To be competent in the field of accounting requires knowledge of a multitude of terms related to financial situations, activities, and strategies. Oftentimes two distinct accounting elements will overlap or interconnect, making it challenging to distinguish them. Obtaining a bachelor’s degree in accounting creates a foundation that helps students clarify the similarities and differences between related accounting elements.
Two terms that arouse confusion are bankruptcy and insolvency. While the terms may be familiar, understanding how they connect and where they don’t connect is crucial when pursuing a career in accounting. Although each term deals directly with an organization’s ability to pay its debt, insolvency is really a problem that bankruptcy is designed to solve.
Insolvency vs bankruptcy
The bulk of the confusion around the connection between insolvency and bankruptcy exists because of how the two terms play off each other. You can be insolvent, unable to pay debts when they’re due, without being bankrupt. However, you can’t be bankrupt, undergoing the legal process the resolves debt with a court’s oversight, unless you prove insolvency. One is a state of economic distress that an organization may be able to work through, while the other leads to a court order, dictating how debts will be covered. It’s similar to a two-line defense system for when a business gets into financial trouble. Insolvency is the first line, where an organization can work to resolve its debt even though paying obligations off may be difficult. When those attempts fail, bankruptcy comes in as the second line, where a court has the ability to excuse some debt and rule on a payment plan to resolve the organization’s financial trouble for them.
What does insolvent mean? It can feel like a complicated question to figure out, even though the definition is really quite simple. It may only be temporary, but an organization becomes insolvent when it is unable to pay off debts with assets. While insolvency does signify a tough time for a business, there is a way through. Debts can be covered by borrowing funds, increasing revenue or negotiating a payment or settlement plan with creditors. It’s possible to overcome insolvency as long as an organization can make progress toward paying down what it owes.
There are two different types of insolvency based on where the payment challenges occur:
- Cash-flow insolvency is when a business does not have the cash to make payments against debt. Organizations find themselves in this situation when there is no money left because additional funds can’t be borrowed or there are no more assets to liquidate.
- Balance-sheet insolvency occurs when debts exceed assets. Payments may still be made if there is enough cash on hand, but doing so will deplete funds, eventually leading to cash-flow insolvency.
Once an organization has reached either type of insolvency, it will then need to decide whether or not it can overcome the challenge through some detailed analysis and review of finances, or even running a test. A balance sheet insolvency test, for example, includes a way to evaluate financial inflows, outflows, and assets. If the business’s inflows are less than its outflows and the value of all assets is worth less than the debt, management may conclude that they can’t resolve this situation on their own and declaring bankruptcy is the best course of action.
In the fourth quarter of 2018, over 22,000 companies filed for bankruptcy, according to Trading Economics. An organization reaches the point where bankruptcy is the only way to stop the financial downturn initiated by insolvency when selling off all assets still won’t cover the total debt. At this point, the court steps in to assist in the legal process of resolving the debt. Once the court decides how an insolvent debtor will deal with unpaid obligations, the organization is required to carry out the plan, whether that means selling additional assets or establishing payment plans for vital debts that must be paid. The court can also decide to erase debt that simply can’t be compensated due to the financial situation of the organization.
There are two common types of bankruptcies, known as Chapter 7 and Chapter 13. Chapter 7 generally wipes out or excuses unsecured debts, such as credit card bills, while Chapter 13 sets out a method for reorganizing or structuring debts in a way that allows an organization to continue making payments. The goal of Chapter 13 is for a business to catch up on the debt that must be paid such as tax obligations or a property mortgage.
Although the different types of bankruptcies provide a solution to the financial struggle a business may experience, businesses avoid bankruptcy as long as possible since it brings about negative consequences such as severely damaging credit ratings and the ability to borrow funds.
Becoming adept in accounting
If you find yourself asking questions like, “what is insolvency?” or “what is bankruptcy?” your curiosity might best be met with a degree in accounting. An educational background in accounting helps you develop the financial literacy necessary to fully grasp the myriad of financial terms, like insolvency and bankruptcy, among many others. With an online Bachelor of Science in Accounting degree from University of Alabama at Birmingham, you not only gain fluency in conceptual accounting and business, but also delve into topics like the legal environment of business, financial management, and financial accounting, all of which are relevant in understanding concepts like insolvency and bankruptcy.
Gain strong accounting skills while exploring every aspect of the field as you earn your bachelor’s degree in accounting. Start today by contacting an enrollment advisor at University of Alabama at Birmingham for more information.