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 # 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