Solvency is an entity’s ability to cover the whole of what it owes out of what it owns, and to keep meeting its obligations as they come due over the long run. It is a reading of the whole balance sheet, everything owned against everything owed, which is what separates it from holding enough cash to get through this month. An entity that fails the test is insolvent, and insolvent is the word US bankruptcy and tax law actually define, with solvency standing as its complement.
Where the Test Is Written Down
The bankruptcy definition is a balance sheet comparison. For an entity other than a partnership and a municipality, insolvent means a financial condition such that the sum of the entity’s debts is greater than all of the entity’s property, at a fair valuation, exclusive of property transferred, concealed, or removed with intent to hinder, delay, or defraud the entity’s creditors, and of property that may be exempted from property of the estate under section 522 of this title (11 U.S. Code section 101(32)).
Two words in it decide the answer. Fair valuation means the comparison is not read off carrying amounts, so a sheet holding land at historical cost is not the measurement. Exclusive means the two named categories are struck from the property side rather than added to the debts, which moves the result toward insolvency rather than away from it. The subtraction underneath is the residual defined in net assets, taken at values the ledger may not carry.
The same paragraph carries two more definitions. For a partnership, insolvent means the sum of the partnership’s debts is greater than the aggregate, at a fair valuation, of two amounts: all of the partnership’s property, exclusive of property transferred, concealed, or removed with intent to hinder, delay, or defraud creditors, and the sum of the excess of the value of each general partner’s nonpartnership property, exclusive of both kinds of property named in the first definition, over that partner’s nonpartnership debts (11 U.S. Code section 101(32)). A partnership whose own books fail the comparison can therefore still be solvent on the statute when its general partners hold enough net worth outside the partnership, meaning personal property in excess of personal debts.
For a municipality, insolvent means the municipality is generally not paying its debts as they become due unless such debts are the subject of a bona fide dispute, or is unable to pay its debts as they become due (11 U.S. Code section 101(32)). One term, three tests: a stock comparison for companies, the same comparison reaching each general partner’s outside net worth for partnerships, and a payment test for cities.
Tax law fixes its own version. In the section governing income from discharge of indebtedness, insolvent means the excess of liabilities over the fair market value of assets, and whether the taxpayer is insolvent and the amount by which the taxpayer is insolvent are determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge (26 U.S. Code section 108(d)(3)). That is a dated snapshot a preparer has to build, not a balance the books already carry.
Where Solvency Reaches a CPA Firm’s Work
Solvency reaches the firm through the going concern evaluation that attaches to the statements the firm prepares at the close. Continuation of an entity as a going concern is presumed as the basis for financial reporting unless and until the entity’s liquidation becomes imminent, and preparing statements on that presumption is what is meant by the going concern basis of accounting; once liquidation is imminent the statements move to the liquidation basis under Subtopic 205-30 (FASB, Accounting Standards Update 2014-15, paragraph 205-40-05-1).
The standard puts the evaluation on management, and it repeats every period. In connection with preparing financial statements for each annual and interim reporting period, management shall evaluate whether there are conditions and events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued, or within one year after the date they are available to be issued when applicable (FASB, Accounting Standards Update 2014-15, paragraph 205-40-50-1).
Substantial doubt is a defined term rather than an impression. It exists when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within that same window (FASB, Accounting Standards Update 2014-15, Master Glossary). Probable is defined too, as meaning that the future event or events are likely to occur, and the same glossary states that the term probable is used consistently with its use in Topic 450 on contingencies (FASB, Accounting Standards Update 2014-15, Master Glossary).
The sequence is where the work slips. The evaluation initially shall not take into consideration the potential mitigating effect of management’s plans that have not been fully implemented as of the date that the financial statements are issued, with plans to raise capital, borrow money, restructure debt or dispose of an asset given as the examples (FASB, Accounting Standards Update 2014-15, paragraph 205-40-50-4). The rescue gets weighed second.
There is no private company carve-out, and no audit trigger either. The Board decided not to provide an exemption for nonpublic entities from evaluating and disclosing conditions or events that raise substantial doubt, having noted that the amendments would require relevant disclosures any time financial statements are prepared in accordance with GAAP, even when those financial statements are not audited. The amendments took effect for annual periods ending after December 15, 2016 (FASB, Accounting Standards Update 2014-15, paragraphs BC38, BC40 and BC41).
Then it becomes a sentence somebody has to write. If, after considering management’s plans, substantial doubt is not alleviated, the entity shall include a statement in the footnotes indicating that there is substantial doubt about its ability to continue as a going concern within one year after the date that the financial statements are issued (FASB, Accounting Standards Update 2014-15, paragraph 205-40-50-13).
Solvency and Liquidity Answer Different Questions
Liquidity asks whether what is already cash, or one step from it, covers what falls due now. Solvency asks whether the whole of what the entity owns covers the whole of what it owes, and whether the payments keep being made over years. The acid-test arithmetic on the liquidity side, including which balance sheet lines count as quick assets, sits in quick ratio.
They come apart in both directions. A business may look liquid on cash it borrowed last week while its debts still exceed its property at fair valuation, and a business with an unencumbered asset base may miss a payment because none of that base converts by Friday.
The standard treats both as evidence rather than as verdicts. Its examples of adverse conditions open with negative financial trends, for example recurring operating losses, working capital deficiencies, negative cash flows from operating activities, and other adverse key financial ratios, and it states that the existence of one or more of these conditions or events does not determine that there is substantial doubt (FASB, Accounting Standards Update 2014-15, paragraph 205-40-55-2).
What counts as an obligation at all, and where it splits between current and noncurrent, is settled before either question is asked, in liabilities and long-term liabilities. How much of the asset base creditors funded is the reading in equity multiplier, which is total assets over equity and says nothing about when the debt falls due.
Common Questions
In accounting the word attaches to the basis the statements are built on rather than to a ratio. Statements are prepared on the going concern basis unless and until liquidation becomes imminent (FASB, Accounting Standards Update 2014-15, paragraph 205-40-05-1), so an entity treated as solvent is one whose accounts still rest on the assumption that it will continue.
That property, taken at value rather than at carrying amount, is not less than debts. Which test is being run changes the count. Under the bankruptcy definition an individual’s property side is narrower than a personal tally of what they own, because property that may be exempted from property of the estate under section 522 is struck out of it first (11 U.S. Code section 101(32)).
The discharge of indebtedness definition carries no such exclusion and measures the excess of liabilities over the fair market value of assets (26 U.S. Code section 108(d)(3)). On the two texts, exempt property large enough can put the same person on opposite sides of the two tests.
Both halves have to hold, the balance and the payments. The second is usually what fails first, and the standard says as much: conditions or events that raise substantial doubt ordinarily relate to the entity’s ability to meet its obligations as they become due (FASB, Accounting Standards Update 2014-15, paragraph 205-40-50-2).
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