Insolvency: How to recognise the signs

The sooner an insolvency practitioner is made aware of a client’s financial difficulties, the more options become available to the accountant and client.

Learning to recognise early signs of trouble, and partnering with an insolvency expert, can help public practitioners save their clients from going under.

At a glance

  • Challenging market conditions have resulted in many small businesses operating on the brink of insolvency.
  • The best outcomes can be achieved when businesses, tax practitioners and insolvency experts partner to recognise the early signs of trouble and work proactively.
  • However, there are complexities around determining if a small business is trading insolvent, and it is important to seek the right advice early.

By Zilla Efrat

If your clients are finding it hard to keep their heads above water during COVID-19, it could be time to call in an insolvency expert; and the sooner you do this, the better.

“This may sound counter-intuitive or contradictory, but early intervention is of the essence,” says Dr John Purcell FCPA, ESG policy advisor with CPA Australia.

“This not only enables a business to ‘take stock’ of the situation, but further allows appropriate analysis of what parts of the business and its tangible and intangible assets can be redeployed or re-enlivened.”

Purcell adds that calling in an insolvency practitioner early gives greater protection to directors and increases the chances of recovery.

“Additionally, the human welfare benefits of enabling a ‘clear headed’ recognition of the financial realities should not be underestimated, and that action, even if it is to exit the business, is in and of itself empowering,” he says.

Graeme Beattie FCPA, a partner at solvency and forensic accountant firm Worrells, concurs.

“We’ve seen what happens to businesses and individuals who are experiencing financial difficulty but fail to make important decisions before it’s too late,” he says.

“The sooner an insolvency practitioner is made aware of a client’s financial difficulties, the more options become available to the accountant and client.”

Kristen Beadle CPA, a partner at accounting firm Hall Chadwick, adds that not seeking advice early if a company cannot be turned around could lead to personal liability under the Corporations Act 2001 for insolvent trading.

It could also boost your client’s personal liabilities for director guarantees or secured loans against personal property, as well as acerbate the mental health concerns that can flow on from financial distress, she says.

From a practitioner’s point of view, Brian Goodridge CPA, managing director of Goodridge Advisory, also agrees it is better to call in the insolvency professional sooner rather than later. “In that way, we can make some informed decisions with the client about where we can take the business going forward,” he says.

“It makes the directors more aware of what they are facing, so that they can take it more seriously. It either makes them more committed to turning their business around or to pressing the button on liquidation before they get into a position that’s going to cause them bigger problems later on.”

The value of a specialist

“No one can be an expert in everything. Just like a medical GP [general practitioner] consults a specialist for a specific ailment, it’s best for accountants to involve an insolvency practitioner at the first sign of insolvency,” says Beattie, highlighting the specialist qualifications and experience insolvency experts are likely to bring to the table.

“With the constant temporary changes to legislation, it’s now more important than ever to engage a specialist in this area, as a generalist may not be up-to-date with all the recent amendments and how these may impact a client’s specific situation.”

Beadle says not being familiar with specific legislation and case law when providing advice can have both civil and criminal ramifications.

An insolvency expert can also assist with compliance with the safe harbour protection from civil liability for insolvent trading in the Corporations Act.

As Purcell points out, this protection is dependent on, among other things, obtaining advice from an appropriately qualified entity and on the development of a restructuring plan to improve financial performance.

Beattie, who is the chair of CPA Australia’s Public Practice Committee in New South Wales, believes the relationship between insolvency experts and tax and accounting practitioners should be symbiotic.

“Together they can provide a client with an understanding of the current financial position and all the options available when it comes to their own or their business’s financial health.

“Insolvency practitioners are also well positioned to have the ‘tough conversations’ that may be difficult for an accountant to have with their clients.”

Lines not to be crossed

Purcell says there is a clear line between the advice business or tax accountants can provide to a struggling client and the advice insolvency practitioners can give.

“The rules or mechanisms of corporate insolvency and company liquidators are highly regulated under the Corporations Act. Voluntary administrations, winding up proceedings – including the recovery of dispositions in the lead-up to winding up – and liquidations – including distributions to creditors – can only be done by insolvency practitioner through powers established in the Corporations Act.

“Insolvency practitioners are also under statutory obligation to report on the affairs of failed companies in term of any suspected wrongdoing by directors.”

Yet, while the advice and services insolvency professionals can provide may be different, Purcell says it is still important for accounting and tax advisers to familiarise themselves with the insolvency rules. This will prevent them from straying into areas where they have no powers to act and advise, and help them avoid adverse professional indemnity consequences.

"A critical function of the accounting adviser, now and in the future, will be to aid the stress testing of the business model in dramatically shifting economic and market conditions." Dr John Purcell FCPA, CPA Australia

“From a good governance or even ethical perspective, it’s also important that the accountant be able to advise on any unrealistic expectations about scope of current protections, most notably in relation to insolvent trading,” he says.

Purcell cautions that there are also risks associated with accountants becoming too enmeshed in the affairs of a client to the point where they might be regarded, under corporate law, as de facto or shadow directors, and thus liable in relation to breaches of both general law duties, such as care and diligence, and specific duties, such as the prevention of insolvent trading.

“This will arise if the accountant takes on what might be seen as management decision-making, or the client becomes utterly reliant on the accountant or adviser,” Purcell says.

“Further avenues of legal exposure could arise where there is wrongdoing by a company and by its directors, which the accountant or adviser might be seen to be associated with, such as breaching corporate law or in relation to what is now illegal phoenixing.”

Strategies to prevent insolvency

“It seems trite to say this, but the essence is all around appropriately managing cash flow,” says Purcell.

“This should never be regarded as a passive or static exercise. It requires a high level of analytic understanding of the business’s dynamic and the shifting trading or commercial circumstances.

“More generally, a critical function of the accounting adviser, now and in the future, will be to aid the stress testing of the business model in dramatically shifting economic and market conditions. Also important throughout is to ensure that appropriate accounting records are maintained.”

Goodridge highlights that understanding and knowing when a client may be insolvent is often not straightforward.

“We examine the trends affecting the business, where the business is expected to go, cash flow forecasts, the level of debt and obligations to pay debt,” he says.

“We also look at whether directors are starting to get into a hole they may not be able to get out of. That’s when we call in an insolvency professional to have a conversation around what could happen and what the obligations of the directors are.”

When determining whether or not a company is solvent, Beadle advises tax and accounting practitioners to scrutinise aged payables, whether the business is able to source external funding, aged stock or stock not easy to sell, overdrawn bank accounts, rejected payments due to insufficient funds or legal action underway for non-payment of debts owed.

Also important to consider, she says, are assets that cannot be converted to cash to pay outstanding creditors, the negative net asset position and the outstanding lodgement and payment obligations to the Australian Taxation Office (ATO) or employee entitlements such as superannuation.

“An accountant has access to an entity’s ATO portal and can easily see if lodgements are missing or overdue, and what the tax debt payable is.”

Beadle notes that the framework for doing business is changing almost daily and depends on the kind of industry the client is involved in.

“The advice should be on new ways the business can be operated,” she says. “Should it be moved online? Can costs be cut? Is there an area of the business that is no longer profitable or obsolete that can be permanently closed? And, is now the time to branch out into a new area of business?”

CPA Australia podcast: How Public Practitioners can work with clients facing insolvency

Signs that it is time to call in an insolvency expert

In the case of Asic v Plymin (2003), the judge provided a checklist of 14 indicators of insolvency. They were:

  1. Continuing losses
  2. Liquidity ratio below one
  3. Overdue Commonwealth and state taxes
  4. Poor relationship with present bank, including inability to borrow further funds
  5. No access to alternative finance
  6. Inability to raise further equity capital
  7. Suppliers imposing cash-on-delivery terms or otherwise demanding special payments before resuming supply
  8. Creditors unpaid outside trading terms
  9. Issuing of post-dated cheques
  10. Dishonoured cheques
  11. Special arrangements with selected creditors
  12. Solicitors’ letters, summonses, judgments or warrants issued against the company
  13. Payments to creditors of rounded sums that are not reconcilable to specific invoices
  14. Inability to produce timely and accurate financial information to display the company’s trading performance and financial position and make reliable forecasts.

    Source: Graeme Beattie FCPA, Worrells

Five steps to prevent insolvency

Worrells partner Graeme Beattie FCPA recommends these steps to avoid insolvency:

  1. Assess: Understand the current position the business is in, what threats it faces, and what resources it has available. Focus on what is within your control.
  2. Consult: Speak to a restructuring expert for a qualified, unbiased assessment and opinion.
  3. Plan: After identifying the key drivers of the business, develop a plan. Documenting the plan, allocating responsibilities and setting agreed timelines is essential. Ensure staff and key stakeholders are supportive of the plan. Communication is key.
  4. Respond: Implement the plan and respond to the issues identified as soon as possible.
  5. Monitor: Regularly review the financial situation and adapt or amend the plan if necessary.

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