Capital reduction and reconstruction

Capital reduction and reconstruction is a way to reduce the capital amount of the company. Within the company, there are several reasons for such treatment but here are some common ones:

Purpose of Capital reduction

in order to pay off the unnecessary capital of the company which is of no use. 

in order to extinguish the liability against the unpaid shares of the company,

in order to cancel paid up share capital which is unrepresented by the available assets.

How to Reduce Capital / Capital Reduction Process

An entity can proceed to capital reduction only when it is allowed by:

  • it's article of association,
  • it is accepted by the shareholders by a special resolution, and
  • it is approved by the court.

The consent of the creditors is also required, however,  the court may dispense with such approval of the court in following cases:

if the entity is securing the creditor's amount,

if the entity is not willing to secure the creditor's amount, then the amount as fixed by the court.

 

Journal Entries on internal reconstruction 

The following entries are passed in order to do the bookkeeping in the accounting records. Capital reduction account in internal reconstruction is used to do the proper accounting work. Accounting treatment in case of capital reduction is as follows:

S. NO

Particulars

Debit

Credit

1

If the face value of shares is changed or altered by doing reduction in share capital:

Share capital account (old)

Share capital account (new)

Capital reduction account (balancing figure)

(To record change of category/ types of shares)

 

xxx

 

 

xxx

xxx

2

If some sacrifice is done by debenture holders or creditors of the company:

Debenture account

Creditor account

Capital reduction account

xxx

xxx

 

 

 

xxx

3

In case, new shares or debentures issued against the old ones:

Debenture account (old)

Debenture account (new)

Share capital account

Capital reduction account (balancing figure)

 

 

xxx

 

 

 

xxx

xxx

xxx

4

If any asset value gets increased, then it would be recorded as follows:

Assets account

Capital reduction account

xxx

 

 

xxx

5

If the company management thinks that the amount of capital reduction should be used for writing of fictitious assets, past losses and excess asset value recognized previously, then it could be recorded as follows:

Capital reduction account

Profit & loss account

Discount on issue of debenture account

Discount on issue of shares account

Goodwill account

Plant & machinery account

Trademarks account

Patent account

Inventory account

 

 

 

xxx

 

 

 

 

xxx

xxx

xxx

xxx

xxx

xxx

xxx

xxx

6

If still there is a balance in capital reduction account, it would b e transferred into the capital reserve account.

Capital reduction account

Capital reserve account

xxx

 

 

xxx

 

Capital Reduction Example # 1

The balance sheet of Jack as on 31st Dec, 2012 is as follows:

Balance Sheet

Equities   Assets  
Authorized capital    Machinery  165,000 
72,000 shares of $10 each  720,000  Patents  201,000 
Paid up capital    Equipments  75,000
54,000 shares of $10 each  540,000  Preliminary expenses  15,000 
Accounts Paybale  36,000  Stock/ Invenory  24,750 
Accrued liabilities  12,000  A/ Receivables  14,040 
    Cash  180 
    Profit & Loss  93,000 

 

The special resolution for capital reduction  has been passed and confirmed as per following details:

$10 shared are to be reduced to $6 for the same number of shares,

The amount of reduction should be utilized for:

  1. the balance of the profit and loss account and preliminary expenses,
  2. machinery to be reduced to $100,000.
  3. $9,000 write off against inventory,
  4. Patents should be reduced to $167,000.

Required:

Pass the journal entries in the books of Jack.

Solution

Jack

Journal Entries

Description Debit Credit
$10 Share capital 540,000  
   $6 Share capital   324,000
   Capital reduction   216,000
     
Capital reduction  216,000   
   Profit and Loss account   93,000 
   Machinery    65,000 
   Preliminary expenses    15,000 
   Patents   34,000 
  Inventory   9,000 

 

Example # 2

TP is a private limited company engaged in telecommunication business. The balance sheet of TP as on 31st December, 2012 is as follow:

Assets   Liabilities  
Cash 15,000 Accounts payable/ creditors 75,000 
Accounts receivable/ debtors 250,000 Depreciation allowane - plant 150,000 
Inventory 50,000 Authorized Capital   
Investment 100,000 Authorized share capital 250,000 ordinary shares @ $ 10 each  2,500,000 
Preliminary expenses 25,000    
Goodwill 35,000 Paid-up capital   
Profit & loss 150,000 10,000 shares @ 10 $ each  1,000,000 
Plant & machinery 650,000 Share premium  50,000 
Total 1,275,000 Total  1,275,000

 

The following scheme of reconstruction was agreed upon and implemented on July 31, 2013.

1. Ordinary shares of $ 10 each are to be reduced to an equal number of fully paid shares of $ 5 each.

2. Share premium was utilized to accommodate the reconstruction.

3. Investment was sold at loss for $ 90,000.

4. The account thus available will be utilized to write off preliminary expenses, profit & loss, and goodwill completely.

5. Accounts receivables are not estimated to be recovered fully. Estimated to realize $ 200,000.

6. Inventory is valued at $ 40,000 due to lower NRV (net realizable value).

7. Plant & machinery are assigned a lower book value of $ 300,000.

Required

a) Entries in general journal to give effect to the above scheme.

b) Revised balance sheet of TP.

Solution

TP Limited

Journal entries

To record capital reduction by $ 5 per share, we will pass this entry:

   

$10 ordinary share capital

1,000,000

 

$ 5 ordinary share capital

 

500,000

Capital reduction

 

500,000

     

To close premium account:

   

Share premium

50,000

 

Profit & loss account

 

50,000

     

In order to record the sale of investment at a loss:

   

Loss on sale of investment

10,000

 

Cash

90,000

 

Investment

 

100,000

     

In order to write-off various assets account in reconstruction, we will pass:

   

Capital reduction

500,000

 

Preliminary expenses

 

25,000

Loss on sale of investment

 

10,000

Profit & loss

 

100,000

Goodwill

 

35,000

Accounts receivable

 

50,000

Inventory

 

10,000

Plant & machinery

 

200,000

Capital reserve

 

70,000

 

TP Limited

Balance Sheet

As on December 31, 2013

Assets

Equities

Cash

105,000

Accounts payable / creditors

75,000

Accounts receivable/ Debtors

200,000

   

Inventory

40,000

Authorized capital

 
   

Authorized share capital 250,000 ordinary shares @ $ 5 each

1,250,000

       
   

Paid up capital

 
   

10,000 shares @ $ 5 each

500,000

Plant & machinery

300,000

Capital reserve

70,000

Total

645,000

Total

645,000

 

Internal Reconstruction Exercise

This is Internal reconstruction problems with solutions that is asked in various examinations of universities. You are advised to practice this question to make sure you can tackle even a difficult question. The key to solve these types of question is to remember whether you have to debit or credit the Capital Reduction Account. Other items get debited or credited against Capital reduction account and are given in question. You have to just write them in your journal entries by copying from the question paper. Once, all entries are completed, you are all set to complete the paper and gain handsome marks.

Al Ain is involved in the manufacturing of industrial materials. The balance sheet of Al Ain as a t Dec 31, 2016 is as follows:

Equity & Liabilities

Assets

Authorized share capital

25$ per share

Paid up capital $ 25 each

Bonds payable

Creditors

Allowance for depreciation

2,000,000

 

1,500,000

400,000

140,000

160,000

Plant & Machinery

Goodwill

Preliminary expenses

Inventory

Cash

Profit & loss

Debtors

1,600,000

100,000

20,000

240,000

10,000

50,000

180,000

After detailed discussion, management has approved the internal reconstruction scheme under the following terms and conditions:

The amount of authorized capital of the company will remain same. However, the par value would be now $ 10.

The shareholder will get three new shares for two previously held at $ 10 each.

Bonds are to be redeemed fully by issue of new 44,000 ordinary shares of $ 10 each to bond holders.

Profit & loss, preliminary expenses and goodwill are to be written off completely.

Asset’s estimated realization values are as follows:

Inventory $ 200,000

Plant & machinery $ 1,100,000

Debtors $ 170,000

Required

  1. Prepare journal entries for the internal reconstruction.
  2. Revised balance sheet after the internal reconstruction process.

Solution

Date

Particulars

Debit

Credit

 

Share capital ($ 25 each)

Share capital ($ 10 each)

Capital reduction (balancing figure)

(To record reduction of shares from $ 25 to $ 10)

1,500,000

900,000

600,000

 

Bonds payable

Capital reduction

Share capital

400,000

40,000

440,000

 

Capital reduction

Preliminary expenses

Goodwill

Profit & loss

(To record writing off fictitious assets, preliminary expenses & profit loss)

170,000

20,000

50,000

100,000

 

Capital reduction

Debtors

Inventory

Plant & machinery

390,000

10,000

40,000

340,000

Working for new shares after internal reconstruction

Authorized capital

This will remain same, though number of shares will change 1,000,000 / 10 = 100,000 shares

Paid up capital

Number of paid up shares 1,500,000 / 25 = 60,000 shares

Number of new paid up shares 60,000 x 3 /2 = 90,000

New paid up share capital value 90,000 x 10 = $ 900,000

In order to calculate value for capital reduction against plant & machinery, following procedure is followed:

Plant & machinery                        1,600,000

Less: Allowance for depreciation (160,000)

                                                    1,440,000

Less: revised value                    (1,100,000)

Amount to be reduced                  340,000

Capital Reduction A/c

     

Share capital

Profit & loss

Preliminary expenses

Goodwill

Debtors

Inventory

Plant & machinery

40,000
50,000

20,000

100,000

10,000

40,000

240,000

Share capital

600,000

 

600,000

 

600,000

Al Ain

Balance Sheet

As at December 31, 2016

EQUITIES

ASSETS

Authorized capital 100,000 shares @ $ 10 each

Paid up share capital

Creditors

Allow for depreciation

1000,000

1,340,000

140,000

160,000

Plant & machinery

Inventory

Debtors

Cash

1,260,000

200,000

170,000

10,000

 

1,640,000

 

1,640,000