A situation that occurs when an entity’s total book liabilities (liabilities recognized in book value) exceed the total book value of its assets. Accounting insolvency is judged only by examining the balance sheet, comparing book values of total assets with that of total liabilities at a given point in time. An entity with negative net worth (negative equity) is insolvent on the books, i.e., from an accounting perspective.
Insolvency is a state where an entity faces financial stringency, being unable to pay its liabilities to the lenders on the due dates. Actual insolvency may initiate proceedings where the insolvent’s assets get liquidated to pay due debts. Unlike actual insolvency, accounting insolvency is determined internally (on an entity’s balance sheet), and may not lead to a declaration of insolvency, as it relates the statement of financial position, rather than actual state of affairs. However, actual insolvency, occurring due to a great increase in expense, cash flow drying up and poor cash management, may be preceded by an accounting insolvency as a precursor (or early alarm signal).
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