Preparing a deficiency account should be a relatively simple process, but ICAEW’s monitoring visits are revealing some key errors and omissions.
During a recent ICAEW Insolvency Community webinar, Gareth Limb from Compliance On Call, which provides case reviews and technical support to IPs, took viewers back to basics and discussed how to avoid the most common pitfalls.
“If you think of a statement of affairs as equivalent to a balance sheet, then a deficiency account is the equivalent of a profit and loss account, covering the period since the last accounts to the date of the statement of affairs,” explains Gareth.
“A deficiency account explains the change in financial position of the company in numerical terms,” he says. “It will be very much a best estimate based on the information available, rather than an accurate set of final accounts. But it will identify whether the company made a profit or a loss in its last period of trading, and the estimated amount of that profit or loss.”
Why prepare deficiency accounts?
Statement of Insolvency Practice 6 (SIP 6) requires the preparation of deficiency accounts but there are also practical benefits for IPs in preparing these accounts.
“The director will have given you their reasons for the failure of the company,” explains Gareth. “But a deficiency account will actually help you establish the reason for insolvency and test the director's explanation.”
Linked to that, the preparation of these accounts can also flag whether there is anything the IP needs to investigate.
“For example,” says Gareth, “a large trading loss in a short period clearly indicates the need for investigations, but so could the fact that the company has been making a profit in a final period of trading.”
Starting point
One of the common errors ICAEW reviewers see is IPs not using the latest accounts as their starting point when preparing a deficiency account.
“Make sure you use the most recent accounts, be they finalised, draft or management,” stresses Gareth. “I’ve seen a deficiency account prepared using accounts of 15 months old that suggested a significant trading loss in the final period. But management accounts prepared by the company's accountants that were just three months old suggested a small profit had been made in that final three-month trading period.”
He cautions, however, that before using management accounts, you need to decide how much reliance you can place on them, or whether it is safer to use the most recent formal accounts instead.
Key factors to consider if you’re using management accounts include:
- are they consistent with the last formal set of accounts; and
- who prepared them - the directors and internal accountant, or the external accountants?
“If you're using formal accounts, make sure that you get a copy of the full accounts, not a filleted version,” Gareth adds.
Simple steps
There are two slightly different approaches IPs can take when preparing deficiency accounts. “You can reconcile the profit and loss account balance to the deficiency in the statement of affairs as regards creditors,” explains Gareth. “Or you can reconcile the total assets less liabilities to the deficiency in the statement of affairs as regards members’’.
“A common mistake IPs make is not using either the profit and loss account balance or the total assets less liabilities as the starting position, but instead using some other random amount,” he says
During the webinar, Gareth takes viewers through a worked example using the first method (profit and loss). You can see him discussing this example here.
To get from the financial position in the last accounts to that shown in statement of affairs, the first thing to consider is any exceptional profits or losses or amounts written off since the last accounts were prepared.
“For example,” says Gareth, “the simplest one is employee claims for redundancy and pay in lieu of notice. Those liabilities would not have arisen were it not for the liquidation, such that they are exceptional amounts that would increase the deficiency of the company.”
The company may have suffered bad debts in the final period of trading since the last accounts were prepared. “How you treat those debts in the deficiency account depends on whether they have already been recognised as bad debts by the company in its accounting records,” says Gareth.
If they have been recognised in the accounting records, and hence in the book value of the book debts in the statements of affairs, then treat them as an amount written off since the last accounts were prepared. If they have not been recognised, then treat them as an amount written off for the purpose of preparing the statement of affairs.
“The next thing to consider,” says Gareth, “is whether the company sold any assets since the last accounts, and if so, were they sold at a profit, which would reduce the deficiency? Or were they sold at a loss, which would increase the deficiency?
“You should compare the book value in the accounts with the amount for which the assets were actually sold,” he explains. “You should have this information readily available from your work when preparing the statement of affairs or the SIP 6 report.”
You also need to look at depreciation. Where the book value of the fixed assets in the statement of affairs is less than that in the last accounts, but there have been no known asset disposals, then treat the difference as being depreciation that increases the company's deficiency.
The next issue to look at is assets written off for the purposes of preparing the statement of affairs. “In other words, this is the difference between the book value and the estimated to realise value in the statement of affairs,” says Gareth. “Again, the difference between book value and estimated to realise value increases the deficiency of the company.”
A common error made by IPs is to add, rather than deduct, losses or amounts written off from the opening position, or deducting, rather than adding, profits on disposals.
Sense check
“The difference between the deficiency of the company after taking into account the exceptional write-offs you have made and the final deficiency of the company will be a balancing item, either an estimated trading profit, or, more normally, a trading loss,” says Gareth.
“The estimated trading profit or loss is the balancing item within the deficiency account,” he explains. “But we do occasionally see it mistakenly treated as an amount written off for the purpose of preparing the statement of affairs.”
Finally, he recommends carrying out a sense check to see if the profit or loss appears reasonable, and fits with what else is known about the company and the reasons for its failure.
“If it does, then all well and good,” he says. “If it doesn’t, then check whether you have missed something. If you haven’t, that’s a good indicator of something being amiss that needs investigating.”
He concludes by reminding IPs that although both the statement of affairs and deficiency accounts are simple documents, they are not always easy to navigate. “They do need some thought during preparation, especially when gathering the information required,” he stresses.
