How to Prepare Insolvency Accounts?

The following article will guide you about how to prepare insolvency accounts.

Generally, a person is said to be and insolvent who is unable to pay or settle his debts. But, in law, a person is declared as insolvent provided his liabilities exceed his assets and when he is so declared by a competent court.

In other words:

“a person is said to be insolvent when he commits an act of insolvency, i.e., refuses to discharge a debt of Rs. 500 or more; transfer all or substantially all his property to a third person with the intent to defeat or dealy his creditors; remains out of India, departs from India, departs from his dwelling house, secludes himself with the intent to defeat or delay his creditors; notifies his creditors that the payment has been suspended or is about to be suspended, etc.”

The Law of Insolvency in India is contained in two statutes; viz.:

(a) The Presidency Towns Insolvency Act, Chennai 1909—It applies only to the Presidency Towns of Bombay, Calcutta and Chennai; and

(b) The Provincial Insolvency Act, 1920, —It applies to rest of India.

Procedure under Insolvency Act:

If a person commits an Act of insolvency, an insolvency petition is filed in a proper court of law either by the debtor himself or by the creditors. Practically, the term ‘act of insolvency’ has not been defined in the Insolvency Acts but both the Acts prescribe certain acts as indicators of insolvency.

According to both the Insolvency Acts (Prov. Sec. 6, Presi. Sec. 9) a debtor commits an act of insolvency provided the following conditions are satisfied:

(a) If in India or elsewhere he makes a transfer of all or substantially all his property to a third person for the benefit of his creditors;

(b) If in India or elsewhere he makes transfer of his property or any part thereof with intent to defeat or delay his creditors;

(c) If in India or elsewhere, he makes any transfer of his property or any part thereof which would under the Insolvency Acts or any other law in force, be void as a fraudulent preference, if he was adjudged insolvent;

(d) If with intent to defeat or dealy his creditors:

(i) He departs from or remains out of India; or

(ii) He departs from his dewelling house or usual place of business or otherwise absents himself; or

(iii) He secludes himself so as to deprive his creditors the means of communicating with him.

(e) If any of his property in sold is execution of the decree of any court for the payment of money;

(f) If he petitions to be adjudged insolvent;

(g) If he had given notice to any of his creditors that he has suspended or is about to suspend payment of his debts;

(h) If he is imprisoned in the execution of a decree of any court for the payment of money; and

(i) If a creditors who has obtained a money decree against the debtor, has served on him an insolvent notice and he does not comply with that notice within the specified period.

The scheme of the two Acts is almost similar. The latest amendment to both the Insolvency Acts was made in 1978 by Insolvency Laws (Amendment) Act, 1978.

Interest:

A creditor is not entitled to earn interest after the date of insolvency. But if it is found that all claims have been met in full, that interest @ 6% only is allowed up to the date of payment.

Insolvency of Individuals and Partnership Firms:

Individuals:

We know that in case of an individual there is practically no difference between the private assets and business assets and private liabilities and business liabilities.

For example, If Mr. X has a business liability of Rs. 40,000 and business assets having Rs. 25,000 and at the same time, if he has a private liability amounting to Rs. 5,000 and has private assets amounting to Rs. 10,000, for insolvency purpose, his total liabilities will be Rs. 45,000 (i.e. 40,000 + 5,000) and his total assets will be Rs. 35,000. As such, the assets will be proportionately distributed among the creditors without making any difference between individual and business debts.

Partnership Firm:

In case of partnership, there is a clear distinction between the private assets and business assets, and private liabilities and business liabilities. Firm’s assets must first be utilized for the purpose of paying business debts and, if there is a surplus, a partner can utilise his share of surplus in order to pay off his private debts. Similarly, private assets must first be utilised for paying-off private debts and, if there is a surplus, the same can be utilised in order to pay the firm’s debt, if necessary.

It should be remembered in this respect that a minor partner is not liable to contribute anything out of his private assets and the creditors of the firm are not able to look to the private estate of the minor for their unsatisfied claims, i.e., private assets and private liabilities of the minor will be kept totally separate from those of the business.

A. Insolvency of an Individual:

Statement of Affairs:

A Statement of Affairs is to be prepared if a person or a firm is adjudicated as insolvent in order to show the true financial position almost like a Balance Sheet. Here, the assets must be shown at realisable values and not at book value. Because, the object is to show how much money is available for paying-off the creditors and, as such, the assets are recorded at their expected realisable values. Similarly, all liabilities should also be recorded.

Preferential Creditors:

According to the provisions of the Insolvency Act, some unsecured creditors are known as preferential creditors since they have priority of payments over other creditors.

A list, under the two Acts, is presented below:

Needless to mention here that if the unpaid amounts relating to Salary, Wages or Rent is more than the preferential limit, the said amount must be included with ‘Unsecured Creditors’ and, hence, if the assets of the debtor is insufficient to pay all the debts, they will rank equally.

From the above it becomes clear that the creditors are of four types, viz.:

(i) Preferential;

(ii) Fully secured;

(iii) Partly secured; and

(iv) Unsecured.

Similarly, the debtor is to prepare separate lists for each of the above categories of creditors.

Now we are to know the following list:

(a) List ‘A’ — Contains the names of unsecured creditors;

(b) List ‘B’ — Contains the particulars of fully secured creditors;

(c) List ‘C — Contains the names of partly secured creditors;

(d) List ‘D’ — Contains the names of preferential creditors;

(e) List ‘E’ — Contains properties;

(f) List ‘F’ — Contains book-debts;

(g) List ‘G’ — Contains bills of exchange in hand; and

(h) List ‘H’ — Shown as ‘Deficiency’.

Statement of Affairs:

(As required by the Presidency Towns Insolvency Act, 1909) In the High Court of Justice (In Insolvency):

To the insolvent—you are required to fill up, carefully and accurately, this sheet and the several sheets, A, B, C, D, E, F, G and H, showing the state of your affairs on the day on which the order of adjudication was made against you, viz., the……. day of…… 19…….

Such sheets, when filled up, will constitute your schedule and must be verified by oath or declaration:

I/we………… make oath, solemnly affirm, and say, that the above statement and several lists hereunto annexed marked A, B, C, D, E, F, G and H, are to the best of my/our knowledge and belief, a full, true and complete statement of my/our affairs on the date of the above-mentioned order of adjudication made against me/us.

Some Important Points:

We know that unsecured creditors include: Bills Payable, Bills Discounted likely to be dishonoured. Any kind of contingent liability which is likely to mature and the private liability of the debtor in addition to the ordinary creditors for goods. In Statement of Affairs, all those figures are to be consolidated in one single figure.

There is another point to remember, that is, creditors may often first or second charge over some of the assets. Naturally, the creditors who have first charge on any asset will have priority for recovering the claims against the sale proceeds of that particular asset and if there is any surplus left, the said surplus will be taken by the creditors who have second charge on that particular asset.

Consider the following example:

Now, if the estimated realisable value of the Plant becomes only Rs. 35,000 Mr. X will be partly secured as the amount is insufficient to liquidate his claims fully, and Mr. Y will be totally unsecured as no surplus is left for him after Mr. X.

Now, if the estimated realisable value becomes Rs. 60,000, in that case, Mr. X will be fully secured and Mr. Y will be partly secured as he is not paid-up in full (i.e. he is paid-off by Rs. 20,000 instead of his claims of Rs. 30,000).

But if the estimated realisable values of the Plant become Rs. 75,000 both Mr. X and Mr. Y will be fully secured (leaving a surplus of Rs. 5,000 which may be utilised for the purpose of paying-off the unsecured and/or preferential creditors (although Mr. Y will be paid after paying-off Mr. X).

I/we……… make oath/solemnly affirm, and say that the above statement and several lists hereunto annexed marked A, B, C, D, E, F, G, and H are, to the best of my/ our knowledge and belief, a full, true and complete statement of my/our affairs on the date of the above mentioned order of adjudication made against me/us.

Deficiency Accounts:

Deficiency Account expresses the amount contributed by the proprietor and the amount lost by him as well. Needless to mention that the amount lost by the proprietor will always be more than his contribution and, in that case only, it is possible to lose the money contributed by the outsiders which results in deficiency.

It is interesting to note that when the proprietor loses only his own contribution then there is no insolvency since the amount contributed by the outsiders is safe and secured. In this account, the amount which is contributed by the proprietor is shown in the left hand side (i.e. the amount includes original contribution plus profit earned and further introduction of capital etc.) and losses including drawings are shown on the right hand side.

Usually, losses arise due to:

(i) Losses arising from normal course of business;

(ii) Penalties paid by the firm;

(iii) Loss in value of assets;

(iv) Creation of fresh liabilities etc.

Deficiency account is to be prepared in the following manner:

B. Insolvency of a Firm:

While discussing ‘Partnership Firm’ it has been pointed out that a clear distinction should be made between the private assets and business assets, and private liabilities and business liabilities. Naturally, a separate Statement of Affairs and Deficiency Account should be prepared for the firm and for each of the partners as well.

Needless to mention here that if there is any surplus shown by the private ‘Statement of Affairs’, the same should be transferred to the firm’s Statement of Affairs. But it should be remembered that the deficiency of a partner must not be transferred to the firm’s Statement of Affairs.

If any security is provided by a partner from his private assets in order to pay the debts of the firm, there are two alternative approaches for the purpose. Either the creditor will realise the security and prove the balance of debt against the firm, or, he (creditor) at first proves against the firm for the entire debts and obtains the dividend and then he enforces the security which is provided by the partner for the balance of the debt.

The following example will make the principle clear:

Suppose, firm XY has taken an unsecured loan, i.e., Bank Overdraft to the extent of Rs. 30,000 and partner X, for this purpose, has given his life policy as security. The firm pays a dividend @ 50 paise in the rupee. The surrender value of the policy, say, is Rs. 6,000. Calculate the loss which is to be suffered by a bank in this respect.

Thus, under second method loss suffered by the Bank will be less.