1.
Bankruptcy Act
Strictly speaking, it is recommended to resolve
negative equity by increasing capital in order to avoid any risk of being filed
for bankruptcy, because there is a law called Bankruptcy Act that stipulates
that a corporation’s having more total liabilities than total assets on its
balance sheet is one of the grounds for commencement of bankruptcy proceedings.
2.
Corporations not Making Net
Income
However, it would surprise you if you knew how
many corporations in Japan are existing without resolving their negative shareholder’s
equities. Although there is no exact data on how many corporations in Japan are having negative equities, National Tax Agency issues relevant statistics every year
that show the percentage of corporations not earning annual taxable income. Please
see the figures below. The percentage never fell below 60% for the past 20
years. This tells that quite a few corporations in Japan have been existing
without making any net profits for years and without being filed for bankruptcy.
<percentage of corporations that don’t make positive annual taxable income>
2017 - 62.6% 2016 - 63.5% 2015 - 64.3% 2014 - 66.4% 2013 - 68.2%
2012 - 70.3% 2011 - 72.3% 2010 - 72.8% 2009 - 72.8% 2008 - 71.5%
2007 - 67.1% 2006 - 66.5% 2005 - 67.1% 2004 - 67.0% 2003 - 68.1%
2002 - 68.9% 2001 - 68.3% 2000 - 68.4% 1999 - 69.9% 1998 - 67.3%
3.
What is Behind This Situation?
The reasons why so many corporations can be
existing with their net assets being negative are:
- How Bankruptcy Proceedings Start
Bankruptcy proceedings do not automatically commence with a fact
that a corporation has negative net assets. It commences only when it is petitioned to
the court by someone and the someone who can make the petition are strictly
limited by the Bankruptcy Act to certain parties such as creditors, debtors and
directors.
-
Financial Information Is not
Available
Although the Companies Act requires a corporation to make a public
disclosure of its financial information, not a few corporations, unless
specifically required by other laws than the Companies Act, do not follow the
requirement for the following reasons. (1) The penalty stipulated in the Companies
Act is not critical. (2) The authority scarcely checks if the disclosure
requirement is kept. (3) Many corporations simply do not know that there are
such legal requirements. (4) Clients or suppliers rarely ask the financial information of a corporation to start or keep a business relationship with it. Therefore, in many cases, financial information of a corporation is
not available at all and no one tells if the corporation is in the state of
negative net assets or not.
-
Financial Information Is not
Reliable
It is not a common practice to file a petition of bankruptcy only
with the information of negative net assets that is observed from a balance
sheet, because financial statements including balance sheets are not reliable
at all for the following two reasons:
(1) Statutory Audit Requirement
Most of the corporations do not have statutory audits, because the criteria that the Companies Act establishes to require a corporation to have a statutory audit are very high.
² capital amount is 500 million yen ( ≒US$4.7m with the current exchange rate) or more
or
² total liabilities is 20 billion yen ( ≒US$188m with the current exchange rate) or more.
In this context, the financial statements of the most corporations are not checked by statutory audits and they are prepared only for tax purposes, that are quite different from the ones that were audited.
It is commonly seen in Japan that, when a corporation borrows money from a lender, mainly from a financial institution like a bank, a shareholder of the corporation provides a certain type of personal guarantee to the lender. What is interesting is that, under the guarantee, the lender can ask either the corporation or the shareholder to make the repayment of the loan at any time on or after the due dates.
Consequently, the corporation’s borrowing with this type of guarantee attached is functionally quite close to the shareholder’s equity, although the borrowing itself is recorded as liability on the balance sheet. Therefore, negative net assets on the balance sheet does not necessarily mean that the company is in the state of insolvency.
As mentioned in this blog, since there are so many complicated matters behind, to the beginning question I always answer like this:
“You
should increase the capital to keep the shareholder’s equity positive, if you
want to make risk of being filed for bankruptcy completely zero. However, in
most cases, even when a corporation has negative net assets, the risk of being
filed for bankruptcy is very small as far as it has enough cash-flow to run the business appropriately.”
