Accounting for Reconstruction of Companies

1. MEANING OF RECONSTRUCTION

When a company has been making losses for several years, the financial position does not present a true and fair view of the state of the affairs of the company. In such a company the assets are generally overvalued, as the balance sheet consists of fictitious assets, unrepresented intangible assets and debit balance in the profit and loss account (showing the carry forward of losses). Such a situation always leads the company to show a higher net worth and not depicting a true picture of financial statements. In short, the company is over capitalized. Such a situation brings the need for reconstruction/reorganization of the affairs. 

Reconstruction is a process by which affairs of a company are reorganized by revaluation of assets, reassessment of liabilities and by writing off the losses already suffered, by reducing the paid up value of shares and/or varying the rights attached to different classes of shares. The object of reconstruction is usually to reorganize capital or to compound with creditors so that company can be bailed out from present situation without winding up the existing company.

However, there may be external reconstruction. Wherever an undertaking is being carried on by a company and is in substance transferred, not to an outsider, but to another company consisting substantially of the same shareholders with a view to its being continued by the transferee company, there is external reconstruction. Such external reconstruction is essentially covered under the category of ‘amalgamation in the nature of merger’ in AS 14.

Difference Between Internal and External Reconstruction

2. METHODS OF INTERNAL RECONSTRUCTION

For properly deploying the process of internal reconstruction following methods are generally employed or used simultaneously: 

2.1 Alteration of Share Capital

According to Section 61 of the Companies Act 2013, a limited company can alter its share capital, if so authorized by its Articles, by passing an ordinary resolution in the general meeting. The provisions of the relevant sections of Companies Act will be applicable, but in this chapter, we are going to focus on the accounting treatment of the various conditions pertaining to internal reconstruction.

The following types of Alteration can be done under Section 61-

1. Increase of authorized share capital;
2. Consolidation and sub-division into shares of larger or smaller denominations;
3. Conversion of all or any of the shares into stock or vice versa;
4. Cancellation of shares which have not been taken or agreed to be taken by any person. 

Sub-division and Consolidation of Shares

The existing share capital can be sub-divided or consolidated into 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.

For example, a company with a capital of ₹ 10,00,000 divided into 10,000 equity shares of ₹ 100 each on which ₹ 75 is paid up decides to reorganize its capital by splitting one equity share of ₹ 100 each into 10 such shares of ₹ 10 each. The consequential entry to be passed in such a case would be—

Similar entries will be passed on consolidation of shares of a smaller amount into those of a larger amount.

Conversion of Fully Paid Shares into Stock and Stock into Shares

According to section 61 of Companies Act, 2013, a company can convert its fully paid shares into stock and reconversion of stock into shares. If authorized by its Articles, a company may, in a general meeting by passing an ordinary resolution, can convert its fully paid shares into stock and reconversion of stock into shares. Stock is the consolidation of the share capital into one unit divisible into aliquot parts. Stock is a bundle of fully paid shares put together for convenience so that it may be divided into any amount and transferred into any fractions and subdivisions without regard to the original face value of the shares. While it is impossible for share capital to be one share, any amount of stock may be transferred. In practice, however, companies restrict the transfer of stock to multiples say, ₹ 100. 

A company can convert its fully paid shares into stock. Upon the company converting its shares into stock, the book-keeping entries merely record the transfer from share capital account to stock account. A separate Stock Register is started in which details of members’ holdings are entered and the annual return is modified accordingly.

2.2 Variation of Shareholders Rights

Section 48 of the Companies Act, 2013 provides that 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. The provisions will be applicable as per the Companies Act 2013 , the accounting treatment is discussed in detail here.

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:

1. Debit (Old)% Cum. Pref. Share Capital Account
   Credit (New)% Cum. Pref. Share Capital Account
2. Debit …% Cum. Pref. Share Capital Account
   Credit …% Non-cum. Pref. Share Capital Account

2.3 Reduction of Share Capital

Section 66 of the Companies Act, 2013 lays down the procedure in respect of reduction of share capital. Subject to confirmation by the Tribunal on an application by the company, a company may, by a special resolution, reduce the share capital in the following manner-

1. Extinguishing or reducing the liability of the shareholders in respect of unpaid amount on the shares held by them; or
2. Paying off any paid-up share capital which is in excess of its requirements;
3. Cancelling any paid-up share capital which is lost or is unrepresented by available assets.

Generally, reduction in share capital is followed when a company has been suffering losses continuously for a long time, is not truly represented by its assets. In such a case, any scheme for capital reduction should write-off that portion of capital which is already lost.

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). The accounting treatment is as follows:

(a) When liability of the shareholders is extinguished or reduced in respect of unpaid amount on the shares held by them: Here the shareholders are not called upon to pay the unpaid amount on shares held by them in future. For example, a company decides to reduce ₹ 10 per share, into ₹ 7.5 per share fully paid up, by cancelling the unpaid amount of ₹ 2.5 per share. The entry in this case would be

Share Capital (Partly Paid-Up) Account    Dr.    (₹ 7.5 (Fv ₹10) X No. of Shares)
    To Share Capital (Fully Paid-up) Account (₹ 7.5 (Fv- ₹7.5) X No. of Shares)

(b) When excess paid up capital is paid off: When its not possible for the company to employ profitably its paid up capital, then in such case it may decide to refund the excess capital to its shareholders. For example, a company having fully paid-up share of ₹ 10 each, decides to pay-off ₹ 2 per share to make it of ₹ 8 fully paid-up, entries in that case would be

Share Capital Account (₹ 10)     Dr.     (₹ 10 X No. of Shares)
    To Share Capital Account (₹ 8) (₹ 8 X No. of Shares)
    To Sundry Shareholders Account (₹ 2 X No. of Shares)
Sundry Shareholders Account    Dr.    (₹ 2 X No. of Shares)
    To Bank Account (₹ 2 X No. of Shares)

(c) When the paid up capital which is lost or not represented is cancelled:

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 ₹ 100 per share to paid value of ₹ 10 per share. The sacrifice is ₹ 90 and the entry will be 

Share Capital Account     Dr.    (₹ 90 X No. of Shares)
    To Capital Reduction Account (₹ 90 X No. of Shares) 

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 (₹ 100 Share)     Dr.     (₹ 100 X No. of Shares)
    To Share Capital (₹ 10 Share) (₹ 10 X No. of Shares)
    To Capital Reduction Account (₹ 90 X No. of Shares)

Thus in such treatment we debit the original Share Capital Account so as to close it, credit new Share Capital Account with the amount treated as paid up; and credit Capital Reduction Account with the difference.

2.4 Compromise/Arrangements

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 or debenture holders or by all of them.

Accounting treatment for some of the cases is as follows:

a) When equity shareholders give up their right over the reserves and accumulated profits of the company:

Reserves Account    Dr.    (With the amount of reserves)
    To Reconstruction Account

b) Settlement of outside liabilities at lesser amount: Liabilities such as sundry creditors may agree to accept less amount in lieu of final settlement.

Treatment will be as follows:

Outside Liabilities Account    Dr.     (With the amount of sacrifice)
Provision Account (if any)      Dr.     (made by creditors, debenture holders etc.) 
    To Reconstruction Account

2.5 Surrender of Shares

In this method, shares are divided into shares of smaller denominations and then the shareholders are made to surrender their shares to the company. These shares are then allotted to debenture holders and creditors so that their liabilities are reduced. The unutilized surrendered shares are then cancelled by transferring them to Reconstruction Account.

3. ENTRIES IN CASE OF INTERNAL RECONSTRUCTION

On a scheme of internal reconstruction being adopted (through special resolution confirmed by the Court), the accounting treatment of the different situations and the entries to be passed are as follows:

1. Under the above-mentioned methods- the alteration of share capital and the varying of the shareholders rights do not involve opening the capital reduction/reconstruction account.
2. It is only under the reduction of share capital, unrepresented reserves, compromise/ arrangements with the outsiders liabilities and surrender of shares, there shall be capital reduction/reconstruction account used to which the unrepresented assets/liabilities will be transferred as per the arrangement.
3. An appreciation in the value of an asset or reduction in the amount of a liability should be debited to the account concerned and credited to Capital Reduction Account (or Reconstruction Account).
4. Eliminate debit balance of profit and loss account and all over-valuation of assets by crediting the accounts concerned and debiting the Capital Reduction (or Reconstruction) Account. For this purpose, any reserve appearing in the books of the company may be used. If any balance is left in the Capital Reduction (or Reconstruction) Account, it should be transferred to the Capital Reserve Account.
5. If there is any balance in the reconstruction account it is finally transferred to the Capital reserve under Reserves and Surplus. But if the amount for writing off the assets and accumulated losses is more than the reconstruction amount, then reserves will be adjusted against the same.

While preparing the balance sheet of a reconstructed company, the following points are to be kept in mind:

1. After the name of the company, the words “and Reduced” should be added only if the Court so orders.
2. In case of fixed assets, the amount written off under the scheme of reconstruction must be shown for five years.