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. NOParticularsDebitCredit
1If 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
2If some sacrifice is done by debenture holders or creditors of the company:
Debenture account
Creditor account
Capital reduction account

xxx
xxx
  


 xxx
3In 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
4If any asset value gets increased, then it would be recorded as follows:
Assets account
Capital reduction account
xxx  

xxx
5If 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
6If 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

DescriptionDebitCredit
$10 Share capital540,000 
   $6 Share capital 324,000
   Capital reduction 216,000
   
Capital reduction 216,000  
   https://easyaccounting101.com/essays-health-and-social-care-incidence-of-the-copd-health-and-social-care-essay/ 93,000 
   Machinery  65,000 
   Preliminary expenses  15,000 
   Patents 34,000 
  https://easyaccounting101.com/essay-checker-online/ 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 
Cash15,000Accounts payable/ creditors75,000 
Accounts receivable/ debtors250,000Depreciation allowane – plant150,000 
Inventory50,000Authorized Capital  
Investment100,000Authorized share capital 250,000 ordinary shares @ $ 10 each 2,500,000 
Preliminary expenses25,000  
Goodwill35,000Paid-up capital  
Profit & loss150,00010,000 shares @ 10 $ each 1,000,000 
Plant & machinery650,000Share premium 50,000 
Total1,275,000Total 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 capital1,000,000 
$ 5 ordinary share capital 500,000
Capital reduction 500,000
   
To close premium account:  
Share premium50,000 
Profit & loss account 50,000
   
In order to record the sale of investment at a loss:  
Loss on sale of investment10,000 
Cash90,000 
Investment 100,000
   
In order to write-off various assets account in reconstruction, we will pass:  
Capital reduction500,000 
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

AssetsEquities
Cash105,000Accounts payable / creditors75,000
Accounts receivable/ Debtors200,000  
Inventory40,000Authorized capital 
  Authorized share capital 250,000 ordinary shares @ $ 5 each1,250,000
    
  Paid up capital 
  10,000 shares @ $ 5 each500,000
Plant & machinery300,000Capital reserve70,000
Total645,000Total645,000

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 & LiabilitiesAssets
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

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

Solution

DateParticularsDebitCredit
 


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 capital600,000
 600,000 600,000

Al Ain

Balance Sheet

As at December 31, 2016

EQUITIESASSETS
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