Insolvency is defined under Section 123 of the Insolvency Act 1986 and is reproduced in detail below.
Understanding Insolvency's technical definition is only the start of comprehending its impact on a charity or not-for-profit organisation and its management team/trustees or committee members.
Legal precedents through the courts are continually changing and because of this, the point of Insolvency is unfortunately often not black or white nor set in stone. However, even though there will be shades of grey, at the point where its debts cannot be paid in full, a charity or not-for-profit organisation is definitely insolvent.
The Balance Sheet test and the Cashflow test are often referred to as 'tests of Insolvency'.
The Cashflow Test is about being able to pay liabilities when they fall due – for example, are suppliers paid or HMRC tax liabilities paid on time? Does the charity have sufficient short-term resources to deal with its imminent liabilities? This is potentially a situation of charity insolvency if the answers to these questions are 'no'.
The Balance Sheet Test compares all existing assets against all existing and potential liabilities as of today's date, rather than the date of the last available annual or interim accounts. All potential and existing liabilities includes those which are known to exist as well as those that may come about as a result of any current existing circumstances – for example, damages or negligence claims for contracts terminated early, redundancy and notice pay costs of existing employees, etc.
Potential liabilities such as the cost of employment severance if the charity had to close are not always taken into account by trustees. However, many seemingly solvent organisations can be turned into insolvent ones from a dramatic impact on the financial position when all of these are taken into account.
It is extremely important at the point of insolvency being reached that advice is sought because should the organisation subsequently enter into any formal insolvency process, the actions of the trustees from the point of Insolvency onwards will be under close scrutiny.
Other indicators of potential insolvency can be found here.
Insolvency (a position where debts cannot be paid in full) is defined by Section 123 of the Insolvency Act 1986 as:
- the company has not paid, secured or settled a claim for a sum due to a creditor exceeding £750 within three months of having been served with a statutory demand;
- a creditor has attempted an enforcement process against the company in respect of a debt without success;
- it is proven to the satisfaction of the court that the company is unable to pay its debts as they fall due (cash flow test);
- it is proven to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account contingent and prospective liabilities (balance sheet test).