Corporate Financial Reporting · Internal Reconstruction (Capital Reduction)

Reconstruction Schemes with Debenture and Creditor Claims

Updated 11 October 2026 · Fact-checked

In an internal reconstruction, debenture holders, creditors and preference shareholders agree to take less than their claims. Each sacrifice is credited to the Capital Reduction Account. You then debit losses, fictitious assets and crystallised contingent liabilities to it. Any balance goes to Capital Reserve. Then you prepare the revised balance sheet.

Understand Reconstruction Schemes with Debenture and Creditor Claims

A company with accumulated losses cannot pay dividends or raise fresh money easily. Internal reconstruction cleans up the balance sheet without winding up the company. Shareholders, and often debenture holders and creditors, give up part of what they are owed. The lost value is used to write off losses and overstated assets.

For debenture holders and creditors, the key idea is sacrifice. Sacrifice is the old claim minus what they actually receive under the scheme. They may receive new debentures, shares, cash, or a lower claim on the same debt. The sacrifice is a gain to the company, so you credit it to the Capital Reduction Account.

Contingent liabilities are not in the books. Treat them in one of two ways. If the scheme says the claim will be met or provided for, create a liability or provision and debit the Capital Reduction Account. If the scheme says nothing, leave it as a note. Arrears of cumulative preference dividend are also not in the books because no dividend was declared. If holders waive them, pass no entry. If the scheme settles them with shares, debentures or cash, debit the Capital Reduction Account for the amount settled.

The law supports this. Under section 230 of the Companies Act, 2013, the Tribunal can order meetings of creditors or members to consider a compromise or arrangement. The scheme binds everyone only if a majority representing three-fourths in value of those voting agrees and the Tribunal sanctions it. The company's auditor must also file a certificate that the proposed accounting treatment conforms to the accounting standards prescribed under section 133. The company must file the Tribunal's order with the Registrar within thirty days of receiving it. The Act also says that section 66 does not apply to a capital reduction made under a Tribunal order under section 230.

Exam questions test whether you can treat every item in the scheme correctly and make the balance sheet balance. The Capital Reduction Account should close to nil, or to a small balance that you move to Capital Reserve.

Key rules to remember

Sacrifice by debenture holders or creditors: Sacrifice = Old claim − (face value of new securities + cash + any other consideration); Credit the sacrifice to Capital Reduction Account. If the scheme gives them shares, use the face value of the shares issued, not the market value.
Arrears of cumulative preference dividend: Arrears = Rate % × Face value of preference shares × Number of years unpaid; Not a liability in the books. Pass an entry only when the scheme settles it, and then only for the amount settled. If waived, there is no entry.
Contingent liability crystallised under the scheme: Dr Capital Reduction A/c; Cr Liability or Provision for the claim; Do this only when the scheme says the claim is to be provided for or paid. Otherwise disclose it as a note.
Capital Reduction Account balance: Total credits (reduction of capital + sacrifices) − Total debits (losses, write-offs, settlements, provisions); A credit balance goes to Capital Reserve. A debit balance means you missed a credit item. Check the scheme again.
Section 230 approval rule: Majority in number representing three-fourths in value of those voting + Tribunal sanction; The Tribunal may dispense with a creditors' meeting if creditors holding at least ninety per cent in value confirm the scheme by affidavit.
Balance sheet check: Total assets after scheme = Total capital and liabilities after scheme; A mismatch means a wrong entry or a missed item.

How to solve Reconstruction Schemes with Debenture and Creditor Claims questions

Follow the same order for every reconstruction question. Do not start with the balance sheet. Start with the scheme, clause by clause.

1Read the whole scheme and list every clause: share capital, preference shares and arrears, debentures, creditors, contingent liabilities, asset write-offs, and new issues.
2Open a Capital Reduction Account. Under each clause, note whether it is a credit (a reduction or sacrifice) or a debit (a loss, write-off or amount settled).
3Pass entries for share capital first. Debit the old capital at its old value, credit the new capital at its new value, and credit the difference to Capital Reduction Account.
4Deal with debenture holders and creditors. Work out sacrifice as old claim less consideration given. Credit the sacrifice to Capital Reduction Account. Record new debentures, shares or cash separately.
5Deal with arrears of preference dividend and contingent liabilities. Pass an entry only if the scheme settles or provides for them. Otherwise leave them out of the books and show them as a note.
6Write off the P&L debit balance, goodwill and other fictitious assets. Reduce the overstated assets by the stated amounts. Debit all of these to Capital Reduction Account.
7Close the Capital Reduction Account. Move any credit balance to Capital Reserve. Check it matches your total of credits less debits.
8Prepare the revised balance sheet, one line at a time, from the old figures plus your entries. Check that both sides total the same.

Quickest way: Capital Reduction Account first, journal later

When to use it: Use this when the question asks only for the Capital Reduction Account or the revised balance sheet, and time is short.

Draw the Capital Reduction Account with two columns before you write any journal.
List credits: reduction in equity and preference capital, plus the sacrifice from each debenture and creditor clause.
List debits: P&L debit, goodwill, asset write-offs, provisions for crystallised contingencies, and any arrears settled.
Total both sides. The difference must be zero or a credit that goes to Capital Reserve.
Build the new balance sheet by adjusting only the lines the scheme touches. Leave all other lines as they are.
Add up both sides of the new balance sheet. If they differ, look first at issues of shares or debentures and at provisions.

Common mistakes in Reconstruction Schemes with Debenture and Creditor Claims

Passing an entry for arrears of preference dividend when the holders simply waive them.
Students treat arrears as a liability because they are owed under the share terms.
Fix: Arrears on cumulative preference shares are not booked until dividend is declared. If waived, pass no entry. Debit the Capital Reduction Account only for the part settled by shares, debentures or cash.
Crediting the whole old debenture amount to Capital Reduction Account.
Students forget that debenture holders get new securities in exchange.
Fix: Credit only the sacrifice: old debentures less the face value of new debentures, shares and cash given. Record the new securities in their own accounts.
Recording a contingent liability as a liability when the scheme does not mention it.
Students think every contingent liability must be cleared in a reconstruction.
Fix: Provide for it only when the scheme says it will be met or provided for. Otherwise show it as a note below the balance sheet.
Using market value for shares issued to creditors or debenture holders.
Students mix reconstruction with business combination accounting.
Fix: Use the face value stated in the scheme. Any difference from the old claim is sacrifice or gain, and it goes to Capital Reduction Account.
Leaving a balance in the Capital Reduction Account without moving it.
Students stop once the entries are done.
Fix: Close the account. Transfer a credit balance to Capital Reserve. If a debit balance appears, recheck the clauses for a missed credit.
Forgetting the effect of the scheme on shares issued to settle arrears or debentures.
The share capital line is built from the old balance sheet figure only.
Fix: Add the shares issued under each clause to the new equity share capital line and count the total shares.

Worked examples

Example 1

Sunrise Ltd has these balances: Equity share capital 50,000 shares of ₹10 each fully paid ₹5,00,000; 8% cumulative preference share capital 2,000 shares of ₹100 each ₹2,00,000; 10% debentures ₹3,00,000; Creditors ₹2,00,000. Assets: Goodwill ₹1,00,000; Plant ₹4,50,000; Stock ₹2,00,000; Debtors ₹2,00,000; Profit and Loss Account (debit) ₹2,50,000. Preference dividend is in arrears for two years. A damages claim of ₹30,000 against the company is not provided for. Scheme: (1) Equity shares become ₹4 each fully paid. (2) Preference shares become ₹70 each. (3) Arrears of preference dividend are settled by issuing 8,000 equity shares of ₹4 each. (4) Debenture holders accept ₹2,50,000 of new 12% debentures and 10,000 equity shares of ₹4 each in full settlement. (5) Creditors reduce their claim by ₹50,000. (6) The damages claim is to be provided for in full. (7) Write off goodwill and the P&L balance, and reduce stock by ₹8,000. Pass the journal entries and prepare the revised balance sheet.

Show the solution

Arrears: 8% × ₹2,00,000 × 2 years = ₹32,000. The scheme settles this with 8,000 shares of ₹4 = ₹32,000.
Equity: Dr Equity share capital (₹10) ₹5,00,000; Cr Equity share capital (₹4) ₹2,00,000; Cr Capital Reduction A/c ₹3,00,000.
Preference: Dr Preference share capital ₹2,00,000; Cr Preference share capital (₹70) ₹1,40,000; Cr Capital Reduction A/c ₹60,000. (2,000 × ₹30 = ₹60,000.)
Arrears: Dr Capital Reduction A/c ₹32,000; Cr Equity share capital ₹32,000.
Debentures: sacrifice = ₹3,00,000 − ₹2,50,000 − ₹40,000 = ₹10,000. Dr 10% Debentures ₹3,00,000; Cr 12% Debentures ₹2,50,000; Cr Equity share capital ₹40,000; Cr Capital Reduction A/c ₹10,000.
Creditors: Dr Creditors ₹50,000; Cr Capital Reduction A/c ₹50,000.
Damages claim: Dr Capital Reduction A/c ₹30,000; Cr Provision for damages ₹30,000.
Write-offs: Dr Capital Reduction A/c ₹3,58,000 (goodwill ₹1,00,000 + P&L ₹2,50,000 + stock ₹8,000); Cr Goodwill ₹1,00,000; Cr P&L A/c ₹2,50,000; Cr Stock ₹8,000.
Capital Reduction A/c: credits ₹3,00,000 + ₹60,000 + ₹10,000 + ₹50,000 = ₹4,20,000. Debits ₹32,000 + ₹30,000 + ₹3,58,000 = ₹4,20,000. The account closes to nil.
Equity shares now: 50,000 + 8,000 + 10,000 = 68,000 shares × ₹4 = ₹2,72,000.
Revised balance sheet. Liabilities: Equity share capital ₹2,72,000; Preference share capital ₹1,40,000; 12% Debentures ₹2,50,000; Creditors ₹1,50,000; Provision for damages ₹30,000; total ₹8,42,000. Assets: Plant ₹4,50,000; Stock ₹1,92,000; Debtors ₹2,00,000; total ₹8,42,000.

Answer: The Capital Reduction Account closes to nil. The revised balance sheet totals ₹8,42,000, with equity capital ₹2,72,000 (68,000 shares of ₹4), preference capital ₹1,40,000, 12% debentures ₹2,50,000, creditors ₹1,50,000 and a provision of ₹30,000.

Example 2

Zenith Ltd proposes a reconstruction. Equity share capital is to be reduced by ₹4,00,000. Debentures of ₹6,00,000 are settled by ₹4,00,000 of new debentures and equity shares of ₹1,00,000. Creditors waive ₹60,000. The P&L debit balance is ₹3,50,000, goodwill is ₹80,000, and fixed assets are to be written down by ₹70,000. A contingent liability of ₹45,000 is to be provided for. Cumulative preference dividend arrears of ₹40,000 are waived by the holders. Find the balance of the Capital Reduction Account and say where it goes.

Show the solution

Credits: equity capital reduction ₹4,00,000.
Credits: debenture sacrifice = ₹6,00,000 − ₹4,00,000 − ₹1,00,000 = ₹1,00,000.
Credits: creditors' waiver ₹60,000. Total credits = ₹4,00,000 + ₹1,00,000 + ₹60,000 = ₹5,60,000.
Debits: P&L ₹3,50,000 + goodwill ₹80,000 + fixed asset write-down ₹70,000 + provision for contingent liability ₹45,000 = ₹5,45,000.
Arrears of ₹40,000 are waived. They were never recorded, so there is no entry and no effect on the account.
Balance = ₹5,60,000 − ₹5,45,000 = ₹15,000 credit. Transfer it to Capital Reserve: Dr Capital Reduction A/c ₹15,000; Cr Capital Reserve ₹15,000.

Answer: The Capital Reduction Account shows a credit balance of ₹15,000, which is transferred to Capital Reserve. The waived arrears have no effect.

Exam tips

Read the scheme once for headings, then again clause by clause. Tick each clause as you pass its entry so you do not miss any item.
State your treatment of arrears of preference dividend and contingent liabilities in one line. For example: arrears waived, no entry. This earns marks even if a figure goes wrong.
Show working notes for sacrifice on debentures and creditors. Examiners award marks for the working even if the final balance sheet is off.
In MCQs, check whether the question asks for the Capital Reduction Account balance, the Capital Reserve, or the total number of shares. These are different figures from the same working.
If a written question asks about legal steps, mention the three-fourths in value voting requirement, Tribunal sanction, the auditor's certificate on accounting treatment, and filing of the order with the Registrar within thirty days.

Practice questions from Internal Reconstruction (Capital Reduction)

Reconstruction Schemes with Debenture and Creditor Claims: frequently asked questions

How do you treat arrears of preference dividend in internal reconstruction?

Arrears on cumulative preference shares are not recorded as a liability. If the holders waive them, pass no entry. If the scheme settles them with shares, debentures or cash, debit Capital Reduction Account for the amount settled and credit the matching account.

What is the entry for debenture holders who accept less than their claim?

Debit old Debentures at the full claim. Credit new debentures, shares or cash at the amounts given. Credit the difference, which is the sacrifice, to Capital Reduction Account.

How is a contingent liability treated in a reconstruction scheme?

It stays as a note unless the scheme says it will be paid or provided for. If it does, debit Capital Reduction Account and credit a liability or provision. The scheme decides the treatment.

Does a reconstruction scheme need court approval?

A compromise or arrangement with creditors or members under section 230 of the Companies Act, 2013 needs approval by a majority representing three-fourths in value of those voting, and sanction by the Tribunal. The auditor must also certify that the accounting treatment conforms to the prescribed accounting standards.

What happens to the balance in the Capital Reduction Account?

After all credits and debits are posted, a credit balance is transferred to Capital Reserve. If the account shows a debit balance, recheck the scheme for a missed credit item.