Accounting for Internal Reconstruction, Steps, Objectives, Benefits

Internal Reconstruction refers to the process of reorganizing a company’s financial structure without forming a new entity. This process involves the revaluation of assets, settlement of liabilities, and reorganization of capital. It is a comprehensive financial restructuring done internally, typically to eliminate accumulated losses or to adjust the capital structure.

Key Steps in Internal Reconstruction:

1. Alteration of Share Capital:

The company may alter its share capital by reducing the face value of its shares or by consolidating or subdividing its shares. This is usually done to adjust the capital structure and reflect the company’s current financial position.

• Reduction of Share Capital: A reduction in share capital is done to write off accumulated losses or fictitious assets like goodwill. For example, if a company’s share capital is reduced from ₹10 per share to ₹5 per share, the difference is used to eliminate losses.
• Consolidation and Subdivision: Consolidating shares means combining smaller denominations into larger ones (e.g., 10 shares of ₹1 each combined into 1 share of ₹10). Subdivision is the reverse, where larger shares are split into smaller denominations.

2. Writing Off Losses:

Internal reconstruction involves writing off accumulated losses, which are reflected as debit balances in the profit and loss account. These losses are written off against available reserves or by reducing the share capital.

3. Revaluation of Assets and Liabilities:

The company reassesses the value of its assets and liabilities. Overvalued assets are written down, and liabilities are adjusted to reflect their fair value. This process ensures that the company’s balance sheet accurately reflects its financial position.

4. Creditors’ and Debenture Holders’ Adjustments:

In some cases, creditors and debenture holders may agree to accept lower repayment amounts, or they may be issued new shares or debentures in place of their original claims. This reduces the burden of liabilities on the company.

Objectives of Internal Reconstruction:

• Elimination of Accumulated Losses

The most common objective of internal reconstruction is to eliminate accumulated losses that are reflected on the company’s balance sheet. These losses can reduce shareholder confidence and impact the company’s financial health. By reducing the share capital or adjusting reserves, these losses are written off, leading to a more accurate and cleaner financial statement.

• Revaluation of Assets and Liabilities

Internal reconstruction provides an opportunity to reassess the values of the company’s assets and liabilities. Overvalued assets can be written down to their realistic market values, and undervalued liabilities can be adjusted upwards. This revaluation ensures that the company’s balance sheet reflects its true financial position, which is critical for future growth and attracting investment.

• Restructuring of Capital

Another key objective is to restructure the capital base of the company to align it with its current operational needs. This may involve reducing share capital, consolidating shares, or converting debt into equity. By optimizing the capital structure, the company can improve its financial stability and operational efficiency.

• Improvement in Financial Ratios

Internal reconstruction is often undertaken to improve key financial ratios, such as debt-to-equity, return on equity, and earnings per share. A healthier financial profile can enhance the company’s creditworthiness, attract investors, and facilitate easier access to capital.

• Settlement with Creditors

In some cases, internal reconstruction involves negotiating with creditors to reduce liabilities. Creditors may agree to accept reduced payments, convert debt into equity, or extend repayment periods. This reduces the financial burden and helps stabilize the company.

• Retaining the Company’s Identity

Unlike external reconstruction, internal reconstruction allows the company to retain its legal identity and continue operations without the need for liquidation or creating a new entity. This helps maintain brand value and customer loyalty.

Accounting of Internal Reconstruction:

1. Reduction of Share Capital:

The company often reduces the face value of its shares to write off accumulated losses or overvalued assets. This reduction can be done by canceling paid-up capital or decreasing the nominal value of shares.

Journal Entry:

Equity Share Capital A/C (Old)       Dr.

Preference Share Capital A/C (Old)  Dr.

    To Equity Share Capital A/C (New)

    To Preference Share Capital A/C (New)

    To Capital Reduction A/C

2. Utilization of Capital Reduction Account:

The Capital Reduction Account is then used to write off accumulated losses, fictitious assets (like goodwill, preliminary expenses), and reduce overvalued assets.

Journal Entry:

Capital Reduction A/C          Dr.

    To Profit and Loss A/C (Accumulated Losses)

    To Goodwill A/C (Fictitious Assets)

    To Plant and Machinery A/C (Overvalued Assets)

    To Other Assets A/C (If Any)

3. Writing Off Fictitious Assets:

Fictitious assets such as goodwill, preliminary expenses, and deferred revenue expenditures are written off as part of the internal reconstruction process.

Journal Entry:

Capital Reduction A/C       Dr.

    To Goodwill A/C

    To Preliminary Expenses A/C

    To Discount on Issue of Shares A/C

4. Revaluation of Assets and Liabilities:

Assets that are overvalued are written down to their fair market value, while undervalued assets may be increased. Similarly, any hidden liabilities or contingencies are recognized.

Journal Entry: For the reduction in asset value:

Capital Reduction A/C       Dr.

    To Asset A/C (e.g., Plant and Machinery)

For the increase in liability:

Liability A/C (e.g., Creditors)   Dr.

    To Capital Reduction A/C

5. Settlement of Liabilities:

Creditors and debenture holders may agree to accept a reduced amount, convert their debt into equity, or extend the repayment period.

Journal Entry:

Creditors/Debenture Holders A/C   Dr.

    To Equity Share Capital A/C

    To Preference Share Capital A/C

    To Cash/Bank A/C

6. Issue of New Shares or Debentures:

After reconstruction, the company may issue fresh shares or debentures to raise capital or compensate existing shareholders.

Journal Entry:

Bank A/C            Dr.

    To Equity Share Capital A/C

    To Debentures A/C

Benefits of Internal Reconstruction:

• Preserves Company’s Identity:

Unlike external reconstruction, the company retains its legal identity, which is important for maintaining its brand and goodwill.

• Cost-Effective Solution:

Internal reconstruction is less expensive compared to liquidation and starting a new company.

• Flexibility:

Companies have the flexibility to negotiate with creditors, revalue assets, and adjust liabilities according to their needs.

• Improved Financial Health:

By writing off losses and overvalued assets, the company’s balance sheet becomes more accurate and financially stable.