How current assets melt away in an insolvency situation
February 28, 2023
In this third instalment on the devaluation of a business during insolvency, we turn our attention to current assets. These assets can not only shrink alarmingly in value during insolvency proceedings, but can also, in some circumstances, actually turn into net liabilities.
How can current assets lose value?
Inventories include a wide range of different items. From raw material stocks at one end to unsold finished goods at the other, taking in work in progress on the way. Their realisable value depends on so many issues, not least whether the business is to be continued or terminated. If there is no ongoing trade, who will buy finished goods and even then, at what fraction of their cost? Raw materials are often subject to retention of title claims by unpaid suppliers and so cannot be sold. Work in progress may have no value at all if the customer refuses to accept further deliveries, if the insolvency practitioner (IP) has no funds to complete the finished product, or if the finishing costs are greater than the end value.
In theory, unpaid invoices should be collectible, subject to normal issues with those debtors unable to pay. The reality post-insolvency is very different. Some debtors who can pay will hide behind disputes to resist or delay settlement, or else demand discounts. Other customers may have valid counter-claims if the billing relates to an ongoing supply contract, which cannot be fulfilled. Debtor receipts won’t arrive by themselves, so that either existing staff will have to be retained to chase them or professional collection agencies must be called in. Either way, there will be a cost to collect. The task might fall to the IP and their staff, but this too brings extra cost.
In a group scenario, both the parent company and its subsidiaries can have receivables owed to them by other group entities on their books. Whether these are collectible is a highly complex issue, often complicated by offsetting creditor balances and liabilities under cross-guarantees to lenders or other stakeholders, such as landlords. In too many cases, these group balances will have little or no value.
This is where some of the most problematic items lurk in a balance sheet, of which prepayments are the most common. This is the part of a cost incurred in one year which refers to a later accounting period and so has no cash value. There can be deposits lodged with suppliers and service providers, where recovery could be negated by counter-claims. Realisations of other items will depend on circumstances, such as the eventual net position with HMRC in the case of a VAT refund due.
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This could be cash held in a bank account as security against facilities provided by the same lender, or it could be a cash rent deposit against which a landlord could have a claim.
In theory, cash value should remain, but unfortunately, it’s not that simple. Any ‘free’ cash balances may be needed to fund the costs of the insolvency.
Other non-current assets
This heading could include current tax assets potentially receivable within twelve months, pension scheme surpluses, the value of hedging arrangements and other financial derivatives. Much of this accounting value could depend on a set of assumptions on future trading outcomes, which are no longer valid after a company has filed for insolvency.
Another major consideration in judging what non-current assets might fetch is where they are located in contractual terms or for legal and tax purposes. Not only can the costs and practical difficulties in turning such items into cash be higher around the world than in the UK, but a declaration of insolvency can change ownership rights or trigger remittance restrictions and potential tax obligations in some overseas jurisdictions.
Accounting terminology traditionally talked about assets being stated at the lower of cost and net realisable value, implying that realisation costs had been taken into consideration where appropriate. In a formal insolvency, these costs will inevitably be higher than in a going concern scenario. In some circumstances they can be higher than the book value, thereby precluding any recovery for stakeholders.
Are these current assets subject to security in favour of lenders?
Collections from trade receivables linked to asset-based funding are at risk of being diluted by termination fees and ongoing interest costs. Similar issues will apply where inventory financing is in place.
Can a going concern sale of the business help preserve current asset value?
Generally, this will be the case. Just like non-current assets, these items are inevitably worth more if they are going to be used in the same business under new ownership. This underlines the urgency of taking prompt and decisive action when a formal insolvency becomes inevitable. The later the process is started, the fewer and less beneficial the options are and the lower the recoveries will be.
The bottom line for this sort of balance sheet devaluation will be time. The sooner the directors of a distressed business seek professional advice, the more likely it is that the business’s value can be retained.
If you are seeking professional advice for your business, Opus is here to help. You can speak to one of our Partners who can discuss options with you. We have offices nationwide and by contacting us on 020 3326 6454, you will be able to get immediate assistance from our Partner-led team.