Solvency in Financial Accounting

Julie E. Margret

• Publisher: Routledge
• Year: 2011
• Print ISBN: 9780415895828
• eBook ISBN: 9781136473463
• Edition: 1
• Topic: Business
• Subtopic: Auditing
• Index: Business

This book examines the notion of solvency at law and in accounting; and reveals inconsistent ways of determining solvency therein. Solvency is a critical commercial financial attribute. Quantifying solvency has been of concern to many across time, particularly with regard to business continuity. This study demonstrates that conventional financial statements are deficient in establishing the financial state of an entity, and equally lacking in quantifying its state of solvency.

The book contributes to the literature by drawing on real-world observations of how the meshing of commercial and legal foundations creates the environment in which accounting must serve. The aim of this work is to provide insights into what changes to existing financial reporting systems might assist business in mitigating unexpected business failures and the criticism of accounting in the aftermath.

Drawing mainly on major Australian cases, links highlight associations between the language of accounting and the data in financial statements; and situations that may be generalised - that have international significance. Hence, this work is relevant to the interests of a wide range of readers. It is also important from a public policy perspective as regulators grapple with a commercial environment heavily influenced by sometimes perceived scandalous corporate activity. Solvency is a topical and ongoing issue for business and financial accounting.

1 A Crucial Aspect of
Financial Accounting

‘Bad production management and bad sales management have slain their thousands, but faulty finance [leading to insolvency] has slain its tens of thousands.—Collin Brooks’ (in Chambers, 1986, p.v).

THE PROBLEM

This book examines the notion of solvency as revealed in the legal and accounting domains. Inconsistent ways of determining solvency at law and in accounting are revealed.

Solvency is a critical commercial financial attribute. Quantifying solvency has been the focus of many of the concerns expressed across time with regard to business continuity and the financial reporting system. It has featured in myriad press headlines globally about major multi-national corporations. In Australia, the various inquiries—Liquidators', Royal Commissions' and Courts'—into HIH, One.Tel, Ansett, Water Wheel and others have deliberated this financial characteristic. Whilst this is not altogether new, there does appear to be a greater emphasis on solvency in the new millennium than in previous decades.

Arguably accounting data should provide a major input in any assessment of an entity's solvency. Hence, a major premise of this book is that a precondition of ascertaining an entity's corroborable financial state, its dated financial position, is to determine its level of solvency.

Although there appears increasingly to be recourse in the law and in commerce to solvency, its quantification has not been adequately considered, especially in financial accounting.¹ The AASB framework (para.16) [IASB framework equivalent] provides:

The financial position of an entity is affected by the economic resources it controls, its financial structure, its liquidity and solvency, and its capacity to adapt to changes in the environment in which it operates. [and] … Information about liquidity and solvency is useful [arguably essential] in predicting [ascertaining] the ability of the entity to meet its financial commitments as they fall due. Liquidity refers to the availability of cash in the near future…. Solvency refers to the availability of cash over the longer period to meet financial commitments as they fall due.

Regardless of the rhetoric, however, given the content of conventional financial statements, including the cash flow statement in its current form, there is no apparent development on how best to quantify solvency. The primary focus on assets as expectations of future economic benefits is intangible and is arguably unhelpful. For instance, the AASB Framework states: ‘An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’ (at para.49 (a)). The concept of expected future economic benefits allude to anticipation of gains, a hope—not assured financial facts.

The financial industry and its regulators have insisted on minimum solvency requirements—prudential limits—for financial institutions such as banks, superannuation funds, general and life insurers that ‘maintain a prescribed excess of assets over liabilities.’² Similarly, the international balance sheet test of [in]solvency mandates that an entity's assets exceed its liabilities.³ The HIH Royal Commission highlighted the notion of regulatory solvency and noted particularly the recognition and valuation treatment of assets as a prerequisite to determining an entity's state of solvency.⁴

Additionally, Commissioner Owen (2003, s.19, p.20) noted that during the HIH investigation ‘a common theme emerge[d], … that the [minimum solvency] requirement was regarded by some as a requirement of form rather than substance, without due heed to its underlying prudential purpose,’ for instance, assets shaped from the Cotesworth Group letter of credit arrangements.⁵ In accord with the Insurance Act (1973), HIH (and other general insurers) included intangible assets such as goodwill in minimum solvency calculations. Since July 2002 and the release of new prudential regulatory standards, intangible assets are not to be included in determining a general insurer's regulatory solvency—namely, for reporting to APRA.⁶

On the other hand, preceding 2005, there were no such restrictions for external financial reporting purposes under the guidelines of generally accepted accounting principles (GAAP)⁷ and the then AASB1023: Financial Reporting of General Insurance Activities.⁸ Such inconsistencies at law and in accounting are shown below to be pervasive, much to the detriment of achieving an orderly, informed commercial setting.

By 2007 a revised AASB1023: General Insurance Contracts was released that incorporated amendments compliant with the international financial reporting standard IFRS 4: Insurance Contracts. The revised prudential standards were effective from July 1, 2008, and included focus on assets GPS 120, capital adequacy GPS 110 and measurement of capital GPS 112 and risk management including issues of balance sheet and market risk GPG 250 among others. Such standards are subsequent to the APRA Discussion Paper released on November 20, 2003, on “Stage 2 Reforms” of the General Insurance Industry—a bid to further strengthen prudential requirements on solvency issues.

Interestingly now, in accounting, financial assets for insurers are likely recorded at fair value⁹ whereas operating assets for other corporate entities are not.¹⁰ The reason for the difference remains unclear. Similarly confusing the AASB1023 provides: ‘Where assets are not backing general insurance liabilities or financial liabilities that arise under non-insurance contracts, general insurers apply the applicable accounting standards making use of any measurement choices available’ (at para.15.1.1).

Arguably in financial accounting little has changed, and the consequences may be dire; as Clarke et al. (2003, p.310) noted:

HIH's published financials at 30 June 2000 brought to account nearly $1 billion dollars of Future Income Tax Benefits, goodwill and various capitalised expenditure [assets] all potentially in accord with the prevailing [accounting] Standards. Those balances are of highly contestable relevance to any assessment of the company's solvency at the time or of its overall financial position. That scenario is not unique to HIH.

Returning momentarily to the notion of “form over substance” or “substance over form,” the AASB Framework (para.35) provides: ‘If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form’ [emphasis added]. The primary objective of financial reports is to provide financial information ‘that is useful to a wide range of users in making economic decisions’ (para.12). Relevance and reliability are principal qualitative characteristics of financial reports (para.24). Hence, to enable financial reports to depict substance over form entails that the content of those reports be relevant to the date of the report.

Therein lies a problem—for, to fulfil the stated ‘objective of financial reports … to provide information about the financial position … of an entity that is useful to a wide range of users in making economic decisions’ (AASB Framework, para.12) necessitates that financial information considered useful for making economic decisions is well-defined. If information on financial substance and economic reality are to be achieved, quality financial information is required. Quality is herein defined as “a degree of excellence,”¹¹ that which is “serviceable,”¹² with excellence apparent as that “surpassing merit.”¹³ Quality financial information is not achieved necessarily by following accounting rules and dictum. West (2003, p.6) showed that across time:

[N]o demonstration has been made of how extant accounting rules redress the alleged “market failures”. Indeed, examination of these rules reveals that they do not embrace any coherent quality specification for accounting information. Nor has any robust explanation been offered for why the “market failures” should necessitate a continuing expansion of the number of rules.

Historically, Chambers (1979b, p.74) ‘described usefulness [in accounting] as a vanishing premise on the ground that every advocate of a rule or practice would contend that the product of it is (or would be) useful.’ Later, with regard to public sector accounting, Carnegie and Wolnizer (1999, p.18) discussed briefly the difference between the use of accounting numbers and the concept of those numbers being useful therein. Chambers (1979b) noted also that accounting data should serve as a warrant—a form of quality control—quality in that sense would ensure that the data depicted truthfully and fairly the salient characteristics that all users require—namely, data about an entity's solvency, liquidity, profitability and adaptability.¹⁴

By 2010 the AASB Framework (para.46) asserted ‘the application of the [four] principal qualitative characteristics [understandability, relevance, reliability and comparability] and of appropriate accounting standards normally results in financial reports that convey what is generally understood as a true and fair view of, or presenting fairly such information’ (emphasis added). Arguably the assertion is confusing and actively, it is not possible. For all of these “principal qualitative characteristics” and “appropriate accounting standards” cannot be applied in all given situations because the standards direct one to disregard relevant financial details if they are deemed unreliable; refer for instance to AASB Framework (paras.26 and 32).

On financial details, Chapter 2 examines the asset test (balance sheet test) of insolvency and the commercial test (cash flow test) of insolvency and explores the various elements therein, and Chapter 4 investigates the constructs of conventional financial statements and their ostensible lack of substance on solvency. With focus on terminology and the sometimes “sloppy” use of words in accounting, Chapter 3 analyses the notion of directors' accountability with regard to knowing the actual financial state of the entity they direct.

In September 2003, CAMAC highlighted the importance of solvency in a group setting. CAMAC released a discussion paper on rehabilitating large, complex enterprises in financial difficulties. It emphasised that directors should know the level of solvency of the businesses they direct (at least) to enable those entities to continue ‘in business as a going concern’¹⁵ and to assist directors to fulfil their legal obligations in preventing insolvent trading.¹⁶ Additionally, under the concept of a financial stress test, CAMAC indicated that directors should determine the extent of the entity's ‘actual or likely insolvency’ prior to initiating any rehabilitation process.¹⁷

Interestingly the law has defined solvency. For instance, in Australia the Corporations Act (2001), s.95A (1) describes solvency as the ability of an entity ‘to pay all … [its] debts, as and when they become due and payable.’ Similar definitions are used in the legislation of other countries.¹⁸ Nonetheless the concept of solvency, especially in the area of commerce, remains deficient, as there is a lack of consonance between law and accounting as to its meaning. Similarly, dissonance exists in the requirements of prudential standards and legislatively-backed accounting standards with regard to quantifying solvency. This is likely to result in practical problems for decision-makers during the ordinary course of commercial activity, a point explored throughout this book.¹⁹

Of specific concern here is the quality of financial information supplied to decision-makers through accounting reports.²⁰ This is because conventional audited financial statements about an entity's financial position do not contain time and circumstance specific financial facts about the entity.²¹ Importantly, both dated financial position and solvency are conditions that require recourse to estimates of the monetary worth of the entity's assets and liabilities as they relate to money and the worth of money at a particular point in time. Hence, financial data contained in the current suite of publicly available and audited financial reports are of concern. Especially where audits are considered a ‘kind of quality control, control of the quality of the information on which managers, investors and creditors will make judgements about the performance and prospects of companies’ (Chambers, 1973b, p.144).²²

Following a long-standing perspective, this study analyses an integral aspect of accounting, namely, the matter of quantification—especially in determining an entity's solvency. Crosby's (1997) analysis of what differentiated the Renaissance from earlier times highlighted the need for knowledge about quantification. This knowledge is equally pertinent today. The deliberations of the HIH Royal Commission in Australia (related inter alia to FAI and HIH's affairs), the Bond Corporation/Arthur Andersen S.A. Supreme Court case and others, for instance, the Enron saga in the US all rely on an understanding of when an entity is (in)solvent.²³ These and other similar cases and the financial dilemmas they entail, in Australia and overseas, make this story topical and important from a public interest and a public policy perspective.

Notably in examination of the demise of Enron in the US, capitalised and deferred expenses were identified as a key risk area producing misleading financial statements.²⁴ Similarly, HIH reported $304.3 million deferred acquisition costs as a current asset in its June 30, 2000, balance sheet along with $738.8 million of intangibles that included goodwill and future income tax benefits (FITB). Of course this is not new. Bond Corporation's $453.4 million FITB is a good example (see Clarke et al., 2003, for many other instances). The amounts recorded, in all those cases, were arguably legitimately shown as “assets” under conventional accounting and GAAP, then supported by AASB1023.

Subsequent to, but not necessarily because of, the collapse of HIH, the Australian Prudential Regulatory Authority (APRA) redefined its concepts of assets and (as noted earlier) in July 2002 released prudential standards that excluded intangibles such as those described above, from prudential calculations of an entity's solvency. Further, the Institute of Actuaries of Australia supported the decision and strongly asserted, for instance, that deferred acquisition costs as an asset ‘has no place in the APRA assessment of solvency’ (IA Aust., 2002, p.28). If such vision were to become universal, the need for general public policy reforms related to...

Table of contents

• Front Cover
• Halftitle
• Routledge Studies in Accounting
• Title Page
• Copyright
• Dedication
• Contents
• List of figures
• List of Tables
• Dramatis Personae
• Glossary
• Preface
• Acknowledgments
• 1 A Crucial Aspect of Financial Accounting
• 2 Financial Statements and Tests of Insolvency: An Analysis of the “Balance Sheet” and “Cash Flow” Tests
• 3 Solvency and the Duty of Company Directors
• 4 The Essence of Solvency
• 5 Circumstances of One.Tel and HIH
• 6 Dilemma in Diversity: Continuing Issues in Quantifying Solvency
• 7 Insolvency Stats and Stories: 2004 to 2011
• 8 The Quantification of Solvency
• Notes
• Bibliography
• Index