02 9683 5999Many companies are currently facing financial pressures due to the “global financial crisis”. As a result, many directors are becoming concerned as to their responsibilities and potential personal liability for debts the company may incur as a result of insolvent trading.
An insolvent company is one that is unable to pay its debts as and when they fall due for payment. There are serious penalties under the Corporations Act for directors who allow a company to incur debts knowing the company cannot repay them. In addition, directors can become personally liable for the debts of the company.
Compensation proceedings for amounts lost by creditors can be initiated by ASIC, a liquidator or a creditor against a director personally. A compensation order can be made in addition to civil penalties.
Compensation payments are potentially unlimited and could lead to the personal bankruptcy of directors. The personal bankruptcy of a director disqualifies that director from continuing as a director or managing a company.
INDICATORS FOR INSOLVENCY
The question of whether the company is solvent is a judgement to be made by the Board of Directors. The solvency situation is one which can vary with changes in circumstances both within and beyond the company’s control. Factors which determine solvency include the security, level and timing of future income streams to meet expenditure obligations.
The test for solvency relates to examination of cashflows rather than profitability or balance sheet position.
Indictors a company may be at risk of insolvency include:
- Poor cashflow.
- Absence of a business plan.
- Incomplete financial records or disorganised internal accounting procedures.
- Lack of cashflow forecasts and other budgets.
- Increasing debt (liabilities greater than assets).
- Problems selling stock or collecting debts.
- Creditors unpaid outside usual terms.
- Suppliers placing your company on cash-on-delivery terms.
- Payments to creditors of rounded sums rather than specific invoiced amounts.
- Overdraft limit reached or defaults on loan or interest payments.
- Overdue taxes and superannuation liabilities.
The presence of a combination of the above factors would increase the risk of a company being insolvent.
We have found in recent assignments undertaken on behalf of clients for solvency evaluation, the financial accounts were not adequate to properly reflect the true financial position of the company. This is particularly the case where stocktakes are not performed, inventory on hand is not valued correctly, creditors are not completely included in the balance sheet, debtors are not being collected and amounts are being disputed. Cashflow projections were not prepared or prepared based on poor assumptions.
DIRECTORS’ DUTIES
The directors of a company have a duty to ensure the company does not trade while insolvent, nor allow the company to incur a debt knowing there is high likelihood it cannot be repaid. A breach of the directors’ duty will occur if there are reasonable grounds for the directors to have suspicion of insolvency, and continue to allow the company to incur debts.
In addition to the general duties under the Corporations Act, if a company is at risk of insolvency the directors’ duties expand from being accountable and acting on behalf of the shareholders to acting with the interests of the creditors and employees of the company for unpaid entitlements.
AWARENESS OF FINANCIAL POSITION
This duty requires all directors to be constantly aware of the financial position of the company. Reviewing the financial position annually is not sufficient.
In many family businesses, where husband and wife are directors, the wife may not be actively involved in the day to day operations and management of the business, nor be regularly aware of the financial position.
A similar scenario applies to entities where directors may be appointed and have limited financial skills. Regardless of these limitations the responsibilities of the ‘passive’ directors remain the same as for all directors.
KEEPING ADEQUATE FINANCIAL RECORDS
The Corporations Act requires companies to keep adequate financial records to correctly record and explain transactions and the company’s financial position and performance. The failure of a director to take all reasonable steps to ensure a company keeps adequate records contravenes the Corporations Act.
For the purposes of an insolvent trading action against a director, a company will generally be presumed to have been insolvent throughout a period where it can be shown to have failed to keep adequate financial records.
ACT EARLY
If you suspect your company is in financial difficulty, get proper accounting and legal advice as early as possible, as this increases the likelihood of the company surviving.
One of the most common reasons for the inability to save a company in financial distress is that professional advice was sought too late. It is better to take action early than to battle on, hoping business will improve. Without professional advice, quite often the financial position of the company deteriorates to the point where there are limited options available to continue trading
Some of the steps than can be taken when financial difficulties become apparent:
- Call your accountant to perform a review of the financial and cashflow position of the company. CIB have recently undertaken several assignments at the request of clients to investigate the financial position and solvency. The Corporations Act provides some statutory defences for Directors in an insolvency action, however, these will be difficult to rely on if the directors have not taken steps to keep themselves informed about the company’s financial position.
- Critically review your receivables and chase slow payers.
- Consider factoring debtors.
- Perform a stocktake and inventory valuation to obtain an accurate picture of the realisable value of inventory, including identifying slow moving items. Take steps to reduce inventory holdings and sell slow moving items at a discount to free up cash.
- Prepare realistic cashflow forecasts for the ensuing twelve months including worst case scenarios. This may highlight the sensitivity of reduced sales, slower collection from debtors or increased expenses.
Should you need any assistance in preparing cashflow forecasts or reviewing the financial position of your business, please contact one of our partners.
For more details contact Ronelle Wilson CA on 02 9683 5999 or via email to ronelle.wilson@cibaccountants.com.au
