Insolvency is defined as a situation whereby the liabilities of an entity exceed the assets (fair value). This situation will often lead to an entity failing to pay off its obligations as they become due. The Companies Act therefore requires that companies have to satisfy the conditions of Section 4 (Solvency and Liquidity Test) before certain types of transactions occur. There are two types of insolvency which are discussed below:

These two forms of insolvency that have been recognised by our law for many years. Factual insolvency is where the undertaking's liabilities exceed its assets, while commercial insolvency is a state of illiquidity where an undertaking is unable to pay its debts even though its assets may exceed its liabilities. Factual insolvency does not necessarily mean that a going concern problem exists but commercial insolvency is likely to indicate that a going concern problem does exist.

The mere fact that a client undertaking is trading whilst factually insolvent is not regarded as an "irregularity". It does not constitute an offence nor does it infringe any statutory or common law rule or necessarily amount to breach of trust or negligence on the part of management.  Further, the fact that an undertaking is factually insolvent does not necessarily mean that the incurring of further debts would constitute fraudulent or reckless conduct. (Section 22 of the Companies Act.)

Despite what is said in the paragraph above, trading while an undertaking is factually insolvent creates a situation in which certain irregularities may readily take place and, in turn, may give rise to the duty to report by an auditor. As will appear in more detail in the paragraphs below, the irregularities likely to occur are fraud or recklessness in the carrying on of the business in those circumstances.

Common law fraud can be committed by any client undertaking and its officers or employees, whether or not it is a company. On the other hand, there should be proof or evidence that there was “intent to defraud" and "recklessness" on the part of management.

Directors that, for instance, order goods for the company make an implied representation to the seller that they believe the company will be able to pay its debts when they fall due. Although they do not imply that the company is factually solvent, if they know that there is no likelihood of payment and no means of payment, they commit fraud. The same is true if they do not really believe that the company will be able to pay, or  if  they are  recklessly  careless whether there is any chance of the debt being able to be paid or not.

Directors and others who knowingly carry on a company's business "with the intent to defraud" creditors of the company or creditors of any other person or "for any fraudulent purpose", are guilty of an offence in terms of section 76 (3) of the Companies Act 2008 which states that Directors should act in good faith and in the best interest of the company.
A director or other person that is knowingly a party to the carrying on of a company's business "recklessly” is guilty of an offence in terms of section 22 of the Companies Act, 2008.

Liability of directors and prescribed officers

A director of a company may be held liable—

  1. in accordance with the principles of the common law relating to breach of a fiduciary duty, for any loss, damages or costs sustained by the company as a consequence of any breach the director of a duty contemplated in section 76 (3) (a) or (b).
  2. in accordance with the principles of the common law relating to delict for any loss, damages or costs sustained by the company as a consequence of any breach by the director of—
  1. A duty contemplated in section 76
  2. Any provision of this Act not otherwise mentioned in this section; or
  3.  Any provision of the company’s Memorandum of Incorporation.

Procedure where the auditor has to report

Where the client is trading while it is factually insolvent, the auditor should apply his/her mind to the considerations discussed in paragraphs above. If in the auditor's reasonable professional judgment he/she has the duty to act, he/she must forthwith despatch a report in writing to the person in charge of the undertaking (that is, to the person responsible for its management) giving particulars of the irregularity if it so exists.

Going concern basis of accounting

Where the justification for the continuance of trading rests on a subordination agreement, the existence of the agreement will normally justify the adoption of a going concern basis of accounting, as distinct from a realisation basis with possible consequential losses and costs. The subordination agreement returns the company to factual solvency and it may also ensure that the company avoids commercial insolvency. In such circumstances, the continuing existence of the agreement may be of material significance to the view presented by the financial statements. The auditor therefore should ensure that the subordination agreement is current and enforceable each year and that its existence is adequately disclosed in the financial statements.

It is also important to remember that the existence of a valid, enforceable subordination agreement does not necessarily mean that the undertaking is a going concern. Such agreements are concerned with past indebtedness only and not a commitment to provide further funds to keep the undertaking in business for the foreseeable future.  Consideration should be given, therefore, to ensuring that the amount subordinated is sufficient to cover any future losses that might be incurred by the undertaking in the foreseeable future and before its anticipated return to profitability.

Victor Takaindisa

Audit Manager, Johannesburg