Internal Reconstruction and Capital Reduction: Entries and Balance Sheet

Understand Internal Reconstruction and Capital Reduction

Key rules to remember

Reduction in equity share capital

Number of shares × (old paid-up value per share − new paid-up value per share)

Debit Equity Share Capital (old) and credit Capital Reduction Account. Then re-issue at the new face or paid-up value.

Sacrifice by creditors or debenture holders

Old claim − amount agreed to be accepted

Debit the liability, credit Capital Reduction Account. Any amount settled in cash or fresh securities is a separate entry.

Capital Reduction Account closing rule

Total credits (all sacrifices and gains) = Total debits (all write-offs and losses)

Use the account to write off the debit balance of the Statement of Profit and Loss, goodwill, other intangibles, fictitious assets and asset write-downs. Any credit balance left goes to Capital Reserve.

Balance sheet check after the scheme

Total assets (after write-offs) = Equity + Preference + Debentures + Other liabilities (after sacrifices)

The Statement of Profit and Loss debit balance must be nil after the scheme unless the scheme says otherwise.

Entry for write-off of losses and assets

Capital Reduction A/c Dr. to Statement of Profit and Loss, Goodwill, Other assets (write-down)

Pass a single compound entry. Any asset appreciated is credited to Capital Reduction Account instead.

How to solve Internal Reconstruction and Capital Reduction questions

1. 1Read the scheme line by line and list every item: each class of shareholder, debenture holders, creditors, assets to be written off or revalued, new shares or securities to be issued, and expenses of the scheme.
2. 2Compute each sacrifice in rupees and pass entries for the reduction of share capital, for example Equity Share Capital (old) Dr. to Equity Share Capital (new) and to Capital Reduction Account.
3. 3Pass entries for liabilities settled below book value: Liability Dr. to Capital Reduction Account for the amount given up.
4. 4Pass entries for fresh issues, payments in cash, conversion of debentures or creditors into shares, and scheme expenses (debit Capital Reduction Account for expenses of reconstruction if the scheme says so).
5. 5Pass one compound entry: Capital Reduction Account Dr. to Statement of Profit and Loss, Goodwill, Preliminary expenses and asset write-downs. Show any asset appreciation as a credit.
6. 6Post the Capital Reduction Account. Check that it closes to nil. If a credit remains, transfer it to Capital Reserve.
7. 7Prepare the balance sheet after reconstruction using the revised balances. Check that assets equal equity plus liabilities, and show new share capital at the revised paid-up amount.

Quickest way: Capital Reduction Account shortcut

Common mistakes in Internal Reconstruction and Capital Reduction

• Writing off the Statement of Profit and Loss debit balance directly against share capital

  Students want to shorten the entries and forget that the sacrifice must pass through a clearing account.

  Fix: Always credit the Capital Reduction Account with sacrifices and debit it with write-offs. Do not net capital against losses directly unless the question says so.

• Treating a reduction in face value as a reduction in the number of shares

  The words reduce capital sound like fewer shares.

  Fix: Check whether the scheme changes the value per share or the number of shares. Compute the reduction as shares × change in value per share, or as the number of shares cancelled × value, as stated.

• Leaving a balance in the Capital Reduction Account without explanation

  A write-off or a sacrifice is missed, or an asset is not written to the figure given in the scheme.

  Fix: Recheck every item of the scheme. If the balance remains after all items, transfer it to Capital Reserve and say why.

• Forgetting scheme expenses or fresh issue proceeds in the cash balance

  These appear in a note at the end of the question.

  Fix: Tick off each point of the scheme as you pass its entry. Adjust the bank balance for every cash receipt and payment.

• Confusing internal reconstruction with amalgamation or external reconstruction

  All three are called restructuring and all can involve write-offs.

  Fix: Ask whether a new or other company takes over the business. If not, and there is no purchase consideration, it is internal reconstruction.

• Showing preference share dividend arrears as a liability without checking the scheme

  Arrears are mentioned in the question and students assume they must be provided for.

  Fix: Dividend arrears are not a liability until declared. Include them only if the scheme says they are to be paid or waived, and record the waiver as a sacrifice.

Worked examples