LECTURE 7: Capital re-organization and reconstruction


Objectives


  • At the end of this lecture you will be able to:
§  Explain the reasons as to why companies may choose to reorganize themselves
§  Suggest capital reduction schemes or reorganization schemes
§  Prepare capital reduction/reorganization account
§  Prepare the statement of financial position of the company after reconstruction exercise.

Content

§  Principal reasons for capital reconstruction
§  Stages involved in formulating a capital reduction/reorganization scheme
§  Capital reduction/reorganization schemes
§  Preparation of capital reduction/reorganization account
§  Preparation of the statement of financial position of the company after reconstruction exercise.

7.0 Introduction

Capita re-organization or internal reconstruction is a recourse undertaken to make necessary changes in the capital structure of a company without liquidating the existing company. In an internal or capital reconstruction neither the existing company is liquidated, nor is a new company incorporated. It is a scheme in which efforts are made to bail out the company from losses and put it in profitable position. Internal reconstruction of a company is done through the reorganization of its share capital. It is a scheme of reorganization in which all interested parties in the capital structure volunteer to sacrifice part of their claim to the company. These may include the company’s shareholders, debenture holders, creditors etc. Under capital reconstruction, the accumulated trading losses and fictitious assets are written off against the sacrifice made by these interest holders in the form of reduction of paid up value of their interest.

7.1 Situations which call for capital reconstruction of a company

The following situations are generally justification for the Capital reconstruction of a company;
        i.            When the capital structure of a company is complex and it is necessary to make it simple.
      ii.             When there are huge accumulated losses and it is required to write off these losses to depict a better position of the company.
    iii.             When a part of the capital is not represented by available tangible assets.
    iv.             When change is required in the face value of shares of the company so that they can become attractive to the future investors.

7.2 Forms of capital reconstruction

Capital reconstruction of a company can be carried out in the following two ways. These are as under:
(A) Alteration of Share Capital/Reorganizations
(B) Reduction in Share Capital

Reduction of Share Capital

Reduction in capital may involve the shareholders sacrifice of part of their claims to assets of the business. In some cases also other stakeholders, viz., debenture holders and creditors may agree to reduce some of their claim to boost the business on expectations of the future benefit as a result of an improved structure of the business.

Alteration of Share Capital

a)      A company can alter share capital in any of the following ways:
(a)  It may consolidate the whole or any part of its share capital into shares of larger amount.
(b) It may convert shares into stock or vice versa.
(c) It may sub-divide the whole or any part of its share capital into shares of smaller amount.
(d) It may cancel those shares which have not been taken up and reduce its capital accordingly.

To alter capital by any of the above modes require a resolution at a general meeting.

Reduction in share capital

Before going for capital reduction the company should take into consideration the following steps.
}   According to the provision laid down in the companies’ act of 2002 the reduction of share capital is possible only when the articles permit to do so by passing a special resolution to that effect.
}   The company should, after applying to the court seek confirmation order for the purpose of capital reduction and such order should protect the interests of the creditors and share holders. The court having satisfied with the terms for reduction of share capital would make an order for adding the words ''and reduced'' to the name of the company for such period as it thinks fit.
}  The reasons of capital reduction by court order are to be published for public consumption.
 The order of the court so obtained should be produced before the registrar and a certified copy of the order and of the minutes of reduction of share capital should be filed with the Registrar for registration.
Reduction of the share capital is done through the followings;
  1. Reducing or cancellation of the uncalled capital :
This is to write off the uncalled capital on those shares which are partly paid up. However, this affects the interest of the creditors because their risk is increased. Their debt is indirectly secured by paid up capital & uncalled capital.
The writing off of the uncalled capital does not affect the paid up capital, but it reduces the par value of the shares.
  Share capital A/c  (old)........ Dr
                To share capital A/c (New)……….Cr
2.      Return of paid-up Capital ;
 When the company feels that it has excess of capital, it may return such excess to its members. It involves reduction of capital and reduces the face value of shares.  The entry required is.
        i.            Share capital A/c  (old)           Dr       
                        Share capital (New)………Cr
                         Share holder A/c………….Cr
      ii.            Share Holder A/c        Dr
                         Bank A/c        Cr
3.      The Reduction in paid-up capital :
The amount of reduction in paid-up capital is not refunded to the share holder but it is used for reorganization of its financial position. 
This form of capital reduction is important from the view point of Capital reconstruction.  Such portion of reduction of paid up capital is to be transferred to an account called "capital reduction account" or 'reconstruction account".
}   The entry required is
 Share capital (old) A/c .  (paid up value of share)………..Dr
     Share capital (New) A/c    (old capital converted into new shares)……………Cr
    Capital Reduction A/c    (Reduction of paid-up capital)………………………………Cr
            Note :  The above entry will change the face value. Capital reduction and Reconstruction account are inter changeably used. 
4.      Liabilities,  assets and accumulated losses.
In addition to the reduction of capital, internal reconstruction involves other transactions like reduction of liabilities, appreciation or over valuation of assets, writing off of accumulated losses. 
The entries required are :
        i.            When creditors and Debenture holders forego the amount due to them.
            Creditors A/c               Dr     
            (with the amount foregone.)
            Debenture holders A/c            Dr
                        Capital reduction A/c Cr
      ii.            When any contingent liability is to be paid :
a)      Capital reduction A/c  Dr
                        To liability payable A/c           Cr
b)      Liability payable  A/c  Dr
                        Bank                            Cr
    iii.            When any asset appreciated ;
            Asset A/c ..... Dr (with the amount of appreciation).
                 Capital reduction A/c…………….Cr
5.      When the amount in capital reduction is used to write off fictitious assets, past losses etc.
            Capital Reduction A/c            Dr.
                         profit & Loss A/c..                 Cr
                         Goodwill                                Cr
                        Preliminary expenses               Cr
                         Patents                                   Cr
                         Plant & Machinery                 Cr
                         Other assets                            Cr
                         Unrecorded liability, if any,   Cr
Capital Reserve (Balancing figure) is carried forward as capital reserve.

Example;
The following information was extracted from the books of Mwanza Ltd.
Mwanza Ltd Statement of financial position as on 31 December 2011
ASSETS
Tshs.
Tshs.
Non-Current Assets
Freehold property
425,00
Plant
50,000
Patent
37500
Goodwill
130,00
642,000
Traded Investment (at cost)
55,000
CURRENT ASSETS
Receivables
485,00
Inventories
425,00
Deferred advertisement
100,00
1,010,00
Profit and Loss account
435,000
Total
2,142,50
LIABILITIES
Share Capital
4,000 6%cummulative preference shares of Tshs 100 each
400,00
75,000 equity shares of Tshs. 10 each
750,00
1,150,00
6% debentures (Secured on freehold property)
375,00
Accrued interest
22,500
397,500
CURRENT LIABILITIES
Bank overdraft
195,00
Creditors
300,00
Director's Loans
100,00
595,000
Total
2,142,00

The court approved a scheme of reorganization to take effect on 1 January 2012
i)                    The preference share to be written down to Tshs. 75 each and equity shares to Tshs. 2 each
ii)                  Of the preference share dividends, which are in arrears for four years, three fours to be waived and equity share of Tshs 2 each to be allotted for the remaining quarter.
iii)                Accrued interest on debenture to be paid in cash
iv)                Debenture holders agreed to take over freehold property, book value Tshs. 100,000 at a valuation of Tshs. 120,000 in part repayment of their holdings and to provide additional cash of Tshs. 130,000 secured by a floating charge on company’s assets at an interest rates of 8% p.a
v)                  Patents, goodwill and deferred advertising to be written off.
vi)                Inventory to be written off by Tshs. 65,000
vii)              Amount of Tshs. 68,500 to be provided for bad debts
viii)            Remaining freehold to be revalued at Tshs. 387,500
ix)                Trade investment be sold for Tshs. 140,000 
x)                  Directors to accept settlement of their loans as to 90% thereof by allotment of equity shares of Tshs. 2 each as to 5% in cash, and balance 5% being waived.
xi)                There were capital commitments totaling Tshs. 250,000. These contracts are to be cancelled on payment of 5% of the contract price as a penalty.
xii)              Ignore Taxation and cost of the scheme

Required:
Show journal entries reflecting the above transactions (including cash transactions)


Solution:
Journal entries for Mwanza Ltd. Ltd
Dr.
Cr.
Tshs.
Tshs
2011
Dec. 31 Equity share capital a/c (Tshs. 10)
750,000
Capital reduction a/c
600,000
Equity share capital a/c (Tshs.2)
150,000
(Being reduction of equity shares of Tshs.10 to shares of Tshs.2 each)
6% Cumulative preference share capital a/c (Tshs. 100)
400,000
Capital reduction
100,000
Preference share capital a/c (Tshs.75)
300,000
(Being reduction of preference shares of Tshs. 100 each to shares of Tshs. 75 each)



2011
Dec 31 Freehold property
82,500
Capital reduction a/c
82,500
(Appreciation in value of property
Book value
Revalued figure
Tshs. 100,000
Tshs120000
Tshs325,000
Tshs387,500
Total
Tshs.425,000
Tshs. 507,500
Profit on revaluation)
6% Debenture a/c
120,000
To Freehold property a/c
120,000
(Being claims of debenture, in part, in respect of principal discharged by transfer of property
Accrued interest a/c
22,500
 Bank a/c
22500
(Debenture interest paid)

Bank /c
130,000
 8% debenture a/c
130,000
(8% debentures issued for cash)
Bank /c
140,000
Trade investment a/c
55,000
Capital reduction a/c
85,000
(Sales of trade investment for 140,000 cost being Tshs. 55,000; profit credited to C. reduction a/c)
Directors' loan a/c
100,000
Equity share capital a/c
90,000
     Bank a/c
5,000
      Capital reduction a/c
5,000
(Directors'  loan discharged)

Dec 31 Capital reduction a/c
24,000
Equity share capital a/c
24,000
(Arrears of preference dividends satisfied by the issue of equity shares 25% of the arrears-6%*400,000)
Capital reduction a/c
848,500
To Patents
37,500
To goodwill
130,000
To deferred advertising
100,000
To Inventory
65,000
To provision for doubtful debts
68,500
To bank
12,500
To profit and loss a/c
435,000
Writing off patents, g.will, D advertising, P&L a/c, making provisions and payments of penalty)




Mwanza Ltd.
The Statement of financial position as on 31 December 2011 after the scheme
ASSETS
Tshs.
Tshs.
Non-Current Assets
Freehold property(507,500-120,000)
387,50
Plant
50,000
437,500
CURRENT ASSETS
Receivables
416,50
Inventories
360,00
Bank
35,000
811,500
Total
1,594,000
Equity and Liabilities
Share Capital
4,000 6%Cummulative Preference Shares of Tshs 75 each
300,00
87,000 equity shares of Tshs. 2 each
174,00
Profit and loss a/c
435,00
909,000
6% debentures (Secured on freehold property)
   255,00
8% Debenture
130,00
385,000
Current Liabilities
Payables
300,00
Total
1,594,00

8.1 Summary of the Course

There are two methods of capital reduction/reconstruction, these are internal and external
There are motives behind capital reductions both to the company as a separate entity and to the shareholders. The statement of financial position of the new company will show w Principal reasons for capital reconstruction. Stages involved in formulating a capital reduction/reorganization scheme. The main focus of this topic is to make you understand how to prepare of capital reduction/reorganization account and the statement of financial position of the company after reconstruction scheme

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