St.

Joseph’s College of Commerce, Bangalore (Autonomous)

INTERNAL RECONSTRUCTION

Reconstruction: It is an agreement between the company and its members and creditors (both
Long-term creditors and short-term creditors), when the company faces financial problems. It
involves sacrifices by shareholders, or creditors and debenture holders or by all.

Types of Reconstruction:

There are two types of reconstruction, namely External Reconstruction and Internal Reconstruction.

a) External Reconstruction: Where a new company is formed by transferring the undertaking of

an existing company, it is known as External Reconstruction.
b) Internal Reconstruction: Where the affairs of the company are re-aligned, without liquidating
the company and forming a new company is called Internal Reconstruction.
Internal reconstruction of a company is done through the reorganisation of its share capital. It
is a scheme of reorganisation in which all interested parties in the capital structure volunteer to
sacrifice. They are the company's shareholders, debenture holders, creditors etc.

Differences between Internal and External Reconstruction

Internal Reconstruction External Reconstruction

Existing Company is not liquidated.
No new company is formed, but only the rights
of shareholders and creditors are changed.
This requires court’s confirmation.
It is a slow and tedious process.
There is a certain reduction of capital and
sometimes outside liabilities like debenture
holders and creditors.
This involves the setting off of fictitious assets
and losses.
Past losses can be carried forward and set-off
against future profits for tax purposes.
Existing company is liquidated and wound up.
A new company is formed to take over the
Liquidated company.
This does not require court’s confirmation.
It can be carried out easily.
There is no reduction of capital. In fact there is a
fresh issue of share capital of the new company
This does not involve setting off of fictitious
assets and losses.
The business will technically end when the
company is liquidated. Hence, past losses
cannot be carried forward and set-off against
future profits for tax purposes.

Objectives of Internal Reconstruction

1. To retain Creditors, specially bank overdraft and debenture-holders in the company.

External Reconstruction will involve payment of claims to outsiders.
2. To set off its past losses against future profits for income-tax purposes. This will materially
reduce the income-tax liability depending on the losses suffered during the preceding eight
years. Losses can be carried forward for eight years provided the business is carried on.

Procedure for Internal Reconstruction

1. A company cannot reduce its share capital unless it is authorized by its articles. However, if the
company’s articles does not permit capital reduction, then the company must pass a special
resolution to reduce its share capital.

Mr. Jayakumar Nair, B. Com., FCA. Page 1

 St. Joseph’s College of Commerce, Bangalore (Autonomous)

2. The company must apply to the court for an order confirming the capital reduction. The court
will look into the interest of creditors and shareholders’ before passing the order confirming the
capital reduction.
3. The order of the court confirming capital reduction has to be produced before the Registrar of
Companies and a certified copy of the order and the minutes of capital reduction should be filed
with the Registrar of Companies for registration.

Aspects covered in Internal Reconstruction:

a) Re-statement of capital by reducing the paid-up value of shares, (both equity and preference)
and / or varying the rights attached to different classes of shares.
b) Re-assessment of liabilities by seeking waiver/reduction/remission of liability from creditors and
lenders (including debenture holders, if any), recording previously unrecorded liability, etc.
c) Revaluation of assets to a realistic value.
d) Writing off of fictitious assets and losses.

Methods generally adopted in Internal Reconstruction:

a) Alteration of Share Capital.

b) Variation of shareholders’ rights.
c) Reduction of Share Capital.
d) Compromise and arrangement.
e) Surrender of shares.

Capital Reduction Account:

It is an account that shows the sacrifices made by various parties, viz. equity shareholders,
preference shareholders, debenture-holders, creditors, etc., to the company and how these
sacrifices have been used in writing-off accumulated losses, intangible assets, over-valuation of
assets, etc. Any balance in this account is transferred to Capital Reserve Account.

JOURNAL ENTRIES FOR VARIOUS TRANSACTIONS IN THE COURSE OF INTERNAL RECONSTRUCTION

1. Reduction of Share Capital by reducing paid-up value of shares, without reducing face value
(Say Rs. 100 face value retained, but Rs. 100 paid up is reduced to Rs. 15 paid up)
Equity Share Capital A/c Dr 85
To Capital Reduction A/c 85
2. Reduction of Share Capital by reducing both face value and paid up value. (Say Rs. 100
reduced to Rs. 15)
Equity Share Capital (Rs. 100) A/c Dr 100
To Equity Share Capital (Rs. 15) A/c 15
To Capital Reduction A/c 85
3. Variations of Shareholders’ rights without affection Reconstruction A/c.
…. % Preference Share Capital A/c (old) Dr
To ….. % Preference Share Capital A/c (new)

4. Conversion of Fully paid Shares into Stock

Mr. Jayakumar Nair, B. Com., FCA. Page 2

 St. Joseph’s College of Commerce, Bangalore (Autonomous)

Equity Share Capital A/c Dr

To Equity Stock A/c
5. Sub-division and consolidation of shares (say Rs. 100 shares divided into 10 shares of Rs. 10
each)
Equity Share Capital A/c (Rs. 100) Dr
To Equity Share Capital A/c (Rs. 10)
6. Shareholders giving up their claim to Reserves and Accumulated profits
Reserves (individually) A/c Dr
To Capital Reduction A/c
7. Shares surrendered and cancelled subsequently
Equity Share Capital A/c Dr
To Shares Surrendered A/c

Shares Surrendered A/c Dr

To Capital Reduction A/c
8. Downward Revaluation of Assets
Capital Reduction A/c Dr
To Sundry Assets (individually) A/c
9. Upward Revaluation of Assets
Sundry Assets (individually) A/c
DrTo Capital Reduction A/c
10. Sacrifices made by Debenture holders, Creditors, etc., by agreeing for a lower amount of
dues payable to them.
External Liabilities (individually) A/c Dr
To Bank A/c (to the extent payment made immediately)
To Capital Reduction A/c
11. Expenses of reconstruction and previously unrecorded liability paid.
Capital Reduction A/c Dr
To Bank A/c
12. Provisions settled at higher amount than appearing in the Balance Sheet
Provisions (individually as per B/S) A/c
Dr
Capital Reduction A/C
DrTo Bank A/c (total amount paid immediately)
13. Writing off of Fictitious Assets, Intangible Assets and losses.
Capital Reduction A/C Dr
To Fictitious Assets (individually) A/c
To Profit and Loss A/c (Dr. balance in any)
14. Transferring the balance left in reconstruction account to Capital Reserve A/c
Capital Reduction A/c Dr
To Capital Reserve A/c
Meaning of Equity Stock: Equity Stock is the aggregate of fully paid-up shares of a member, merged
into one fund of equal value. Stock can be divided into fractions of any amount. Any part of the
fund can be transferred. However, Companies may restrict the transfer of stock to multiples of, say,
Rs. 100.

Mr. Jayakumar Nair, B. Com., FCA. Page 3