Insolvency and liquidation

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12/05/2021
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Chapter 18
Insolvency and liquidation
©2021 John Wiley & Sons Australia Ltd
Insolvency and administration
• The main intention of the Corporations Act 2001 is to treat
liquidation of a company as a last resort
– Part 5.3A deals with the appointment of an administrator where directors
believe the company may be insolvent
• s. 95A of the Act
1. A person is solvent if, and only if, the person is able to pay all the person’s
debts, as and when they become due and payable.
2. A person who is not solvent is insolvent
• If a company is insolvent directors
– Are required to act on behalf of both shareholders and creditors
– Can appoint a voluntary administrator or liquidator
– Can be prosecuted if they allow the company to trade whilst insolvent
Directors are expected to appoint a voluntary administrator even
before the company becomes insolvent
Insolvency and administration
• An administrator may also be appointed:
– By a liquidator if the liquidator believes that the company will become
insolvent (s. 436B)
– Or by a person who is entitled to enforce a charge on the whole, or
substantially the whole, of a company’s property (s. 436C).
• Administration is designed to resolve the company’s future direction
quickly
• The administrator
– Is an independent and suitably qualified person
– Takes full control of the company, to save either the company or the
company’s business
– Otherwise a liquidator should be appointed to wind up the company
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Insolvency and administration
Role and powers of the administrator
• Section 437A(1) sets out the role of an administrator:
(1) While a company is under administration, the administrator:
(a) has control of the company’s business, property and affairs; and
(b) may carry on that business and manage that property and those affairs; and
(c) may terminate or dispose of all or part of that business, and may dispose of
any of that property; and
(d) may perform any function, and exercise any power, that the company or any
of its officers could perform or exercise if the company were not under
administration
Insolvency and administration
Role and powers of the administrator
• After taking control of the company the administrator must:
– Investigate the company’s business, property, affairs and financial
circumstances
– Report to creditors on these matters
• The administrator will provide three options available to creditors
1. End the administration and return the company to the directors’ control
2. Approve a deed of company arrangement through which the company will
pay all or part of its debts and then be free of those debts
3. Wind‐up the company and appoint a liquidator
• The administrator will also provide an opinion on which option is in
the best interests of the creditors
Winding up in insolvency and by the court
• Winding up is the process whereby a company is dissolved
• Company ceases to be a legal entity
• Also referred to as a liquidation
• Legal requirements contained in chapter 5 of Corporations Act
• Two modes:
– Winding‐up in insolvency and by the court
– Voluntary winding‐up by members or creditors
• Accounting method the same in both cases
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Winding up in insolvency and by the court
• Where a company is insolvent, application may be made to the court
for winding‐up
• Insolvency is presumed to exist under a number of circumstances set
out in the Corporations Act. These include where:
– A creditor serves a demand for unpaid debts over $2,000 and the
debt remains unpaid after 3 months
– A receiver of property has been appointed under a circulating
security interest in such property
• Insolvency is the most common reason for liquidation – therefore the
major accounting problem is the apportionment of limited assets
between creditors and shareholders
Winding up in insolvency and by the court
Corporations Act also contains general grounds for winding‐up. These
include:
• The company has resolved by special resolution that it be wound‐up
• The company does not commence business within a year of
incorporation or suspends business for more than a year
• Directors have acted in self‐interest or unfair or unjust manner
• Directors actions have been oppressive, or unfairly prejudicial or
discriminatory
• ASIC issue a request for the company to be wound up
Winding up in insolvency and by the court
A liquidator, whether appointed by court order or voluntary, is required
to oversee the liquidation. The task of the liquidator is to:
• Take possession of the company’s assets
• Realise the assets or carry on the business as necessary for the
beneficial disposal of the assets
• Determine the creditors and order of priority of payment
• Pay the creditors
• Distribute the balance of funds (if any) to shareholders
• Bring about the dissolution of the company
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Winding up in insolvency and by the court
• Within 14 days of the making of the order for winding‐up
– The directors must prepare and submit a ‘Report of Affairs’ to the liquidator
(prescribed Form 507)
• The Report of Affairs includes:
– Estimated realisable values of assets
– Any expected surplus or deficiency of assets after deducting creditors’ claims
• Within 2 months of receipt of the Report of Affairs, the liquidator
must lodge a preliminary report with ASIC outlining:
– The amount of capital issued, subscribed and paid up (where applicable)
– Estimated assets and liabilities of the company
– The causes of failure
Voluntary winding‐up
A company may be wound‐up voluntarily at the instance of either the
members or the creditors
Members voluntary winding‐up
• Can only occur if the company is solvent
• Declaration of solvency must be made by the directors
• Using prescribed Form 520 – Refer to Figure 18.1
• Included after the declaration is a statement of affairs, showing
• The estimated realisable value of assets
• The amounts payable for liabilities and the amount of the surplus
Voluntary winding‐up
Creditor’s voluntary winding‐up
• In this type of winding up, there is no declaration of solvency
• In such cases the winding‐up is under the control of both members
and creditors
• Prior to the meeting of creditors the company must provide creditors
with a Presentation of summary of affairs of a company (summary of
affairs)
– Using Prescribed Form 509 – Refer to Figure 18.2
• At the meeting of creditors the directors must provide the more
detailed Form 507 Report as to affairs (as discussed earlier)
• At the meeting creditors can nominate a liquidator
– Where this is different to the member appointed liquidator the creditors’
liquidator will be appointed as a replacement
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Powers of the liquidator
• Liquidator has wide ranging powers under the Corporations Act
– E.g., continue to operate the business or enter into legal
proceedings
• Powers depend on whether the liquidation had been ordered by the
court or is voluntary
• In both cases liquidators must:
– Not make any concessions on any debts owing to the company of
$20,000 or more
• Liquidator entitled to inspect the records of the company – illegal to
try and stop this
Powers of the liquidator
• In the case of a court ordered liquidation key powers under
s. 477(1) include:
– Carry on the business of the company so far as is necessary for beneficial
disposal or winding‐up
– Pay any class of creditors in full
– Make arrangements with parties claiming to be creditors
– Come to agreements regarding calls, liabilities, existing claims…
• An extensive list of other powers are contained in s. 477(2)
– Including the power to do everything that is necessary to wind up the affairs of
the company and distribute the property
Powers of the liquidator
• In the case of a voluntary liquidation powers are specified under s.
506
• They include all the powers given under s. 477 to court appointed
liquidators
• Section 506 also confers some additional powers in relation to
performing roles that are performed by the courts in court appointed
liquidations
– E.g., fixing a time when debts and claims must be proved
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Proof of debts
• All debts payable by or claims against the company up to the relevant
date are admissible for proof against the company
• Section 9 of the Act – the relevant date is the day on which the
winding up is taken to have begun
• Debts may be accepted by the liquidator without formal proof
– Where formal proof is required Form 535 must be completed
• The size of the debt (including interest) is calculated as at the
relevant date
Priority of payment of debts
• The general principle under the Act is that
– All debts and claims rank equally
– In the event of a shortfall they must be paid proportionately
• Many expectations to this rule. Four different categories of
creditors
– Secured
– Preferential unsecured
– Ordinary unsecured
– Deferred
• A summary of priority of payment of creditors (assuming
insolvency) is set out on the following slide
Priority of payment of debts
1. Secured creditors
a) Secured by a non‐circulating security interest (specific charge)
• Any excess is returned to the liquidator
• Any shortfall is classified as an unsecured creditor
b) Secured by a circulating security interest (floating charge)
• Where there are limited funds available, debts mentioned in items
11, 13 and 14 below receive priority and paid now
2. Expenses incurred by a liquidator or other relevant authority in
preserving, realising, to getting in property of the company, or in carrying
on the company’s business
3. Costs relating to court ordered applications
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Priority of payment of debts
4. Debts relating to the indemnification of the administrator
5. Costs associated with the preparation of a report as to the affairs
of the company in the case of a court ordered liquidation
6. Costs of preparing a report by an administrator to be given to a
liquidator, if the company resolves to be wound up voluntarily
7. Costs of the audit of the liquidator’s accounts
8. Any other expenses properly incurred by a liquidator or other
relevant authority
Priority of payment of debts
9. Liquidator’s remuneration
10. Expenses incurred by members of a committee of inspection
11. Wages, super contributions and superannuation guarantee charge
payable to employees
– Limited to $2,000 for ‘excluded employees’
12. Workers compensation payable
13. Employees leave entitlements (e.g. annual leave, LSL, sick leave)
– Limited to $1,500 for ‘excluded employees’
‘excluded employee’ refers to a director, spouse of a director, or relative of a director
Priority of payment of debts
14. Retrenchment payments to employees (except ‘excluded
employees’)
15. Ordinary unsecured creditors
– Includes shortfalls of secured debts and salary and wages,
employee entitlements and retrenchment payment to ‘excluded
employees’
– Includes all debts payable to the government – e.g., PAYG tax, GST
– Although utility companies (electricity, telcos etc.) are unsecured
they commonly receive preferential treatment by threatening to
withdraw services
16. Deferred creditors
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Rights of contributories (members or
shareholders)
• Contributories are defined as members or past members of a
company
– If the company is limited by shares, members do not have to contribute more
than the amount unpaid on the shares
– Past members do not have to contribute to debts incurred after they ceased to
be members
– Past members may be required to contribute to the winding up, but only in
very particular circumstances
• Four issues need to be dealt with:
– Insufficient funds for creditors
– Sufficient funds to pay creditors, but not to repay share capital
– A surplus of funds
– Calls in advance / arrears of dividends
Rights of contributories (members or
shareholders)
Insufficient funds for creditors
• This is the most common scenario in practice
• Where partly paid shares exist an order may be made to make calls
on all or any of the contributories to the extent of their liability
• Once all shares have been paid in full, and deficiency is borne by
creditors
Rights of contributories (members or
shareholders)
Sufficient funds to pay creditors, but not to repay share capital
• This scenario is uncommon in practice
• Distributions made in accordance with the company’s constitution
– For example, preference shareholders will receive preferential treatment over
ordinary shareholders ONLY if stated in the constitution
• Distributions proposed by the liquidator are approved by a special
resolution of members
• More modern company constitutions specify that:
– Distributions are made on the basis of the number of shares held, regardless of
the issue price of the shares
– Amounts unpaid on partly paid shares is treated as property of the company
Refer to Illustrative example 18.1
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Rights of contributories (members or
shareholders)
A surplus of funds
• This scenario is rare in practice
• The rights of contributories to participate in a surplus should be
specified in the constitution
– Preference shareholders may or may not participate in any surplus
– Any right to preferential return of capital in the constitution does not
necessarily give them a right to share in any surplus
• The surplus may be shared on the basis of number of shares held
rather than price paid
– Using the table in Figure 18.3 as used in Illustrative example 18.1
Rights of contributories (members or
shareholders)
Calls in advance and arrears of dividends
• Calls in advance
– The constitution may deal with this situation
– Without constitutional guidance, calls in advance with related interest will be
repaid after creditor payments but before payments to shareholders
• Arrears of preference dividends
– In some cases the constitution will provide for payment of such dividends prior
to return of capital
– Where the constitution is silent and a dividend has been declared (a legal
debt), the unpaid amount ranks after unsecured creditors and before other
returns of capital to shareholders
Accounting for liquidation
Five main tasks:
1. Prepare relevant forms
• Report on company activities and property
• Summary of affairs (creditors voluntary winding‐up only)
• Declaration of solvency (members voluntary winding‐up only)
2. Realisation of assets
3. Possession of assets by secured creditors
4. Payment to the creditors in order of priority
5. Return of capital and surplus (if any) to shareholders
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Accounting for liquidation
Realisation of assets
• A ‘liquidation’ account is used to account for the realisation of assets
• All assets (excluding cash and assets subject to a security) are
transferred to this account
• On realisation of these assets the cash account is debited, and the
liquidation account is credited
Possession of assets by secured creditors
• Assets over which a non‐circulating security interest are held are
commonly taken into possession by the secured creditor and sold
• Any net proceeds are handed to the liquidator, with any gain or loss
credited to the liquidation account
The balance of the Liquidation account at this point represents the total
gain/loss on liquidation of the assets
Accounting for liquidation
Payment of creditors in order of priority
• The remaining creditors are paid in order of priority
• Unrecorded liabilities (such as liquidation expenses) are accounted
for by debiting the liquidation account and crediting the appropriate
liability
• On settlement, the liability account is debited, and cash credited
• Where creditors accept an amount lower than the carrying amount
of the debt, this represents a discount given to the company and is
accounted for by crediting the liquidation account
Accounting for liquidation
Return of capital to contributories
Accounting procedures are:
1. Calculate the distribution for each class of shareholder
2. Make any necessary calls on unpaid capital
3. Transfer share capital to a shareholders’ distribution account
4. Transfer reserve accounts to the liquidation account
5. Pay distributions by crediting the cash account and debiting the
shareholders’ distribution account
6. Transfer the balance of the liquidation account to the shareholders’
distribution account
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Closing a company’s books
1. Liquidation Dr
Assets [except cash and
secured assets] Cr
(Closing asset accounts)
2. Accumulated Depreciation Dr
Allowance for Doubtful Debts Dr
Liquidation Cr
(Closing contra asset accounts)
Accounting for liquidation
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3. Cash Dr
Liquidation Cr
(Sale of assets)
4. Liquidation Dr
Expenses Payable Cr
(Unrecorded expenses)
Accounting for Liquidation
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5. Secured Creditors
Cash [cash = sale price > liability]
Secured Assets
Liquidation [Gain on sale = sale
Dr
Dr
Cr
price > carrying amount of asset] Cr
(Sale of assets by secured creditors;
surplus cash to liquidator and gain on sale)
Accounting for Liquidation
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Accounting for Liquidation
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Accounts Payable
Dr
Liquidation
(Discounts given by creditors)
Call
Cr
Dr
Share Capital Cr
(Call on shareholders if any unpaid
amounts at commencement of liquidation)
Accounting for Liquidation
8. Cash
Call
(Receipt of cash from call
or calls in arrears)
Dr
Cr
Check cash balance
9. Expenses Payable
Accounts Payable
Dr
Dr
Cash
(Payment of liabilities)
Cr
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Accounting for Liquidation
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10. Share Capital
Call
Dr
Cr
Forfeited Shares Reserve
(Forfeiture of shares)
11. Forfeited Shares Reserve
Liquidation
Cr
Dr
Cr
(Transfer of forfeiture shares reserve to liquidation)
12. Reserves (Retained earnings, etc.)
Liquidation
(Transfer of reserves)
Dr
Cr
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Accounting for Liquidation
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13. Share Capital
Shareholders’ Distribution
(Transfer of share capital)
Dr
Cr
14. Shareholders’ Distribution
Cash
(Payment to shareholders)
Dr
Cr
15. Shareholders’ Distribution
Liquidation
(Transfer of deficiency or loss on
Dr
Cr
liquidation; if a gain or profit, then
Dr Liquidation and Cr Shareholders’ Distribution)
Accounting for liquidation
• A summary of movements through the relevant accounts follows:
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