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:
- the balance of the profit and loss account and preliminary expenses,
- machinery to be reduced to $100,000.
- $9,000 write off against inventory,
- 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 capital25$ 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
- Prepare journal entries for the internal reconstruction.
- 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 |