What Is Accounting Insolvency?

Accounting insolvency is a situation that occurs when a company has accrued more liabilities on its balance sheet than assets. When this occurs, the company has a negative net worth, which essentially means it is insolvent. What makes accounting insolvency different than standard insolvency is that a company that appears insolvent on its books might be able to still pay off its debts for a limited period of time. Still, when evidence of the insolvency reaches the company's creditors, those creditors will likely demand that some action be taken by the company to alleviate this dire situation.

Companies often use loans in the course of their business dealings to fund new initiatives or strengthen operations. As those loans pile up, it necessitates a company doing enough business to help to pay those loans back. When a company lacks the ability to do that, it can no longer function in the same manner and it becomes insolvent. One specific type of insolvency known as accounting insolvency involves information solely gleaned from a company's balance sheet.

A balance sheet is a document which includes all of the information related to a company's assets and liabilities. Ideally, the assets outweigh the liabilities and allow the company to operate with a profit. In a worst-case scenario, the value of the liabilities will exceed the value of the assets, leading to accounting insolvency. This is an untenable situation for a company that wants to stay in business.

In some cases, a scenario where accounting insolvency exists may be covered up by the fact that the company is still able to pay its monthly bills. This is usually due to the fact that loans may have terms of various lengths, meaning that some debt obligations might not be immediately due. Still, when the liabilities are greater than the assets, the company is headed toward a reckoning with those people and firms to whom money is owed, also known as creditors.

Even though accounting insolvency may allow a company to subsist for a short amount of time, evidence of it will likely cause creditors to take action. These creditors are not likely to sit by and watch their loans go unrewarded. They may force the company in question to come up with a definitive plan to get out of the financial hole in which they are dwelling. In some cases, the company might have no other choice but to declare bankruptcy as a way of satisfying its debts.