, p. 15), Goldberg and Hill (1958, p. 17), Chambers (1966, p. 56), Hinton (1972, p. 56), Wolnizer (1987, p. 58), Scheutze (1991, p. 116), Scheutze (1993, p. 68), particularly Chambers (1995, p. 1005). Many such references were also mentioned in Potter (1999, pp. 55, 56).
8 Such a view implies that “an economic resource . . . [be] defined as an element of wealth that possesses … utility, scarcity and exchangeability … [and] exchangeability means that an economic resource is separable from a business as a whole and that it has value in and of itself – that it is not solely dependent on the fortunes of the particular business enterprise to which the resource is attached” (Hinton 1972, p. 56).
9 The conceptual definition of liabilities in Statement of Accounting Concepts 4 (SAC 4) para. 48 asserts they are “future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events”.
10 New Zealand company law now requires that contingent liabilities be included in the assessment of a company’s ability to pay its debts. The NZ Companies Act 1993, Part 1, s.4(l)(b) states as part of the meaning of the solvency test that “the value of the company’s assets [must be] greater than the value of its liabilities, including contingent liabilities”.
11 For further details of the committee’s view on implications for valuation of provisions and contingencies refer to American Accounting Association (1998).
12 SAC 4, para. 14, states that assets are “future economic benefits controlled by the entity as a result of past transactions or other past events”. The emphasis is on control, not ownership, of the asset, the probability that future economic benefits will eventuate, that assets (as for liabilities) must be able to be reliably measured, and that
they may be tangible or intangible. The definition is ambiguous and the monetary amounts attributed to assets in conventionally prepared financial statements are usually based on historical costs; they do not indicate current values of money, the current financial worth of that money, or possible access to money to pay debts when due.
13 For instance in Re Newark Pty. Ltd. (in liq) (1993) 1 Qd R 409, Justice Thomas stated: “A debt does not necessarily become ‘due’ within the meaning of the section upon the date originally stipulated for its payment.” Also see Keay (1995, p.317) and Duns (2000, pp. 31, 32) for insightful discussion of this point.
14 For instance, “if the time for payment of a debt is extended then the debt is not payable and cannot be taken into account in assessing solvency” (Keay 1995, p. 321).
15 Support for this idea can be found in Bank of Australasia v Hall (1907) 4 C.LP, 1514 where the court held that all liabilities, otherwise provable in insolvency, were to be considered debt. Griffith CJ stated: “The words `as they become due’ require … that some consideration shall be given to the immediate future; and, if it appears that the debtor will not be able to pay a debt which will certainly become due in say, a month … by reason of an obligation already existing, and which may before that day exhaust all his available resources, how can it be said that he is able to pay his debts `as they become due’ out of his own moneys?”
16 “At present the primary source of information about financial position is the balance sheet, which can reveal much about the reporting entity’s liquidity if the assets, liabilities and equity are appropriately identified and categorised” (Loftus and Miller 2000, p. 105).
17 Further: “While some references to this dynamic view of a firm as a going concern may be found in the accounting literature (eg, Pixley 1926, p. 520; Edwards and Bell 1961, p. 381, the implications of it for accounting practice have been substantially ignored except by Chambers (in several works, eg, 1986, chapter 6, but especially and systematically in his principal exposition of CoCoA, 1966) and Sterling (eg, 1979)” (Tabart-Gay and Wolnizer 1997, p. 194).
18 For further information refer to the current Australian accounting standard, AASB 1021 Depreciation of Non-Current Assets.
19 In addition to the extended arguments provided by Chambers (1966) and Sterling (1979) refer to note 8; see for example, Canning (1929, p. 199), Jones (1934, p. 6), Boulding (1950/1962, p. 187), Sterling (1970, p. 101), Wolnizer (1987, p. 76), Clarke et al (1997, pp. 220-5).
20 See International Bar Association (1994).
21 The work of Keay (1995) was helpful when selecting relevant legal cases.
22 Court transcript available at http://www.austlii. edu.au
23 Lindgren J observed in Melbase Corporation Pty.Ltd.  17 ACSR 187 at 198, s.95A(1) of the Corporations Law states a “cash flow test” rather than a “balance sheet test” of insolvency.
24 Other recent cases referenced include: David Grant & Co Pty. Ltd. v Westpac Banking Corporation (1995) 184 CLR 265; Howship Holdings Pty. Ltd. (1996) 14 ACLC 1549; Melbase Corporation Pty. Ltd. v Legenhoe Pty. Ltd. (1995) 17 ACSR 187; The Roy Morgan Research Centre v Wilson Market Research Pty. Ltd. (1996) 39 NSWLR 311; Re Bond Corporation Holdings Ltd. (1990) 1 ACSR 350; Trade Practices Commission v Arnotts Ltd (No. 5) (1990) 21 FCR 324.
25 “Each company’s circumstances are going to be different. It is an area where one cannot be technical. Rather, a court must assess each company’s overall trading and financial position and ascertain whether the company is able to meet its debts” (Keay 1995, p. 316).
26 See also Kehl (1976, pp. 3-13)
27 For instance, “the concept of capital maintenance provides a benchmark that can be used to establish whether or not income has been earned” (Carsberg 1982, p. 60) and “the concept of maintaining capital intact … is the benchmark for the definition and measurement of income” (Barton 1984, P. 90).
28 For instance: “‘Assets’ are future economic benefits controlled by the entity as a result of past transactions or other past events; and `control of an assef means the capacity of the entity to benefit from the asset in the pursuit of the entity’s objectives and to deny or regulate the access of others to that benefit” (ACI, SAC 4, para. 14).
29 The FASB defines financial flexibility as “the ability of an entity to take effective actions to alter amounts and timing of cash flows so it can respond to unexpected needs and opportunities”. Loftus and Miller (2000, pp. 25, 26) give a detailed and technical expose on the terms financial flexibility and financial adaptability. For an explanation and argument on the term adaptive behaviour refer to Chambers (1966).
30 “At the entity or micro level, the executives who run the business have a good deal of freedom to choose among alternative ways of presenting its operating results and its financial position” (Solomons 1989, p. 1). This freedom provides opportunities for creative practice. “But creative accounting takes on many meanings. To management analyst John Argenti (in the seventies) it was a deliberate policy pursued by managers to deceive shareholders, creditors or themselves (or
all three) regarding a company’s wealth and progress in general and its financial difficulties in particular” (Clarke et al 1997, p. 21).
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Julie E. Margret is in the Faculty of Business and Law at Deakin University. The author acknowledges Julie Cassidy, Graeme Dean, John Duns, Stewart Jones, participants at the Conference of the Asia Pacific Economic Law Forum, Hong Kong, 3-5 December 1998 and the three anonymous referees for their helpful comments.
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