ACC703

FINANCIAL ACCOUNTING THEORY AND PRACTICE

LECTURE 8

Liquidation of Companies

Textbook Reference:Leo et al. Company Accounting 8th EditionChapter 20

What is a winding-up?• Process whereby a company is dissolved

• At this point the company ceases to be a legal entity

• Also referred to as a liquidation

• Legal requirements contained in chapter 5 of Corporations Act

• Two modes of winding up a company:– Winding-up in insolvency and by the court– Voluntary winding-up by members or creditors

• Accounting entries are the same in both cases

Winding-up in Insolvency and by the court• Where a company is insolvent, application may be made to

the court for winding-up

• Application to the court may be made by the company itself, a creditor, a director and a contributory

• Once an application is made, the court may order the insolvent company to be wound up

• Insolvency is presumed to exist under a number of circumstances set out in the Corporations Act. These include where:

– A creditor serves a demand for unpaid debts over $2,000 and the debt remains unpaid after 3 months

– A receiver has been appointed under a floating charge on property

• A contributory refers to the holders or immediate past holders of shares in the company continued

Corporations Act also contains general grounds for winding-up by the court. These include:

• The company has resolved by special resolution that it be wound-up

• The company does not commence business within a year of incorporation or suspends business for more than a year

• The company has no members

• Directors have acted in their own interests, or in a manner that is unfair or unjust to other members

• Affairs of the company are being conducted in a manner that is oppressive or unfairly prejudicial to, or unfairly discriminatory against a member or members, or in a manner that is contrary to the interests of the members as a whole

continued

• Insolvency is the most common reason for liquidation – therefore the major accounting problem in liquidation is the apportionment of limited assets between creditors and shareholders

• A liquidator is appointed after the filing of the applications in order to see that the status quo of the company is maintained i.e. that the assets are not quickly drained from the company

• Liquidator is appointed to oversee the liquidation. The task of the liquidator is to:

• Take possession of the company’s assets• Realize the assets or carry on the business as necessary for

the beneficial disposal of the assets• Determine the creditors and order of priority of payment• Pay the creditors• Distribute the balance of funds (if any) to shareholders, or if

necessary to make calls on shareholders for extra funds to meet creditors claims

• Bring about the dissolution of the companycontinued

• The directors and secretary of the company must prepare and submit a Statement of Affairs to the liquidator within 14 days of the making of the order for winding-up

• The Statement of Affairs includes:– Summary of assets and liabilities– Details of charges over assets and secured liabilities

• Aim of the Statement of Affairs is to provide information concerning the company’s estimated realizable values of assets and any expected surplus or deficiency of assets after deducting creditors’ claims

• After the liquidator has realized all the property, discharged the liability to creditors, and made a final return (if any) to contributories, he/she may apply to the court for the company to be deregistered.

• After deregistration, the company ceases to exist

Voluntary winding-up

A company may be wound-up voluntarily at the instance of either the members or the creditors

Members’ voluntary winding-up

• The company is wound up by the members passing a special resolution to wind up

• Can only occur if the company is solvent

• Declaration of solvency must be made by the directors and attached to the statement of affairs

continued

Creditors’ voluntary winding-up

• Occurs where there is no declaration of solvency. In such cases the winding-up is under the control of both members and creditors

• Company must provide creditors with a summary of affairs as well as a list of all creditors

• Creditors can nominate a liquidator, who will then proceed to wind up the company

Powers of the liquidator• Liquidator has wide ranging powers under the Corporations Act. Powers

depend on whether the liquidation had been ordered by the court or is voluntary.

• In both cases liquidators must:

– Not make any concessions on any debts owing to the company of $20,000 or more

– Keep proper records in which entries and details of proceedings of meetings must be made

– Every 6 months during the liquidation appointment, the liquidator must prepare a statement of receipts and payments

continued

• In the case of a court ordered liquidation key powers of the liquidator include:

– Carry on the business of the company so far as is necessary for beneficial disposal or winding-up

– Pay any class of creditors in full– Make arrangements with creditors or parties claiming to be

creditors– Come to agreements regarding calls, liabilities and claims

existing, and take any security for the payment of such calls, liabilities and claims

• Other powers include everything that is necessary to wind up the affairs of the company and distribute the property

• Additional powers in relation to performing roles that are performed by the courts in court appointed liquidations (e.g. fixing a time when debts and claims must be proved)

Priority of payment of debts

• The general principle under the Act is that all debts and claims rank equally and, if the property of the company is insufficient to meet them in full, they must be paid proportionately

• Many expectations to this rule. Four different categories of creditors– Secured – Preferential unsecured– Ordinary unsecured– Deferred

• A summary of priority of payment of creditors (assuming insolvency) is set out on the following slide

Priority of creditors 1. Secured creditors

a) Secured by a specific charge• Those claims against the company whereby the creditor

has a charge against specific property, and holds a registered mortgage, bill of sale or lien over that property

• Any excess is returned to the liquidator• Any shortfall is classified as an unsecured creditor

b) Secured by a floating charge• The security in this case does not relate to a specific item

of property but relates to all assets of the company, i.e. It ‘floats’ over whatever assets the company has at a particular time

• Where there are limited funds available, debts mentioned in items 12, 14 and 15 receive priority

2. Expenses incurred by a liquidator or other relevant authority in preserving, realizing, to getting in property of the company, or in carrying on the company’s business

3. Costs relating to court ordered applications continued

4. Debts relating to the indemnification of the administrator

5. Debts incurred by an official manager (where the management ceased < 2 months prior to the appointment of the liquidator)

6. Costs associated with the preparation of a report as to the affairs of the company in the case of a court ordered liquidation

7. Costs of the audit of the liquidators accounts

8. Auditors fees related to the period of official management referred to in 5 above

9. Any other expenses properly incurred by a liquidator or other relevant authority

continued

10. Liquidator’s remuneration

11. Expenses incurred by members of a committee of inspection

12. Wages and superannuation contributions payable to employees

– Limited to $2,000 for directors

13. Workers compensation payable

14. Employees leave entitlements – Limited to $1,500 for directors

15. Retrenchment payments to employees (excluding directors)

continued

16. Unsecured creditors• Includes shortfalls of secured debts and salary & wages,

employee entitlements and retrenchment payment to directors

• Includes all debts payable to the government – eg PAYE tax, VAT

• Although utility companies (electricity, etc) are unsecured they commonly receive preferential treatment by threatening to withdraw services

17. Deferred creditors

Rights of contributories• Contributories are defined as members or past members of a

company

• In certain circumstance past shareholders may be required to contribute in the winding-up

• Three possible situations may arise

– Insufficient funds for creditors, requiring calls to be made on contributories

– Sufficient funds to pay creditors, but not to repay all share capital

– A surplus of funds over and above creditors’ claims and share capital

Insufficient funds for creditors

• Where partly paid shares exist an order may be made to make calls on all or any of the contributories to the extent of their liability

• Once all shares have been paid in full, any deficiency is borne by creditors

• Most common scenario in practice

Sufficient funds to pay creditors, but not to repay share capital

• Distributions made in accordance with the company’s constitution

• For example, preference shareholders may receive preferential treatment over ordinary shareholders

• Distributions proposed by the liquidator are approved by a special resolution of members

• It is common for company’s constitutions to specify that distributions are made on the basis of the number of shares held, regardless of the issue price of the shares

• Uncommon in practice

Surplus of funds

• The rights of contributories to participate in a surplus should be specified in the constitution

• Note that a preference shareholders claim to preferential return of capital does not necessarily give them a right for preferential treatment with regard to a surplus

• Rare in practice

Accounting for liquidation

Five main tasks

1. Prepare relevant forms• Statement of Affairs• Summary of Affairs (creditors voluntary winding-up only)• Declaration of solvency (members voluntary winding-up

only)

2. Realization of assets

3. Possession of assets by secured creditors

4. Payment to the creditors in order of priority

5. Return of capital and surplus (if any) to shareholders

Accounting for liquidation

Realization of assets

• Realization of assets accounted for in the company’s records using a “liquidation” account

• All assets (except cash) and all contra-asset accounts are transferred to this account

• On realization of the assets the cash account is debited and the liquidation account is credited

Possession of assets by secured creditors

• Assets over which a specific security is held are commonly taken into possessions by the secured creditor and sold

• Any net proceeds are handed to the liquidator, with any gain or loss credited to the liquidation account

Accounting for liquidation

Payment of creditors in order of priority

• The remaining creditors are paid in order of priority • Unrecorded liabilities (such as liquidation expenses) are

accounted for by debiting the liquidation account and crediting the appropriate liability

• On settlement, the liability account is debited and cash credited

• Where creditors accept an amount lower than the carrying amount of the debt, this represents a discount given to the company and is accounted for by crediting the liquidation account

Accounting for liquidation

Return of capital to contributories

Accounting procedures are:

• Calculate the distribution for each class of shareholder• Make any necessary calls on unpaid capital• Transfer share capital to a shareholders distribution account• Transfer reserve accounts to the liquidation account• Pay distributions by crediting the cash account and debiting

the shareholders distribution account• Transfer the balance of the liquidation account to the

shareholders distribution account

• Basic format as follows:

Liquidation Carrying amts. of assets Contra-assets transferred

xx

transferred (excluding cash) xx Proceeds of sale xx

Unrecorded liabilities xx Gain on disposal of secured asset

after satisfaction of secured creditorxx

Discounts from creditorsxx

Other reserves & retained earningsxx

Balance (deficiency) transferred to

Shareholders’ Distribution a/cxx

xxxx

Liquidator’s CashBalance xx Payment to creditors xx

Net amts. from secured creditors xx Distribution to contributories xx

Proceeds on sale by liquidatorxx

Any calls on contributories xx

xx xx

Shareholders’ DistributionDistribution of cash to contributories xx Share capital xx

Transfer of deficiency from

Liquidation a/c xx

xx xx

Example: Bobby Ltd went into voluntary liquidation on 30 June 2011, its summarized statement of financial position then being:

Equity Current Assets

Share Capital:

80 000 shares issued at a price Receivables 5 000

Of $1, called to 50c 40 000 Inventory 6 000

Less: Calls in arrears (20 000 at 25c) (5 000) Cash 4 000 15 000

Non-current assets

Land 20 000

Plant 9 000 29 000

Total assets 44 000

Current Liabilities

Payables 9 000

Total Equity 35 000 Net Assets 35 000

All assets realized $30,000. Calls in arrears were fully collected. Payables allowed $500 discount. Costs of liquidation were $2,500.

Record the above in the Liquidation a/c, the Liquidators Cash a/c and the Shareholders’ Distribution a/c

LiquidationCarrying Amts:

Land 20 000 Cash (from sale of assets) 30 000

Plant 9 000 Discount from creditors500

Receivables 5 000 Deficiency (to shareholders

Inventory 6 000 distribution a/c) 12 000

Liquidation exp. Payable 2 500

42 500 42 500

Liquidators CashBalance 4 000 Liquidation exp payable 2 500

Liquidation (sale of assets) 30 000 Payables 8 500

Calls in arrears 5 000 Shareholders distribution 28 000

39 000 39 000

Shareholders DistributionLiquidation (deficiency) 12 000 Share capital 40 000

Cash 28 000

40 000 40 000

End

of

Lecture 8

Tutorial Questions for Week 10

Leo et al. Company Accounting 8th Edition

Chapter 20

Review Questions: 2, 7, 11

Practice Questions: 20.3, 20.7, 20.9