Internal Reconstruction

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1 1 Internal Reconstruction IPCC Paper 1 : Accounting Chapter V CA. S.S. Prathap, FCA

2 2 Learning Objectives To understand the concept of Internal reconstruction Learn to pass Reconstruction / Capital Reduction Journal Entries. Learn to do full fledged 16 marks exam sums.

3 3 Internal Reconstruction An Intro. Internal Reconstruction - a kind of financial Re-engineering When the company is having substantial accumulated losses it becomes a sinking ship. Banks, Financial Institutions Sundry Creditors will no more be willing to extend credit and there is no way for the company to pull itself back to good health; except through scarifies by the various stake holders Preference and Equity Share Holders Debenture Holders Directors...

4 4 Internal Reconstruction An Intro. The sacrifices made by the stake holders are Profits to the company and have to be credited to a special a/c called Reconstruction a/c ( old name is Capital Reduction a/c ) It is a nominal a/c and all gains of Internal Reconstruction will be credited to it and all expenses and losses will be debited to it. If there is any credit balance in Reconstruction a/c it has to be transferred to Capital Reserve a/c.

5 5 Steps 1 Carefully pass Journal Entries involving reduction of capital, settlement of Liabilities and revaluation of assets. 2 3 Note the changes in the Balance Sheet which have to come in after reconstruction. The Balance Sheet after reconstruction should always have the heading (And Reduced) as per Section 100 of Companies Act.

6 6 Methods of Internal Reconstruction Alteration of Share Capital as per Section 94,95 and 97 of the Companies Act. Variation of Shareholders rights as per section 106 of the Companies Act,1956. Reduction of Share Capital as per Section 100 to 105 of the Companies Act,1956 Surrender of Shares

7 7 Illustration 1 Vishnu Ltd has 20,000 Equity Shares of Rs.10/- each = Rs.2,00,000 The Equity Shares are to be reduced to Rs.4/- each = Rs.80,000 JOURNAL ENTRY : Equity Share capital Dr. 2,00,000 (Rs.10 Face Value) To Equity share capital a/c 80,000 (Rs.4 each) To Reconstruction a/c 1,20,000

8 8 Illustration 2 Adwait Ltd has 5000 Equity share of Rs.100/- each fully paid up. They are to be divided into shares of Rs. 10/- each. JOURNAL ENTRY : Equity Share capital a/c Dr. 5,00,000 (5,000 * 100) To Equity Share capital a/c 5,00,000 (50,000 * 10) (Being stock split)

9 9 Illustration 2 - Continued 50 % of new share were surrender. JOURNAL ENTRY : Share Capital a/c Dr. 2,50,000 (25,000 * 10) To Reconstruction a/c 2,50,000

10 10 Illustration No. 3 JSN Sum

11 11 JSN Ltd The following is the Balance Sheet of JSN Ltd as on ,000,10% Preference share of Rs.100 each 24,000, Equity shares of Rs.100 each 12,00,000 Goodwill 90,000 24,00,000 Land and building 12,00,000 10% Debentures 6,00,000 Plant & Machinery 18,00,000 Bank Overdraft 6,00,000 Stock 2,60,000 Sundry Creditors 3,00,000 Debtors 2,80,000 Cash 30,000 Profit & Loss 14,00,000 Preliminary expenses 40,000 51,00,000 51,00,000

12 12 JSN Ltd (Contd...) The equity Shares are to be reduced to shares of Rs.40 each fully paid and the preference shares to be reduced to fully paid shares of Rs.75 each. The debenture holders took over stock and debtors in full satisfaction of their claims. The land and Building to be appreciated by 30% and Plant and Machinery to be depreciated by 30%. The fictitious and intangible assets are to be eliminated. Expenses of Reconstruction amounted to Rs.5,000 Give Journal Entries incorporating the above scheme of Reconstruction and prepare the reconstruction Balance Sheet.

13 13 JSN Ltd Accounts to be opened : 1. Reconstruction a/c 2. Cash a/c

14 14 Steps Record the sacrifice of Equity Share holders and Preference Share holders. Credit Reconstruction a/c with the gain. Settlement of 10 % Debentures.

15 15 Step - 2 Revaluation of Land, Building, Plant and Machinery. Debit Reconstruction a/c with accumulated losses (P & L balance), Goodwill a/c & Preliminary expenses. Any remaining credit balance in Reconstruction a/c transferred to Capital Reserve.

16 16 The Equity Shares are to be reduced to shares of Rs.40 each fully paid Equity share capital a/c(100) Dr. 24,00,000 To Equity Share capital a/c(75) 9,60,000 To Capital Reduction a/c 14,40,000 (Being 24,000 equity shares of Rs.100 each reduced to Rs.40 each) Reconstruction a/c By Equity share holder 14,40,000

17 17 Preference shares to be reduced to fully paid shares of Rs.75 each. 10% Pref. Share capital a/c(rs.100) Dr. 12,00,000 To 10% Pref.Share capital a/c(rs.75) 9,00,000 To Capital Reduction a/c 3,00,000 (Being 12,000 Preference share of Rs.100 each reduced to Rs.75 each) Reconstruction a/c By Equity share holder 14,40,000 By 10% Pref.Share holders 3,00,000

18 18 The debenture holders took over stock and debtors in full satisfaction of their claims. 10 % Debentures a/c Dr. 6,00,000 To Stock a/c 2,60,000 To Debtor s a/c 2,80,000 To Capital Reduction a/c 60,000 ( Being debenture holders given stock and debtors in full settlement of their claims ) Reconstruction a/c By Equity share holder 14,40,000 By 10% Pref.Share holders 3,00,000 By 10% Debentures 60,000

19 19 Land and Building to be appreciated by 30% Land and Building a/c Dr. 3,60,000 To Capital Reduction a/c 3,60,000 ( Being Land and Building appreciated by 30 % ) Reconstruction a/c By Equity share holder 14,40,000 By 10% Pref.Share holders 3,00,000 By 10% Debentures 60,000 By Land & Buildings 3,60,000

20 20 Plant and Machinery to be depreciated by 30%. Capital Reduction A/c Dr. 5,40,000 To Plant and Machinery A/c 5,40,000 (Being Plant and Machinery depreciated by 30%) Reconstruction A/c To Plant and Machinery 5,40,000 By Equity share holder 14,40,000 By 10% Pref.Share holders 3,00,000 By 10% Debentures 60,000 By Land & Buildings 3,60,000

21 21 Expenses of Reconstruction amounted to Rs.5,000 Reconstruction a/c Dr. 5,000 To Cash a/c 5,000 (Being expenses of reconstruction paid) Cash A/c To balance B/d 30,000 By Reconstruction 5,000 Reconstruction A/c To Plant and Machinery 5,40,000 By Equity share holder 14,40,000 To cash 5,000 By 10% Pref.Share holders 3,00,000 By 10% Debentures 60,000 By Land & Buildings 3,60,000

22 22 Cash a/c To balance B/d 30,000 By Reconstruction 5,000 By c/s balance 25,000 30,000 30,000

23 23 The fictitious and intangible assets are to be eliminated. Capital Reduction a/c Dr. 16,15,000 To Goodwill a/c 90,000 To Profit & Loss a/c 14,00,000 To Preliminary expenses a/c 40,000 To Capital Reserve a/c(bal. fig) 85,000 (Being various losses written off, assets written down and balances in capital Reduction a/c transferred to Capital Reserve a/c)

24 24 Reconstruction a/c To cash 5,000 By Equity share holder 14,40,000 To Plant & Mach 5,40,000 By 10% Pref.Share holders 3,00,000 To goodwill 90,000 By 10% Debentures 60,000 To Profit & Loss 14,00,000 By Land & Buildings 3,60,000 To Preliminary 40,000 To Capital Reserve 85,000 21,60,000 21,60,000

25 25 Reconstruction A/c To cash 5,000 By Equity share holder 14,40,000 To Plant & Mach 5,40,000 By 10% Pref.Share holders 3,00,000 To Goodwill 90,000 By 10% Debentures 60,000 To Profit & Loss 14,00,000 By Land & Buildings 3,60,000 To Preliminary 40,000 To Capital Reserve 85,000 21,60,000 21,60,000

26 26 Notes to Accounts Share Capital : Equity share capital 24,000 equity shares of Rs.40 9,60,000 Preference share capital 12,000, 10% Preference shares of Rs.75 each 9,00,000 TOTAL 18,60,000

27 27 Notes to Accounts Reserves and Surplus : Capital Reserve Rs.85, Tangible Assets : Land and Building Rs.15,60,000 Plant and Machinery Rs.12,60,000 TOTAL Rs.28,20,000

28 28 Balance Sheet (And reduced)of JSN Ltd as on I. Equity and Liabilities Note No. (1) Shareholder s Funds (a) Share capital 1 18,60,000 (b) Reserves and Surplus 2 85,000 (2)Current Liabilities Short term borrowings 6,00,000 Trade Payables 3,00,000 TOTAL 28,45,000

29 29 Balance Sheet (And reduced)of JSN Ltd as on II. Assets Note No. (1) Non-Current assets (a) Fixed Assets Tangible Assets 3 28,20,000 (2) Current Assets Cash and cash equivalents (30,000 5,000) 25,000 TOTAL 28,45,000

30 30 Illustration No.4 Rocky Sum May 2002 (20 marks)

31 31 Rocky Sum The following is the Balance Sheet of Rocky Ltd. As at March 31,2002 : Liabilities : Rs. In lacs Fully paid equity shares of Rs.10 each 500 Capital Reserve 6 12% Debentures 400 Debenture Interest Outstanding 48 Trade Creditors 165 Director s Remuneration Outstanding 10 Other Outstanding Expenses 11 Provisions 33 1,173

32 32 Rocky Sum (contd...) Assets Rs. In lacs Goodwill 15 Land and Building 184 Plant and Machinery 286 Furniture and Fixture 41 Stock 142 Debtors 80 Cash at bank 27 Discount on issue of Debentures 8 Profits and Loss Account 390 1,173

33 33 Rocky Sum (Contd...) The following scheme of Internal Reconstruction was framed & approved by the Court & all the concerned parties: (i) All the equity shares be converted into the same number of fully paid equity shares of Rs.2.50 each. (ii) Directors agree to forego their outstanding remuneration. (iii) The debentureholders also agree to forego outstanding interest in return of their 12% debentures being converted into 13% debentures. (iv) The existing shareholders agree to subscribe for cash, fully paid equity shares of Rs.2.50 each for Rs.125 lacs.

34 34 Rocky Sum (Contd...) (v) Trade creditors are given the option of either to accept fullypaid equity shares of Rs.2.50 each for the amount due to them or to accept 80% of the amount due in cash. Creditors for Rs.65 lacs accept equity shares whereas those for Rs.100 lacs accept Rs.80 lacs in cash in full settlement. (iv) The Assets are revalued as under: Rs. in lacs Land and building 230 Plant and Machinery 220 Stock 120 Debtors 76 Pass journal entries for all the above mentioned transactions and draft the company s Balance Sheet immediately after the reconstruction.

35 35 Rocky Accounts to be opened : 1. Reconstruction a/c 2. Bank a/c

36 36 Steps 1 Open Reconstruction a/c and to its credit record the sacrifices of Equity Share holders, Directors, 12 % Debenture holders and trade creditors. 2 3 The Revaluation of assets should be passed through Reconstruction a/c The balance left in Reconstruction a/c should be used to write off Goodwill Discount on issue of Debentures and Accumulated Losses (P&L a/c)

37 Journal Entries 37

38 All the equity shares be converted into the same number of fully paid equity shares of Rs.2.50 each. Equity Share Capital Rs. In lacs (Rs.10 each) a/c Dr. 500 To Equity Share Capital (Rs.2.50 each) a/c 125 To Reconstruction a/c 375 (Conversion of all the equity shares into the same number of fully paid equity shares of Rs.2.50 each as per scheme of reconstruction) 38 Reconstruction A/c By Equity Share Capital A/c 375

39 39 Directors agree to forego their outstanding remuneration. Rs. In lacs Director s Remuneration Out Standing a/c Dr. 10 To Reconstruction a/c 10 (Out Standing remuneration foregone by the directions as per scheme of reconstruction) Reconstruction A/c By Equity Share Capital A/c 375 By Director s Remuneration O/s 10

40 The debentureholders also agree to forego outstanding interest in return of their 12% debentures being converted into 13% debentures. 12% Debentures a/c Dr. 400 Debenture Interest Out Standing a/c Dr. 48 To 13% Debentures a/c 400 To Reconstruction a/c 48 (Conversion of 12% debentures into 13% debentures, Debenture holders forgoing outstanding debenture interest) 40 Rs. In lacs Reconstruction A/c By Equity Share Capital A/c 375 By Director s Remuneration O/s 10 By Debenture Interest Outstanding 48

41 The existing shareholders agree to subscribe for cash, fully paid equity shares of Rs.2.50 each for Rs.125 lacs. Rs. In lacs Bank Dr. 125 To Equity Share Application a/c 125 (Application money received for equity shares) 41

42 42 Trade creditors are given the option of either to accept fully-paid equity shares of Rs.2.50 each Rs. In lacs Equity Share Application a/c Dr. 125 To Equity Share capital (Rs.2.50 each) a/c 125 (Application money transferred to share capital)

43 Trade creditors are given the option of either to accept fully-paid equity shares of Rs.2.50 each Rs. In lacs Trade Creditors Dr. 165 To Equity Share Capital a/c 65 To Bank a/c 80 To Reconstruction a/c 20 (Trade creditors for Rs.65 lakhs accepting shares for full amount and those for Rs.100 lakhs accepting cash equal to 80% of claim in full settlement) Reconstruction A/c By Equity Share Capital A/c 375 By Director s Remuneration O/s 10 By Debenture Interest Outstanding 48 By Trade Creditors 20 43

44 44 Use of old Capital Reserve Capital Reserve Dr. 6 Rs. In lacs To Reconstruction a/c 6 (Capital Reserve being used for purpose of reconstruction) Reconstruction A/c By Equity Share Capital A/c 375 By Director s Remuneration O/s 10 By Debenture Interest Outstanding 48 By Trade Creditors 20 By Capital Reserve 6

45 45 Revaluation of Land & Building Land and Building Dr. 46 To Reconstruction a/c 46 (Appreciation made in the value of land and building as per scheme of reconstruction) Reconstruction A/c Rs. In lacs By Equity Share Capital A/c 375 By Director s Remuneration O/s 10 By Debenture Interest Outstanding 48 By Trade Creditors 20 By Capital Reserve 6 By Land & Building 46

46 46 Writing off accumulated losses & fictitious assets etc. Rs. In lacs Reconstruction a/c Dr. 505 To Goodwill a/c 15 To Plant and Machinery a/c 66 To Stocks a/c 22 To Debtors a/c 4 To Discount on issue of Debentures a/c 8 To Profit and Loss Account 390 (Writing off losses and reduction in the value of asset)

47 47 Reconstruction a/c To Goodwill 15 By Equity Share Capital A/c 375 To Plant & Machinery 66 By Director s Remuneration O/s 10 To Stock 22 By Debenture Interest Outstanding 48 To Debtors 4 By Trade Creditors 20 To Discount on issue of debentures 8 By Capital Reserve 6 To Profit & Loss 390 By Land & Building

48 48 Note 1 Rs. In lacs Equity Share capital as on (after reconstruction) Equity Share Capital(Rs.2.50 each) 125 (+) Fresh issue 125 (+) Equity shares issued to creditors

49 49 Note 2 Rs. In lacs Cash at Bank as on (after reconstruction) Cash at Bank(before reconstruction) 27 (+)Proceeds from issue of equity shares (-)Payment made to creditors 80 TOTAL 72

50 50 Balance Sheet (And reduced)of Rocky Ltd as at I. Equity and Liabilities (1) Shareholder s Funds Note No. Rs. Lakhs Share capital (2) Non - Current Liabilities Long term borrowings 400 (3)Current Liabilities Outstanding expenses 11 Provisions 33 TOTAL 759

51 51 Balance Sheet II. Assets (1) Non-Current assets (a) Fixed Assets Note No. Rs. In Lakhs Tangible Assets 491 (2) Current Assets Stock 120 Trade Receivables 76 Cash and cash equivalents 2 72 TOTAL 759

52 52 Ice sum (16 Marks, Nov 2011)

53 53 Ice Sum The Balance Sheet of M/s Ice Ltd as on is given below: Liabilities Amount Assets Amount 1,00,000 equity shares Freehold Property 5,50,000 Rs 10 each fully paidup 10,00,000 4,000,8% Pref. shares Rs 100 each fully paid 4,00,000 Plant and machinery 2,00,000 6% Debenture Secured by freehold property 4,00,000 Trade Investments (atcost) 2,00,000 Arrear Interest 24,000 4,24,000 Sundry Debtors 4,50,000 Sundry Creditors 1,01,000 Stock-In-Trade 4,50,000 Directors Loan 3,00,000 Deferred Advertisement Expenses 50,000 Profit & Loss Account 4,75,000 Total 22,25,000 Total 22,25,000

54 54 Ice Sum (Contd...) The Board of Directors of the company decided upon the following scheme of reconstruction with the consent of respective stakeholders: Preference shares are to be written down to Rs 80 each and equity shares to Rs 2 each. Preference dividend in arrear for 3 years to be waived by 2/3 rd and for balance 1/3 rd, equity shares of Rs 2 each to be allotted. Debenture holder agreed to take one freehold property at its book value of Rs 3,00,000 in part payment of the holdings. Balance debentures to remain as liability of the company. Arrear debenture interest to be paid in cash. Remaining free hold property to be valued Rs 4,00,000

55 55 Ice Sum(Contd...) Investment sold out for Rs 2,50,000 75% of Directors loan to be waived and for the balance, equity share of Rs 2 each to be allotted. 40% of sundry debtors, 80% of stock and 100% of deferred advertisement expenses to be written off. Company s contractual commitments amounting to Rs 6,00,000 have been settled by paying 5% penalty of contract value. Show the journal entries for giving effect to the internal reconstruction and drawn the Balance Sheet of the company after effecting the scheme.

56 56 Approach to the sum The sacrifices of Preference share holders, Directors have to be recorded and credited to Reconstruction a/c. For all other movements Journal Entries to be passed. The credit balance in Reconstruction a/c to be used to write off Profit and loss debit balance.

57 Journal Entries 57

58 Preference shares are to be written down to Rs 80 each and equity shares to Rs 2 each. 58 8% Preference share capital a/c(rs.100 each) Dr. To 8% Preference share capital a/c (Rs.80 each) To Capital Reduction a/c (Being the preference shares of Rs.100 each reduced to Rs.80 each as per the approved scheme) 4,00,000 3,20,000 80,000 Equity Share capital a/c (Rs.10 each) Dr. To Equity Share capital a/c (Rs.2 each) To Capital Reduction a/c (Being the Equity shares of Rs.10 each reduced to Rs.2 each) 10,00,000 2,00,000 8,00,000

59 Preference dividend in arrear for 3 years to be waived by 2/3 rd and for balance 1/3 rd,equity shares of Rs 2 each to be allotted. 59 Capital reduction a/c Dr. 32,000 To Equity share capital a/c 32,000 (Being arrears of preference share dividend of one year to be satisfied by issue of 16,000equity shares of Rs.2 each)

60 60 Debenture holder agreed to take one freehold property at its book value of Rs 3,00,000 in part payment of the holdings. 6% Debentures a/c Dr. 3,00,000 To Freehold property a/c 3,00,000 (Being claim settled in part by transfer of freehold property)

61 Arrear debenture interest to be paid in cash. 61 Accrued debenture interest a/c Dr. 24,000 To Bank a/c 24,000 (Being accrued debenture interest paid)

62 Remaining free hold property to be valued Rs 4,00,000. The opening Freehold property was Rs.5,50,000. Of this 3,00,000 was taken over by Debenture holders. The balance remaining property of Rs.2,50,000 has been valued upwards at Rs.4,00, Freehold property a/c Dr. 1,50,000 To Capital reduction a/c 1,50,000 (Being appreciation in the value of freehold property)

63 63 Investment sold out for Rs 2,50,000. Bank a/c Dr. 2,50,000 To Trade investment a/c 2,00,000 To Capital Reduction a/c 50,000 (Being trade investment sold on profit)

64 64 75% of Directors loan to be waived and for the balance, equity share of Rs 2 each to be allotted. Director s Loan a/c Dr. 3,00,000 To Equity share capital a/c 75,000 To Capital Reduction a/c 2,25,000 (Being Director s loan waived by 75% and balance discharged by issue of 37,500 equity shares of Rs. 2 each)

65 65 40% of sundry debtors, 80% of stock and 100% of deferred advertisement expenses to be written off. Reconstruction a/c Dr. 4,70,000 To Sundry Debtor s a/c 1,80,000 To Stock in hand a/c 2,40,000 To Deferred 50,000 advertisement expenses a/c

66 Company s contractual commitments amounting to Rs 6,00,000 have been settled by paying 5% penalty of contract value. Reconstruction a/c Dr. 30,000 To Bank a/c 30,000 (Being penalty paid) 66

67 67 Write off of accumulated losses Reconstruction a/c Dr. 7,73,000 To P & L a/c 4,75,000 To Capital Reserve a/c 2,98,000 (Being Profit and loss account debit balance written off and balance transferred to capital reserve account )

68 68 Notes to accounts 1. Share Capital : 1,53,500 Equity shares of Rs.2 each 3,07,000 4,000, 8% Preference shares of Rs.80 3,20,000 TOTAL 6,27, Reserves and Surplus : Capital Reserve 2,98,000

69 69 Notes to accounts 3. Long Term Borrowings : 6% Debentures 1,00, Tangible Assets : Freehold Property 4,00,000 Plant & Machinery 2,00,000 TOTAL 6,00, Cash and Cash Equivalents : ` Cash at Bank (2,50,000-24,000-30,000) 1,96,000

70 70 Balance Sheet (As reduced)of Ice Ltd I. Equity and Liabilities (1) Shareholder s Funds (a) Share capital Note No. 1 Rs. Lacks 6,27,000 (b) Reserves and Surplus 2 2,98,000 (2)Non- Current Liabilities Long term borrowings 1,00,000 (3)Current Liabilities Trade Payables 1,01,000 TOTAL 11,26,000

71 71 Balance Sheet (As reduced)of Ice Ltd II. Assets Note No. (1) Non-Current assets (a) Fixed Assets Rs. In Lakhs Tangible Assets 4 6,00,000 (2) Current Assets (a) Inventories 60,000 (b) Trade Receivables 2,70,000 (c)cash and cash equivalents 5 1,96,000 TOTAL 11,26,000

72 72 Lesson Summary So we learnt how to handle an Internal Reconstruction sum. The first step is to pass Journal Entries, Credting Reconstruction A/c with all gains and Debiting the various stake holders who are sacrificing The Assets and Liabilities should simultaneously be taken at their revised valuation The remaining credit balance in Reconstruction A/c should be transferred to Capital Reserve A/c.

73 Thank You 73

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