Internal Reconstruction of Companies

Activity

Before learning about Internal Reconstruction of Companies, lets take up a task and answer few questions. 

We will check out the following two Balance Sheets and understand which is a healthier one.

Looking at the above Balance Sheets, Company A seems to be a smaller company whereas Company B seems to be a bigger company. But what matters more with respect to sound financial status is the content present in the Balance Sheet. Company A's Balance Sheet has a very favorable debt equity ratio with a decent amount of reserves, which means the Company is able to retain its earning. Hence, there's a possibility for growth. In short, the Company is doing well!

But on the other hand, Company B has no reserves and surplus. Moreover, it shows a very unfavorable Debt Equity Ratio and Current Ratio thereby creating risk of long term as well as short term insolvency. Over and above, the Company has Goodwill (Capital Loss, as it cannot be converted into money) and Profit and Loss A/c Debit Balance which represents accumulated losses. Hence, it can be proven that Company B is unstable and requires immediate attention. It can either be dissolved, or taken over or restructured financially with the consent of the stakeholders duly approved by the National Company Law Tribunal. 

Lets understand the process of Internal Reconstruction in detail....

Internal Reconstruction is a form of capital re-organization which is governed by Sec 61 to 66 of Indian Companies Act, 2013. The guidelines talk about steps to revive a company from getting knocked out due to losses. It involves arrangement of a scheme with the consent from various stakeholders of an organization duly approved by the National Company Law Tribunal leading to sacrifice a part of their claims. To be precise, shareholders, debenture holders, creditors and other payables are the ones who agree to sacrifice a part of their outstanding amount which is used to write off the existing obsolete, preliminary, capital and accumulated losses. 

Objectives of Internal Reconstruction 

The major objectives of reconstruction are listed below:

1. To resolve the problem of over-capitalization/huge accumulated losses/over valuation of assets and under provision of liabilities. 

2. To simplify the complex capital structure of a company.

3. To alter the the face value and paid up value of shares of the company so as to make shares fully paid up or call in more funds respectively.

4. To use the existing reserves and surplus for writing off accumulated losses & writing down overstated assets. 

5. To raise fresh capital by issue of new shares. 

6. To alter the memorandum of association of the company. 

7. To generate cash for working capital needs, asset replacement, to add balancing equipment’s, modernize plant & machinery etc. 

Conditions/Provisions regarding Internal Reconstruction 

The following conditions have to be fulfilled by an organization while executing the scheme of Internal Reconstruction:

1. Authorization by Articles of Association: The company must be authorized by its articles of association to execute capital reduction. Articles of association contains all the details regarding the internal affairs of the company and mention the clause containing the most appropriate manner of reducing the 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 in favor 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 National Company Law Tribunal: The company must get the due permission from the National Company Law Tribunal before starting the process of the capital reduction. The tribunal grants permission only if it is satisfied only if 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 creditors who disagree to the scheme. The company gets the permission of the tribunal after the tribunal 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 

There are various methods of Internal reconstruction as stated below:

1. Alteration of Share Capital:

Alteration of Share Capital is dealt by Section 61 to 64 of the Indian Companies Act, 2013. This should be permitted by the Articles of Association and a Board Resolution to this effect should have been passed in a 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.

Bank A/c.... Dr

To Share Capital A/c (Equity / Preference)

(b) The Company may consolidate the whole or any part of its share capital into shares of larger amount.

Eg. Consolidation of 1000 Equity Shares of Rs. 10 each into 100 Equity Shares of Rs. 100 each.

Equity Share Capital A/c.... Dr   (Rs. 10 X 1000 shares)  Old

To Equity Share Capital A/c        (Rs. 100 X 100 shares) New

Note: The New Equity Shares of Face Value Rs. 100 will appear in the New Balance Sheet.

(c) The Company may sub-divide the whole or any part of its share capital into shares of smaller amount.

Eg. Sub-division of 100 Equity Shares of Rs. 100 each into 1000 Equity Shares of Rs. 10 each.

Share Capital A/c.... Dr (Rs.100 X 100 shares) Old

To Share Capital A/c (Rs. 10 X 1000 shares) New

Note: The New Equity Shares of Face Value Rs. 10 will appear in the New Balance Sheet.

(d) The Company may convert Equity Shares into Equity Stock.

Equity Share Capital A/c.... Dr

To Equity Stock A/c

Note: Equity Stock will appear in the New Balance Sheet.

(e) The Company convert Equity Stock into Equity Share Capital.

Equity Stock A/c.... Dr

To Equity Share Capital A/c

Note: Equity Share Capital will appear in the New Balance Sheet.

(e) The Company may cancel those shares which have not been taken up and reduce its capital accordingly. 

No entry need to be passed for cancelling unissued shares

2. Variation of Shareholder's Rights:

A scheme where existing rights enjoyed by shareholders are altered. Perhaps, by way of dividend or participative rights, etc. 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 75% 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. 

(a) Reduction in Dividend Rate of Preference Shares from 10% to 8%

10% Preference Share Capital A/c.... Dr (Old)

To 8% Preference Share Capital A/c (New)

Note: The new Preference Share Capital @ 8% will appear in the new Balance Sheet.

(b) Converting Cumulative Preference Share Capital to Non-Cumulative Preference Share Capital without any change in the amount of Preference Share Capital

10% Cumulative Preference Share Capital A/c.... Dr (Old)

To 10% Non-Cumulative Preference Share Capital A/c (New)

Note: 10% Non-Cumulative Preference Share Capital will appear in the new Balance Sheet.

3. Reduction of Share Capital:

A scheme where share capital is reduced by way of sacrifice, contributing to Capital Reduction as per Section 66 of the Companies Act, 2013. It not so far not applicable on redeemable preference shares, forfeiture of shares on non-payment of calls, surrender of shares and cancelation of shares.

(a) Reduction in Face Value only and not Paid up Value of Equity Shares (From Rs. 100 to Rs. 90)

Equity Share Capital A/c.... Dr (FV: Rs. 100; PUV: Rs. 90)

To Equity Share Capital A/c (FV: Rs. 90; PUV: Rs. 90)

Note: Equity Share Capital of Rs. 90 will appear in the new Balance Sheet thereby making shares fully paid up. 

(b) Reduction in Paid Up Value only and not Face Value of Equity Shares (From Rs. 100 to Rs. 10)

Share Capital A/c.... Dr (Rs. 90 X no. of shares)

To Capital Reduction A/c (Rs. 90 X no. of shares)

Note: As there is no change in the Face Value of the shares, the same account i.e. Equity Shares of Rs. 100 each will be shown in the new Balance Sheet. But the paid up value will be Rs. 10 for 'x' number of shares as Rs. 90 per share has been sacrificed. This gives chance to the Company to call in funds from the shareholders to make the shares fully paid up.

(c) Reduction in both Face Value and Paid Up value of Equity Shares (From Rs. 100 to Rs. 10)

Equity Share Capital A/c.... Dr (Rs. 100)

To Equity Share Capital A/c (Rs. 10)

To Capital Reduction A/c (Rs. 90)

Note: Equity Share Capital of Rs. 10 will appear in the new Balance Sheet with a paid up value of Rs. 10, thereby making the shares fully paid up. Here, Rs. 90 per share has been sacrificed.

(d) Surrender of Equity Shares

(i) On surrender of shares

Share Capital A/c.... Dr

To Shares Surrendered A/c

(ii) Re-issue of surrendered shares

Shares Surrendered A/c.... Dr

To Share Capital A/c

(iii) Cancellation of surrendered shares

Shares Surrendered A/c.... Dr

To Capital Reduction A/c

4. Compromise/Arrangement: 

A scheme where claims and arrangements pertaining to reserves and surplus, preference shares, debentures, creditors are partly sacrificed. 

(a) Sacrifice of Reserves 

Reserves A/c.... Dr (Extent of reserves transferred to Capital Reduction A/c)

To Capital Reduction

Note: In the above entry, existing reserves are sacrificed and transferred to Capital Reduction A/c.

(b) Revaluation of Assets (Increased Value)

Assets A/c.... Dr (Amount of Overvaluation)

To Capital Reduction A/c

Note: In the above entry asset value increases, hence debit. This increase is credited to Capital Reduction A/c.

(c) Sale of Assets at Profit

Bank A/c.... Dr (Sale Value)

To Assets A/c (Book Value)

To Capital Reduction A/c (Profit Amount)

Note: In the above entry, profit on sale of asset is credited to Capita Reduction A/c. If loss, it will be debited. 

(d) Third Party Liability Sacrificed

Liability / Provision A/c.... Dr

To Capital Reduction A/c

Note: In the above entry, liability holders forego a part of their claim and it reduces, hence debit. This sacrificed amount will be credited to Capital Reduction A/c.

(e) Payment to Third Party Liabilities

Liability A/c.... Dr

To Bank A/c

To Assets A/c

To Equity Share Capital / Preference Share Capital A/c

Note: In the above entry, liabilities are fully or partly settled by issue of cash or assets or fresh shares.

(f) Arrears of Preference Dividend Paid

• Creation of Dividend Payment Liability towards Preference Shareholders

Capital Reduction A/c.... Dr

To Preference Shareholders A/c

Note: In the above entry, a short term payable is created in name of Preference Shareholders (credit) using balance from Capital Reduction A/c.

• Payment of Dividend to Preference Shareholders

Preference Shareholders A/c.... Dr

To Bank A/c

Note: In the above entry, payment is made to the Preference Shareholders, eliminating the short term liability created in the previous entry.

5. Utilization of Capital Reduction Balance

(a) For writing-off Intangible Assets / Obsolete Assets / Fictitious Assets

Capital Reduction A/c.... Dr

To Profit & Loss A/c (shown as debit balance in the old Balance Sheet)

To Miscellaneous Expenses not written-off A/c

To Goodwill A/c

Note; In the above entry, balance of Capital Reduction A/c is utilized to remove the existing debit balances of Profit & Loss A/c, Goodwill and Miscellaneous Expenses. Hence, credit. A credit entry is given here against the exiting debit balances of the above accounts so as to settle them (make them NIL).

(b) For writing down Fixed and Current Assets

Capital Reduction A/c.... Dr

To Fixed / Current Assets A/c

Note: In the above entry, balance of Capital Reduction A/c is utilized to bring down the value of Fixed and Current Assets, it resolved. Hence credit assets.

(c) For recording new Liability / Provision

Capital Reduction A/c.... Dr

To Liability / Provision A/c

Note: In the above entry, balance of Capital Reduction A/c is used to create a liability. When liability creates, credit liability.

(d) For Reconstruction Expenses

Capital Reduction A/c.... Dr

To Bank A/c

(e) Transfer of Balance of Capital Reduction A/c to Capital Reserve A/c

Capital Reduction A/c.... Dr

To Capital Reserve A/c

Note: Incase of excess balance in Capital Reduction A/c, the same should be transferred to Capita Reserve A/c which is then shown under Reserves and Surplus in the new Balance Sheet.