Insolvency: Definition

Insolvency arises when an entity is unable to pay its debts when they fall due.

Insolvency: Explanation

An insolvent person may have some valuable assets. When they are declared as insolvent or bankrupt, their property is sold by a court-appointed liquidator.

The amount realized through asset sales is normally less than the debts. Creditors are paid out of realized money. The amount which is paid to creditors is termed as the dividend.

Effect of Insolvency of Drawee

When a drawee of a bill of exchange is declared as insolvent, any bill of exchange that they accept will be dishonored immediately.

In the books of the drawer, a ledger account will be prepared for the drawee. The drawee’s ledger account will show the total amount receivable from the drawee. The amount realized by selling their property will be received as a final dividend.

In addition, the balance that could not be recovered will be debited to the bad debts account in the drawee’s books.

Accounting Treatment of Drawee’s Insolvency

Treatment of the drawee’s insolvency in accounting will be passed in the books of both the drawer and drawee.

1. When the drawee is declared insolvent

Journal Entries for Insolvent Drawee
2. To receive final dividend and close the drawee’s account
Final Dividend Received Journal Entries
3. When nothing is recovered from the drawee
Journal Entries for Nothing Recovered

Example

This example focuses on the renewal and insolvency of the drawee.

On 1 January 2019, A sold goods to K worth $15,000. On the same date, A drew a three-month bill on K. A endorsed the bill to his creditor Z to settle his debts. At maturity, the bill was dishonored and A had to pay Z.

K paid $5,000 in cash and accepted a new bill for three months for the balance amount plus interest @ 10% p.a. Before the due date of the second bill, K became insolvent and only $0.50 was received from his estate as a first and final dividend.

Required: Pass journal entries in the books of A and K. Also, prepare K’s account in the books of A.

Solution

A's Journal
K's Account
Working:
Amount of Interest Formula
K's Journal

Frequently Asked Questions

What is the treatment of insolvency in accounting?

Outstanding debts are converted into an asset called bad debts.

When can a debtor be declared insolvent?

The debtor will be declared as insolvent when he fails to make payments or meet his obligations with regards to his creditors or debtors after receiving demand for the same.

What is the treatment of insolvency in accounting?

A debtor will be declared as insolvent when he fails to make payments or meet his obligations with regards to his creditors or debtors after receiving demand for the same.

How can a company become insolvent?

The process of becoming insolvent starts with the filing of a petition by the debtor under chapter 7, 11 or 13 of the bankruptcy code. Once the petition is filed, an automatic stay goes into effect which forbids all creditors from taking any legal or collection action against the debtor.

How does a company become insolvent?

The process of becoming insolvent starts with the filing of a petition by the debtor under chapter 7, 11 or 13 of the bankruptcy code. Once the petition is filed, an automatic stay goes into effect which forbids all creditors from taking any legal or collection action against the debtor.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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