Solvency Rules That Could Make or Break Your Practice
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Many accountants only consider solvency once a client is already in trouble. By that point, the damage has often been done. If a company is trading while technically insolvent, even if there is cash in the bank, it may already be in breach of Section 22 of the Companies Act. As the accountant advising or reviewing such a client, you may also face serious professional risks if this is overlooked.
This article outlines your role and responsibilities in ensuring that clients are not trading recklessly or unlawfully, particularly in relation to the solvency and liquidity test required by the Companies Act, 2008 (Act 71 of 2008).
Understanding Section 22 of the Companies Act
Section 22(1) of the Companies Act states that a company must not carry on its business recklessly, with gross negligence, with intent to defraud, or under insolvent circumstances. Although the Act does not define “trading under insolvent circumstances”, it is generally understood to mean that the company no longer meets the solvency and liquidity test described in Section 4.
Where the Companies and Intellectual Property Commission (CIPC) has reasonable grounds to believe that a company is in breach of this requirement, Section 22(2) gives the Commission the authority to issue a compliance notice. This may result in the company being ordered to stop trading until corrective action is taken.
If you are compiling annual financial statements, drafting board resolutions, or performing an independent review, your involvement in these matters places a duty on you to identify risks and advise your client accordingly.
The Solvency and Liquidity Test in Practice
Section 4 of the Act sets out a two-part test which is used to assess whether a company is financially sound enough to undertake certain actions:
Solvency requires that the assets of the company, fairly valued, are equal to or exceed its liabilities. This includes taking into account contingent liabilities, not only what is reflected in the accounting records.
Liquidity requires that the company is able to pay its debts as they become due in the ordinary course of business over the next twelve months.
It is important to remember that a company may be able to pay its current obligations, yet still fail the solvency test if its liabilities exceed its assets. Both tests must be satisfied for the company to be regarded as compliant. If the directors authorise a transaction without applying the test properly, or where the company fails it, they may be held personally liable in terms of Section 77.
When the Test is Required by Law
Several specific sections of the Companies Act require directors to apply and document the solvency and liquidity test before certain types of transactions may proceed. These include:
Section 44 – Financial Assistance for the Subscription of Securities
When a company intends to offer financial assistance to any person for the purpose of acquiring or subscribing to its own securities, the board must first resolve that the company satisfies the solvency and liquidity test.
Section 45 – Financial Assistance to Directors and Related Persons
Any direct or indirect financial assistance to a director or related party, such as interest-free loans or guarantees, must also be preceded by the solvency and liquidity test and a formal resolution.
Section 46 – Distributions to Shareholders
Before making any form of distribution, including dividends, the board must apply the test and resolve that the company will remain solvent and liquid immediately after the distribution is made.
Section 47 – Capitalisation Shares
Issuing shares for no consideration, for example by converting reserves into share capital, also requires compliance with the test.
Section 48 – Share Buybacks and Acquisitions by Subsidiaries
When a company or its subsidiary acquires its own shares, whether as a buyback or repurchase, the solvency and liquidity test must be applied and documented.
Section 113 – Amalgamations and Mergers
Each board involved in a proposed merger or amalgamation must confirm that its company satisfies the solvency and liquidity test. This is a critical consideration, especially where the transaction involves new borrowings or the assumption of liabilities.
Your Responsibilities as a Business Accountant in Practice
As a CIBA member in practice, you are expected to provide more than technical compliance. Your role is to act as a governance and financial risk adviser to your clients, especially where directors may not fully understand their legal obligations.
You should:
Require formal documentation of the solvency and liquidity test where a company is proposing any action listed above.
Prepare accurate and current financial statements that reflect fair values, rather than relying on historical cost figures that may no longer represent reality.
Ensure that liquidity assessments include reliable forecasts for at least twelve months.
Advise clients in writing where you identify signs of reckless trading, such as continuing operations while the company is technically insolvent.
Be prepared to refuse engagement with transactions where you believe the company fails the test or where directors are unwilling to take corrective action.
Why This Matters
The consequences of non-compliance are serious. Directors may face personal liability for unlawful distributions or financial assistance. CIPC may intervene and suspend trading. As the accountant involved, especially if you are providing assurance or advisory services, your name may be drawn into the matter. Failure to act with care and diligence may lead to disciplinary action or legal consequences.
CIBA members are recognised for their practical insight and professionalism. By ensuring your clients comply with the solvency and liquidity test, you not only help protect their business and directors from risk, but you also position yourself as a trusted and valuable advisor.
Do not wait for a crisis. If your client is approaching insolvency or trading without proper oversight, take action now, professionally, firmly, and in writing.
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