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

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.

Example

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