Internal reconstruction is a process through which the capital structure of a company is reorganized without affecting its legal existence. This means that the company continues to exist in its original form, but its share capital, assets, and liabilities may be restructured to improve the financial position of the company. After the completion of internal reconstruction, the company prepares its balance sheet to reflect the changes that have been made.
Reasons of Internal Reconstruction:
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To Eliminate Accumulated Losses & Restore Financial Health
Companies with heavy accumulated losses and a debit balance in the Profit & Loss Account undergo internal reconstruction to write off these losses against capital reserves or share premium. This cleanses the balance sheet, removes the deficit, and restores the company’s ability to pay dividends and raise fresh capital. It is a financial reset that makes the company viable again without changing its legal identity, often by reducing share capital to reflect true asset values.
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To Overcome Overcapitalization
When a company’s capital base is excessively large relative to its earning capacity (overcapitalization), it leads to low returns and an inability to pay reasonable dividends. Internal reconstruction addresses this by reducing the nominal value of shares or cancelling unpaid capital, thereby scaling down the equity to match the actual profit-generating capacity. This improves key ratios like EPS and ROE, making the company more attractive to investors.
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To Revalue Assets & Liabilities to Reflect True Worth
Over time, book values of fixed assets may become overstated or understated. Internal reconstruction allows for a comprehensive revaluation of assets and liabilities to reflect their current fair market value. This results in a more accurate balance sheet, often creating capital reserves from revaluation surplus that can be used to absorb losses. It ensures that the financial statements present a realistic picture of the company’s net worth.
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To Simplify Complex Capital Structure
Companies with multiple classes of shares, debentures, or arrears of preference dividends may have an overly complex and inefficient capital structure. Internal reconstruction simplifies this by consolidating or converting securities, altering rights, or settling arrears through scheme of arrangement. This streamlines administration, reduces future conflicts, and creates a clearer, more manageable capital framework conducive to future growth and financing.
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To Compromise with Creditors & Settle Debt
When a company is financially distressed but not insolvent, it may negotiate with creditors to reduce the amount of debt (compromise) or convert debt into equity (settlement) as part of a reconstruction scheme. This improves liquidity, reduces interest burden, and prevents bankruptcy. It allows the company to continue as a going concern while giving creditors a better recovery than in liquidation.
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To Facilitate Strategic Turnaround & Continue Operations
Internal reconstruction is a proactive strategic tool to rehabilitate a company without the disruption of liquidation or merger. It allows existing management to implement a turnaround plan—restructuring balance sheet, renegotiating obligations, and refocusing operations—while retaining the company’s legal existence, brand, and contracts. This is often faster and less costly than external reconstruction (amalgamation) and preserves business continuity for stakeholders.
Steps of Preparation of Balance Sheet after Internal Reconstruction:
Step 1: Determine the Purpose of Reconstruction
The first step in preparing a balance sheet after internal reconstruction is to determine the purpose of the reconstruction. The purpose of the reconstruction may be to reduce the company’s debt, improve its financial position, or restructure its operations. The purpose of the reconstruction will determine the changes that need to be made to the company’s balance sheet.
Step 2: Identify the Assets and Liabilities
The next step in preparing a balance sheet after internal reconstruction is to identify the assets and liabilities of the company. This involves a detailed review of the company’s financial statements, including its balance sheet, income statement, and cash flow statement. The assets and liabilities must be classified as per their nature and presented in a systematic manner.
Step 3: Write-off the Unrecoverable Assets and Liabilities
In case of internal reconstruction, the company may have to write-off any unrecoverable assets or liabilities. These may include bad debts, obsolete inventory, or any other assets or liabilities that cannot be recovered or realized. Such assets and liabilities need to be written off in the balance sheet, and the corresponding adjustment entries need to be passed in the books of accounts.
Step 4: Account for the Reduction in Share Capital
If the internal reconstruction involves a reduction in share capital, the balance sheet must reflect this change. The reduction in share capital is credited to the share capital account, and the corresponding reduction in the reserves or surplus is debited to the reserves or surplus account. The reduction in share capital is then shown as a separate item in the balance sheet under the equity section.
Step 5: Account for the New Securities Issued
In case of internal reconstruction, the company may issue new securities such as shares, debentures, or bonds. The balance sheet must reflect the issuance of these new securities. The new securities are credited to their respective accounts, such as share capital account, debenture account, or bond account. The corresponding increase in the reserves or surplus is debited to the reserves or surplus account.
Step 6: Revalue the Assets and Liabilities
If the internal reconstruction involves a revaluation of the company’s assets and liabilities, the balance sheet must reflect this change. The revaluation is reflected by increasing or decreasing the value of the assets and liabilities. The increased or decreased value of the assets and liabilities is credited or debited to their respective accounts. The corresponding adjustment is passed in the books of accounts.
Step 7: Adjust the Reserves and Surplus
If the internal reconstruction involves a change in the company’s reserves and surplus, the balance sheet must reflect this change. The change in the reserves and surplus is credited or debited to their respective accounts. The corresponding adjustment is passed in the books of accounts.
Step 8: Prepare the Revised Balance Sheet
After all the above steps have been completed, the revised balance sheet is prepared. The revised balance sheet must reflect all the changes that have been made to the company’s assets, liabilities, reserves, and surplus. The revised balance sheet must also reflect the impact of the internal reconstruction on the company’s financial position.
Example of Preparation of Balance Sheet after Internal Reconstruction:
ABC Ltd had the following Balance Sheet before reconstruction:
Balance Sheet (Before Internal Reconstruction)
Equity Share Capital ₹10 each fully paid ₹10,00,000
General Reserve ₹2,00,000
Profit and Loss A c Debit ₹3,00,000
12% Debentures ₹5,00,000
Assets:
Goodwill ₹2,50,000
Plant and Machinery ₹7,00,000
Cash ₹4,50,000
The company decided to reduce equity shares from ₹10 to ₹5 each and write off losses.
Journal Entry
| Particulars | Debit ₹ | Credit ₹ |
|---|---|---|
| Equity Share Capital A c Dr | 5,00,000 | – |
| General Reserve A c Dr | 2,00,000 | – |
| To Profit and Loss A c | – | 3,00,000 |
| To Goodwill A c | – | 2,50,000 |
| To Capital Reduction A c | – | 1,50,000 |
Balance Sheet after Internal Reconstruction
Balance Sheet (After Internal Reconstruction)
Equity Share Capital ₹5 each fully paid ₹5,00,000
12% Debentures ₹5,00,000
Assets
Plant and Machinery ₹7,00,000
Cash ₹4,50,000
Balance Sheet after Internal Reconstruction:
ABC Ltd
| Liabilities | Amount ₹ | Assets | Amount ₹ |
|---|---|---|---|
| Equity Share Capital ₹5 each fully paid | 5,00,000 | Plant and Machinery | 7,00,000 |
| 12% Debentures | 5,00,000 | Cash and Bank | 4,50,000 |
| Total | 10,00,000 | Total | 11,50,000 |
Note:
- Goodwill and accumulated losses have been fully written off during internal reconstruction.
- Share capital has been reduced to reflect true financial position.
