What is meant by Insolvency? – Definition
Insolvency of a person arises when he is unable to pay his debts when they fall due. Thus insolvency means inability of a person to pay his debts when they fall due.
An insolvent person may have some valuable assets. When he is declared as an insolvent or bankrupt, his property is sold by the liquidator who is appointed by the court. The amount realized by selling his property is normally less than his debts. Creditors are paid out of realized money. The amount which is paid to creditors is termed as “Dividend”.
Effect of Insolvency of drawee
When a drawee of a bill of exchange is declared as insolvent any bill of exchange accepted by him will be dishonored immediately. In the books of drawer ledger account of drawee will be prepared. Drawee’s ledger account will show total amount receivable from drawee. Amount realized by selling his property will be received as final dividend. The balance which could not be recovered will be debited to “Bad Debts” Account in the books of drawee.
Accounting Treatment of Insolvency
Accounting treatment of insolvency of Drawee will be passed in the books of drawer and drawee:
1). When drawee is declared insolvent
2. To receive final dividend and to close drawee’s account
3. If nothing recovered from drawee
Example (Renewal + Insolvency of Drawee)
On 1st January 2019, A sold goods to K worth $15,000. A drew a three months bill on K on the same date. A endorsed the bill to his creditor Z to settle his debts. At maturity, bill was dishonored and A had to pay Z. K paid $5,000 in cash and accept a new bill for three months for the balance amount plus interest @ 10% p.a. Before the due date of the second bill K became insolvent and only $0.50 was received from his estate as first and final dividend.
Required: Pass journal entries in the books of A and K. Also prepare K’s Account in the books of A.
Working Note (W-1):