Internal Reconstruction: Accounting treatment

05/05/2021 4 By indiafreenotes

Reconstruction is a process of the company’s reorganization, concerning legal, operational, ownership and other structures, by revaluing assets and reassessing the liabilities. It refers to the transfer of company or several companies’ business to a new company. This, therefore, means that the old company will get put into liquidation, and shareholders will therefore agree to take shares of equivalent value in the new company. Reconstruction is required when the company is incurring losses for many years, and the statement of account does not reflect the true and fair position of the business, as a higher net worth is depicted, than that of the real one.

In other words, “Reconstruction” involves the winding up of an existing company and the transfer of its assets and liabilities to a new company formed for the purpose of taking over the business and undertaking of the existing company. Shareholders in the existing company become shareholders in the new company. The business undertaking and shareholders of the new company are substantially the same as those of the old company.

Objectives of Reconstruction

  1. To resolve the problem of over-capitalization/huge accumulated losses/over valuation of assets.
  2. When the capital structure of a company is complex and is required to make it simple
  3. When change is required in the face value of shares of the company
  4. To generate surplus for writing off accumulated losses & writing down overstated assets.
  5. Raising the fresh capital by issuing new shares.
  6. Changing altogether the memorandum of association of the company.
  7. To generate cash for working capital needs, replacement of assets, to add balancing equipment’s, modernise plant & machinery etc.

Types of Reconstruction

  1. External Reconstruction and
  2. Internal Reconstruction.

External Reconstruction: When a company is suffering losses for the past several years and facing financial crisis, the company can sell its business to another newly formed company.

Actually, the new company is formed to take over the assets and liabilities of the old company. This process is called external reconstruction. In other words, external reconstruction refers to the sale of the business of existing company to another company formed for the purposed. In external reconstruction, one company is liquidated and another new company is formed. The liquidated company is called “Vendor Company” and the new company is called “Purchasing Company”. Shareholders of vendor company become the shareholders of purchasing company.

Internal Reconstruction: Internal reconstruction refers to the internal re-organization of the financial structure of a company. It is also termed as re-organization which permits the existing company to be continued. Generally, share capital is reduced to write off the past accumulated losses of the company.

Conditions/Provisions regarding Internal Reconstruction

  1. Authorization by Articles of Association: The company must be authorized by its articles of association to resort for capital reduction. Articles of association contains all the details regarding the internal affairs of the company and mention the clause containing manner of reduction of capital.
  2. Passing of Special Resolution: The company must pass the special resolution before resorting to capital reduction. The special resolution can be passed only if the majority of the stakeholders are assenting to the internal reconstruction. This special resolution must be get signed by the tribunal and deposited to the registrar appointed under the Companies Act, 2013.
  3. Permission of Tribunal: The company must get the due permission of the court or tribunal before starting the process of the capital reduction. The tribunal grants permission only it feels satisfied with the point that the company is going fair and there is positive consent of every stakeholder.
  4. Payment of borrowings: As per Section 66 of the Companies Act, 2013, the company has to repay all the amounts it gets deposited and also the interest due thereon before going for capital reduction.
  5. Consent of Creditors: The written consent of the creditors is required for the company which is going for capital reduction. The court requires the company to secure the interest of the dissenting creditors. The company gets the permission of the court after the court thinks fit that reduction of capital will not harm the interest of the creditors.
  6. Public Notice: The company has to make a public notice as per the directions of the tribunal stating that the company is resorting to capital reduction. Also, the company has to state the valid reasons for the same.

Methods of Internal Reconstruction:

Alteration of Share Capital: Section 61 to 64 of Companies Act, 2013 deals with alteration of share capital. It may take the form of fresh issue of new shares, conversion of fully paid shares with stock, cancellation of unissued capital, consolidation of existing shares and subdivision of existing shares.

Memorandum of Association contains capital clause of a company. A company, limited by shares, can alter this capital clause, if is permitted by

  1. The Articles of Association of the company
  2. If a resolution to this effect is passed by the company in the general meeting.

A company can alter share capital in any of the following ways:

A) The company may increase its capital by issuing new shares.

B) It may consolidate the whole or any part of its share capital into shares of larger amount.

C) It may convert shares into stock or vice versa.

D) It may sub-divide the whole or any part of its share capital into shares of smaller amount.

E) It may cancel those shares which have not been taken up and reduce its capital accordingly.

Variation of Shareholders right: Section 48 of the Companies Act 2013 states that where a share capital of the company is divided into different classes of shares, the rights attached to the shares of any class may be varied with the consent in writing of the holders of not less than three-fourths of the issued shares of that class or by means of a special resolution passed at a separate meeting of the holders of the issued shares of that class.

Reduction of Share Capital: Section 66 of the Companies Act 2013 provides that subject to confirmation by the Tribunal on an application by the company, a company limited by shares or limited by guarantee and having a share capital may, by a special resolution, reduce the share capital in any manner and in particular, may:

(a) extinguish or reduce the liability on any of its shares in respect of the share capital not paid-up; or

(b) either with or without extinguishing or reducing liability on any of its shares:

(i) cancel any paid-up share capital which is lost or is unrepresented by available

assets; or

(ii) pay off any paid-up share capital which is in excess of the wants of the company.

Compromise/Arrangement: A scheme of compromise and arrangement is an agreement between a company and its members and outside liabilities when the company faces financial problems. Such an arrangement, therefore, also involves sacrifices by shareholders, or creditors and debenture holders or by all.

Surrender of Shares: In this method, shares are divided into shares of smaller denominations and then the shareholders are made to surrender their shares to the company. These shares are then allotted to debenture holders and creditors so that their liabilities are reduced. The unutilized surrendered shares are then cancelled by transferred to Reconstruction Account.

Accounting Treatment

There are so many reasons which arises the need for internal reconstruction are as-financial position does not show a true and fair view, assets do not present true book values, overdue outside liabilities and inflated share capital. Thus, reorganize the company by revaluing the assets, reduction in liabilities and capital through internal reconstruction. Hence, no new company is formed. Therefore, it only involves the internal overhauling or reorganization of the company. It involves the issue of fresh share capital, sub-division of shares and cancellation of unsubscribed share capital.

Also, there is reduction of share capital and outside liabilities like creditors etc to reduce their claim. An imperative feature of internal reconstruction is the necessary corrections in the assets of the balance sheet which involves removal of useless intangible assets, accumulated losses and a proper valuation of tangible fixed assets.

There are various methods which are generally used to improve the financial position of a firm are as-Alteration of share capital, change in shareholders rights, reduction of share capital, compromise and arrangement, surrender of shares. Under alteration of share capital, it is done by issue of new share capital, consolidation of shares of smaller nominal value into shares of higher nominal value etc. Therefore, alteration does not mean any reduction of share capital.

When a company issues different classes of shares with which different rights are attached to such shares for example right as to dividend, voting rights etc and however any of the right can be changed. For example, the company may change rate of dividend on preference shares without changing the amount of share capital. Hence, it all comes under the change in shareholders rights. Reduction of share capital may take place in more than one way viz reducing the liability in respect of uncalled or unpaid amount, reducing by refunding the excess capital, reducing the paid up capital. Compromise and arrangement is an agreement between a company and its members and outside liabilities when a company faces any financial problems, shareholders, creditors etc sacrifices their share of profit or claim and it is credited to the reconstruction account. Internal reconstruction does not involve the take over of the business.