Auditing aspects of insolvency (UK Syllabus only)

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1 Meaning of insolvency

A company is insolvent if the value of its assets is less than its liabilities (i.e. the statement of financial position shows a position of net liabilities). If all the company’s assets were sold at carrying amount (‘book value’), the existing liabilities could not be paid. This is a more fundamental problem than simply being short of cash.

• Management’s responsibility for monitoring financial position and performance is especially important when the company has financial difficulties, as cash flow problems can quickly result in insolvency.
  

• When facing insolvency, management must consider the interests of lenders and other creditors, shareholders and other stakeholders.
  

• Management must, therefore, prepare and monitor financial statements and cash flow and profit forecasts on a regular basis.
  

• The auditor may be asked to advise on whether a company is insolvent, or to review historic or projected financial information.
  

• Having up-to-date financial information and taking professional advice may also help to protect directors from legal claims such as wrongful or fraudulent trading.
  

2 Administration or liquidation?

The directors of an insolvent company face a difficult decision. Should the company continue to trade, in the hope of improvement, or ‘cut its losses’ and cease to trade and be wound up? The auditor may be asked to help resolve this dilemma by evaluating the advantages and disadvantages of the options available, and considering the impact of each on the relevant stakeholders. The auditor may also be asked to explain the procedures involved in placing a company into administration or liquidation, as directors will usually have limited knowledge in this area.

3 Administration

If management decides to try to ‘save’ the company, it can be put into administration, which offers some time and legal protections while formulating a rescue plan. The main advantage of this option is that once an administrator is appointed, there is a moratorium over the company’s debts (i.e. the creditors cannot present a winding-up petition to the court).

• The court will only grant an administration order in response to a petition (by the company, its directors or creditors) if satisfied that:
  

  • the company is (or likely to become) insolvent; and
    

  • that administration is likely to achieve its purpose.
    

• An administrator may be appointed without a court order by a floating chargeholder or the company or its directors.
  

• The administrator is given a short period of time (usually eight weeks) to set out a proposal for achieving the aim of the administration or to decide that a rescue is not reasonable.
  

• Proposals are accepted or rejected at a creditors’ meeting.
  

• The administrator takes over the company’s management and has the power to appoint and remove directors.
  

• Administration usually lasts for 12 months, but may be extended (with the creditors’ approval) or end early (if administration is successful).
  

4 Liquidation (‘winding up’)

A company that cannot be saved will cease to trade – assets are sold, liabilities paid (applying the ‘priority rules’ below), and eventually the company will be dissolved. Once liquidation proceedings commence share dealings must stop and the directors lose their power to manage the company.

There are different ways in which the process is initiated:

• Compulsory liquidation – usually on the grounds that the company is unable to pay its debts (i.e. fails to pay a statutory demand for more than £750 within 21 days). A member (for at least six months) may also petition the court for winding up on the ‘just and equitable’ ground.
  

  • An Official Receiver (an officer of the court) takes control of the company and its assets until a liquidator is appointed.
    

  • Company ceases new business, floating charges ‘crystallise’ and employs are automatically dismissed.
    

  • Directors must prepare a ‘statement of affairs’ (i.e. details of all assets, liabilities, creditors and any security they hold).
    

  • Liquidator investigates the causes of the company’s failure, realises the company’s assets and distributes proceeds in a prescribed order.
    

  • Liquidator files a final return with the court and the Register of Companies (company is dissolved).

• Member’s voluntary (‘solvent’) liquidation – can only take place when the directors have made a declaration of solvency. Creditors have no involvement in the process as the declaration means they will be paid in full and therefore have no risk exposure. Shareholders pass a special resolution (i.e. 75% majority) to wind up the company within five weeks of the declaration of solvency and appoint a liquidator. The surplus after assets are realised and debts cleared is returned to the members.
  

• Creditors’ voluntary (‘insolvent’) liquidation – shareholders must pass a special resolution to start the process but the creditors get to choose the liquidator. Both members and creditors appoint representatives to a liquidation committee which supports the liquidator.
  

5 Priority for allocating company assets

This is especially important for creditors and shareholders because, by definition, an insolvent company cannot pay everything that is owed. The amounts that will be paid on liquidation depend on:

• whether debts are secured or unsecured
  

• whether charges over assets are fixed or floating
  

• whether shareholders own preference or equity shares
  

• the costs suffered by the liquidator (generally paid first)
  

• the amount of preferential creditors (including employees’ salaries and other benefits in arrears).
  

Equity shareholders may receive very little, if anything, as they rank last. The auditor of an insolvent or potentially insolvent company may be asked to advise on the allocation of company assets.

6 Benefits of administration

If successful, the company will continue as a going concern:

• shareholders continue to hold shares and, hopefully, eventually receive a return on their investment. (Compared with very little/nothing if the company is wound up.)
  

• for creditors, improved cash flows should allow debts to be repaid and trading relationships can be maintained.
  

• continuing employment of some staff (though there may be some redundancies in the rescue plan). (Compared with automatic dismissal in a compulsory liquidation.)

7 Fraudulent and wrongful trading

These terms are defined in the Insolvency Act 1986.