Loss of equity after the adoption of the financial statements

For most businesses, the period for publishing annual financial statements passed on 31 May. However, for many companies it is only after the financial statements have been approved that it becomes clear whether the company’s equity complies with the capital maintenance requirements of the Hungarian Civil Code or whether the owners are required to take measures to restore the company's equity.

Why is a loss of equity a problem? 

If a company’s equity has been significantly reduced due to losses or has even become negative, owners should not delay taking action making, as the Hungarian Civil Code imposes a statutory obligation to take specific measures in certain circumstances.

The purpose of the capital protection rules is not only to protect creditors but also to ensure that companies maintain an adequate asset base for their long-term operation. Companies suffering from a persistent loss of equity may face the following risks:

•  restricted financing opportunities,
•  disadvantages in grant applications and public procurement procedures,
•  reduced confidence from business partners. 

When does intervention become mandatory? 

The Hungarian Civil Code contains separate rules for so-called “rapid” and “slow” capital losses.

“Rapid capital loss” 

In the case of a limited liability company (Ltd, Hungarian abbreviation: Kft.), the managing director must take action without delay if:

•  due to losses, the company’s equity falls to half of its registered capital, or
•  the equity falls below the statutory minimum level.

In such cases, the members’ meeting must be convened immediately, and the adopted resolutions must be implemented within three months.

Similar capital protection rules apply to companies limited by shares. If:

•  due to losses, equity is reduced to two-thirds of the registered capital, or
•  equity falls below the statutory minimum capital requirement,

the board of directors must convene the general meeting within eight days, while simultaneously notifying the supervisory board, or initiate a decision-making procedure without holding a meeting. Shareholders must decide on the necessary measures, and the adopted resolutions must be implemented within three months.

“Slow capital loss” 

The Hungarian Civil Code also contains the so-called “slow capital loss” rule. If a company’s equity does not reach the minimum amount of registered capital required for its legal form for two consecutive full financial years, the owners must ensure that the equity deficiency is remedied within three months of the adoption of the financial statements for the second year. If they fail to do so, the company must, within 60 days, decide on its transformation, merger or, as a last resort, liquidation without legal succession.

Why is it worth addressing the issue in time? 

Published financial statements make a company’s financial position publicly available. If the amount of equity does not comply with the legal requirements, this may be important information not only for the owners but also for creditors, lenders and business partners. A long-standing unresolved loss of equity may give grounds for a supervisory procedure by the Court of Registration, which, in extreme cases, may result in the liquidation of the company.

In practice, a loss of equity usually does not arise from one year to the next but develops as a consequence of several consecutive loss-making financial years. Therefore, it is advisable not to examine equity only when preparing the annual financial statements but also to monitor it continuously during the year. Regular financial monitoring enables management and owners to prepare for the necessary measures in a timely manner and, where possible, to avoid reaching the statutory capital protection thresholds.

Equity from the auditor’s perspective

The company’s equity position is also an important issue from an audit perspective. In the event of a significant loss of equity, management must assess whether a material uncertainty exists in relation to the going concern assumption and, if necessary, prepare an action plan that appropriately supports the sustainability of the company’s operations.

A decrease in equity does not automatically mean that the company is unable to continue as a going concern. Nevertheless, it is a circumstance that both management and the auditor must evaluate. When assessing the company’s equity position, it is not sufficient to consider only the amount of equity reported in the balance sheet. Management should perform a comprehensive assessment of the company's financial position and operating prospects, taking into account, among other things, the following:

•  profitability,
•  liquidity position,
•  financing opportunities,
•  future business prospects.

The most common tools for restoring equity

 Owners have several options for restoring the company’s capital position:

•  making an additional capital contribution,
•  increasing the registered capital through cash or in-kind contributions,
•  converting a shareholder’s loan into equity,
•  forgiving a shareholder’s loan,
•  waiving an approved dividend claim.

These measures are generally intended to strengthen the company's equity and, if implemented appropriately, may provide a prompt solution to eliminate the equity deficiency. However, the accounting, legal and tax implications of the available equity restoration measures may differ significantly. Therefore, before selecting the most appropriate solution, it is advisable to perform a comprehensive assessment of all available alternatives and, where appropriate, seek professional advice from a tax advisor or an auditor.

Upward revaluation: more than an accounting technique 

In certain cases, the application of an upward revaluation may also contribute to restoring equity. If the market value of a property or another fixed asset eligible for revaluation under the Accounting Act permanently and significantly exceeds its book value, the upward revaluation and the corresponding valuation reserve may increase equity.

However, several important aspects must be considered when applying an upward revaluation:

•  it is not available for all types of assets,
•  it may only be recognised in accordance with the Accounting Act and on the basis of a reliably supported market value,
•  adequate documentation is required to demonstrate the sustained existence of the higher market value.

It is also important to note that an upward revaluation merely reflects an accounting revaluation and does not generate any cash inflow. Consequently, it does not improve the company’s liquidity position.

For companies subject to statutory audit, the appropriateness of an upward revaluation is of particular importance. In such cases, the auditor evaluates not only compliance with accounting requirements but also the reliability of the valuation methodology, the determination of market value and the adequacy of the supporting documentation.

Equity restoration is not always the appropriate solution

In some cases, the company’s economic situation may not justify the injection of new funds. In such circumstances, the following alternatives may be considered:

•  a decrease in registered capital,
•  changing the company’s legal form,
•  a merger or fusion within a group of companies.

Timely decisions by the owners therefore not only ensure compliance with legal requirements but may also contribute to preserving the company's financial stability, creditworthiness and long-term viability.

This article is for general information purposes only and should not be considered as advice.