Understanding Composition in Accounting
Definition
Composition is a legal agreement between a debtor and their creditors in which the creditors agree to accept a portion of the owed amount as full settlement of the debtor’s liabilities. This agreement provides relief to the debtor while enabling creditors to recover part of their funds without the complexities of enforcing full payment or initiating bankruptcy proceedings.
How It Works
- Negotiation Phase: The debtor proposes a plan to the creditors, outlining how much they can realistically pay given their financial circumstances.
- Agreement: Creditors agree to accept a specified percentage of the total debt, which might be detailed in a formal deed of arrangement or as part of an individual voluntary arrangement (IVA).
- Implementation: The debtor makes the agreed payments, often resulting in the remainder of the debt being legally discharged once the terms are fulfilled.
Examples of Composition
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John’s Small Business Debt: John owns a small retail business that runs into severe cash flow problems. He owes $100,000 to several creditors. In a composition agreement, his creditors agree to accept 50% of the owed amount, allowing John to clear his debts by paying $50,000.
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Individual Consumer Debt: Jane, who’s overwhelmed with personal credit card and loan debts totaling $30,000, negotiates an agreement with her creditors to pay back 40% of the total. She ends up paying $12,000 under a legally binding individual voluntary arrangement.
Frequently Asked Questions (FAQs)
Q1: What is a deed of arrangement? A1: A deed of arrangement is a formal legal document that outlines the agreement between a debtor and their creditors, detailing how much of the owed debt will be repaid and the terms of repayment, culminating in the discharge of the remaining debt.
Q2: What’s an individual voluntary arrangement (IVA)? A2: An IVA is a formal agreement in the UK between a debtor and their creditors to pay off debts over time. It’s a legally binding arrangement that requires the debtor to make affordable payments, often leading to a portion of the debt being written off upon completion.
Q3: How does a composition differ from bankruptcy? A3: Composition allows the debtor to settle debts by paying a portion of the owed amount without formal bankruptcy proceedings, which can have severe consequences on credit rating and future borrowing ability. Bankruptcy often involves the liquidation of assets and a more stringent financial and legal oversight.
Q4: Who can propose a composition agreement? A4: Both individuals and businesses facing financial difficulties can propose a composition agreement to their creditors.
Q5: What happens if I cannot fulfill the composition agreement’s terms? A5: Failure to comply with the terms typically results in creditors reverting to enforcing the full original debt or initiating bankruptcy proceedings.
Related Terms
- Voluntary Arrangement: An agreement whereby an individual or business pays off debt over a specified period, albeit sometimes only a portion of the total debt.
- Scheme of Arrangement: A court-approved agreement between a company and its shareholders or creditors, often used for restructuring or solvent rearrangements.
- Bankruptcy: A legal proceeding involving a person or business unable to repay outstanding debts, often resulting in asset liquidation.
- Debt Restructuring: The process of reorganizing debt obligations to provide relief to the debtor, potentially involving changes to the terms or amount owed.
Online Resources
- Insolvency Service - GOV.UK - Information on insolvency and voluntary arrangements.
- Accountex Network - Debt Restructuring - Insights on debt restructuring options and strategies.
- Money Advice Service - Guidance on various debt solutions including compositions and IVAs.
Suggested Books for Further Studies
- “Corporate Financial Distress and Bankruptcy: Predict and Avoid Bankruptcy, Analyze and Invest in Distressed Debt” by Edward I. Altman
- “The Law and Practice of Restructuring in the UK and US” by Christopher Mallon and Shai Y. Waisman
- “Debt Restructuring: Principles and Practice” by Rodrigo Olivares-Caminal
Composition in Accounting: Fundamentals Quiz
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