Understanding Internal Reconstruction in Companies
Internal reconstruction in companies involves reorganizing the financial position without liquidation or forming a new entity. It aims to enhance profitability by aligning assets with true values. Methods include altering share capital, changing shareholder rights, and compromising with creditors. No reduction in capital occurs during this process.
- Internal Reconstruction
- Financial Overhaul
- Share Capital
- Company Reorganization
- Business Improvement
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Internal Reconstruction BY: BHOOMIKA GARG
Introduction Internal Reconstruction is neither liquidation nor formation of a new company to take over any new business. The existing company continues in its legal entity form and is only reorganized internally. Thus, internal reconstruction is concerned with the complete overhauling of the financial position of the company. The purpose is to improve the profitability of the existing company in relation to the true or real value of the assets as compared to the existing book values which are either overvalued or fictitious.
Basis Liquidation Internal Reconstruction The existing company is not liquidated. No new company is formed but only the rights of shareholders and creditors are changed. There is certain reduction of capital and sometimes the outside liabilities like debenture holders may have to reduce their claim. It does not involve takeover of the business. External Reconstruction The existing company is liquidated. A new company is formed to take over the liquidated company. Formation Reduction of capital There is no reduction of capital. In fact there is a fresh share capital of the company. Take Over It involves takeover of the business.
Methods of Internal Reconstruction The following methods are used to give proper shape to the scheme of Internal reconstruction: Alteration of Share Capital Change in Shareholder s rights Reduction of Share Capital Compromise and Arrangement Surrender of Shares
Alteration of Share Capital Note: Alteration does not involve any reduction in share capital. If authorized by its Articles, a company may, in a general meeting by passing an ordinary resolution, decide to sub-divide or consolidate the shares into those of a smaller or higher denomination than that fixed by the Memorandum of Association, so long as the proportion between the paid up and unpaid amount, if any, on the shares continues to be the same as it was in the case of the original shares.
Sub- division of shares Section 61 permits a company to sub- divide its shares of higher denominations (nominal value) into shares of smaller denominations(nominal value). The consequences of sub- division of shares would be: In case of partly paid up shares, the proportion between the paid up and unpaid amount on the shares continues to be the same after sub division as before. The effect of sub- division is that a shareholder becomes entitled to higher number of shares of smaller nominal value in exchange for lesser number of shares of higher nominal value. The accounting entry to record sub- division of shares would be: Equity Share Capital ( Rs. 10 share) Dr. To Equity Share Capital (Rs. 5 share) A/C
Example A company with a capital of Rs. 10,00,000 divided into 10,000 equity shares of ` 100 each on which Rs. 75 is paid up decides to reorganize its capital by splitting one equity share of Rs. 100 each into 10 such shares of Rs. 10 each. Pass the journal entry. Solution Equity Share Capital (Rs. 100) A/c Dr. 7,50,000 To Equity Share Capital (Rs. 10) A/c 7,50,000 (Being the sub-division of 10,000shares of Rs. 100 each with Rs. 75 paid up thereon into 1,00,000 shares of Rs. 10 each with Rs. 7.50 paid up thereon as per the resolution of shareholders passed in the General Meeting held on...)
Consolidation of Shares In this case, the shares of, say Rs. 10 each may be converted into shares of Rs. 100 each. The Accounting entry is: Equity Share Capital (Rs. 10 share) Dr. To Equity Share Capital (Rs. 100 share) A/C Note: The proportion between the paid up and unpaid up amount must be same after consolidation.
Example A company with a subscribed equity share capital of Rs. 5,00,000 divided into 50,000 equity shares of Rs. 10 each on which Rs. 7 per share are paid up has a total paid up equity capital of Rs. 3,50,000. The company decided to consolidate 10 equity shares of Rs. 10 each. Pass the necessary journal entry. Solution Equity Share Capital (Rs. 10) A/c Dr. 3,50,000 To Equity Share Capital (Rs. 100) A/c 3,50,000 (Being the consolidation of 50,000 shares of Rs. 10 each with Rs. 7 paid up thereon into 5,000 shares of Rs. 100 each with Rs. 70 paid up thereon as per the resolution of shareholders passed in the General Meeting held on...) Conclusion The result is that there will be no change in the amount of total paid up capital of the company. Only the face value of the shares and the number of shares after consolidation of shares.
Change in Shareholders Right When a company has issued different classes of shares with different rights or privileges attached to such shares e.g. rights as to dividend, voting rights etc. any of such right may be changed in any manner. For example, the company may change rate of (a) dividend on preference shares or (b) convert cumulative preference shares into non-cumulative preference shares without changing the amount of share capital by passing the following journal entries: a) (Old)% Cum. Pref. Share Capital Account Dr. (New)% Cum. Pref. Share Capital Account b) % Cum. Pref. Share Capital Account Dr. % Non-cum. Pref. Share Capital Account Note: In both the above cases, only the specific rights of preference shareholders have been changed. There is no change in the amount of share capital.
Reduction of Share Capital Section 66 of the Companies Act lays down the procedure in respect of reduction of share capital. The capital reduction can take place in more than one way and, hence the Accounting treatment is not same in each case. The different cases can be:
Case I: Reducing the Liability in respect of uncalled or unpaid amount When the uncalled amount of the share capital is reduced or completely cancelled, the shareholder s are exempted from paying the amount to that extent in future. The journal entry would be: Share Capital ( partly paid up) A/C Dr. To share Capital ( fully paid up) A/C Note: In such a case there is reduction in nominal value only and there is no reduction in the paid up value.
Case II: Reducing by refunding the excess capital It may not be possible for the company to utilize the whole of the capital possessed by it. Thus, the company may refund the excess capital to its members. The accounting entry is: a) Share Capital A/C Dr. ( with the amount to be refunded) To Shareholder s A/C b) Shareholder s A/C Dr. ( with the amount actually refunded) To Bank A/C Note: In such a case the share capital of the company would be reduced by the amount refunded.
Case III: Reducing the paid up capital This reduction is a sacrifice by the shareholders and the amount of reduction or sacrifice is credited to a new account called Capital Reduction Account (or Reconstruction Account). It is used for writing off the accumulated losses, useless intangible assets and over valued amount of other assets. The accounting treatment is: a) Reduction in paid up value only- Here the nominal value of the share remains the same and only the paid value is reduced. For example, the shareholders may agree to reduce the paid capital of Rs. 100 per share to paid value of Rs. 10 per share. The sacrifice is Rs. 90 and the entry will be Share Capital A/C Dr. (Rs. 90 X No. of Shares) To Reconstruction A/C (Rs. 90 X No. of Shares)
Contd. b) Reduction in both nominal and paid up values- In this case, both the paid up capital and nominal value of the shares are reduced. Continuing the above example, the entry will be: Share Capital Account (Rs. 100 Share) Dr. (Rs. 100 X No. of Shares) To Share Capital (Rs. 10 Share) (Rs. 10 X No. of Shares) To Reconstruction A/C (Rs. 90 X No. of Shares)
Compromise and Arrangement A scheme of compromise and arrangement is an agreement between a company and its members and outside liabilities when the company faces financial problems. Such an arrangement therefore also involves sacrifices by shareholders, or creditors and debenture holders or by all. These sacrifices are also credited to Reconstruction A/C. The accounting treatment is as follows: a) When equity shareholders give up there claim to reserves and accumulated profits, if any Reserves Account Dr. (With the amount of reserves) To Reconstruction Account b) Appreciation in the value of assets on revaluation Fixed assets A/C Dr. ( with increase in value of fixed assets) To Reconstruction A/C )
Contd. c) Sale of Fixed assets at a profit Bank A/C Dr. ( Sale Price) To Fixed Assets A/C ( Book Value of the asset sold) To Reconstruction A/C ( Profit on Sale) d) Settlement of outside liabilities ( creditors, debenture holders etc.) at lesser amount Outside liabilities A/C Dr. (With the amount of sacrifice) Provisions A/C, if any Dr. To Reconstruction A/C
Contd. e) Payment of Outside Liabilities: The debenture holders or the creditors may have to be paid in cash or they may accept some assets of the company or shares (or new debentures) in settlement of their claims. The journal entry is: Outside Liabilities A/C Dr. ( Amount of liability) To Bank A/C ( Payment in cash) To Share Capital A/C ( Payment in shares) To New Debentures A/C ( Payment in new Debentures) To Assets A/C ( Payment in Assets)
Contd. f) Preference Dividend: There can be three situations: i. Dividend declared and payable(i.e. given in the balance sheet) but sacrificed: Preference dividend payable A/C Dr. To Reconstruction A/C ii. Arrears of Dividend(i.e. does not given in the balance sheet) but paid now: a) Reconstruction A/C Dr. To Preference Shareholders A/C b) Preference Shareholders A/C Dr. To Bank A/C iii. Dividend neither declared nor paid No Entry, because there is no liability on the company and hence, there is no sacrifice.
