Accounting for Internal Reconstruction

Internal reconstruction is the process of reorganizing affairs of the business in terms of assets revaluation, liability assessment, reducing share capital, restructuring the liability, and varying the rights associated with the equity.

Reconstruction is considered when the business makes consistent losses, and there is a need to review the balance sheet if assets/capital is overstated. For instance, accumulated losses/Debits of the profit and loss account can lead to an overstatement of fictitious assets that have no role in revenue and profit generation.

Further, the process of reconstruction is carried to reflect the true picture of the business performance/status and enhance the use of financial statements for the stakeholders. For instance, if the business has been making consistent losses in recent years, it may indicate that assets of the company are over-valued, fictitious assets have been accumulated, and useless intangibles have been excessively capitalized. So, there is a need to reconstruct the balance sheet items and control capitalization. The concept is mainly applied on the equity side of the financial statement to reflect a true sense of ownership and controls by sub-division of shares and other techniques.

It’s important to note that reconstruction is different from company liquidation and does not result in the formation of a new company but its overhauling of the balances.  Overall, internal reconstruction helps to,

  1. Reduce inflated share capital/alteration of the shares structure.
  2. Show true and fair view of assets by valuation.
  3. Reduce overdue outside liabilities.

Let’s analyze different aspects of internal construction in terms of accounting treatment.

Alteration of share capital

The company can alter share capital. However, compliance needs to be checked. For instance, if the alteration of share capital is allowed by memorandum and article and association. Usually, the following provisional compliance needs to be made.

  1. The article of association should permit alteration.
  2. The company should pass resolution in a general meeting.

The share capital can be altered in the following ways.

  1. The company issues new shares against receipt of cash.
  2. Consolidation of shares to a share of large amount.
  3. Division of shares into a smaller amount.
  4. Cancellation of unissued capital.
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Accounting entries for alteration of share capital

1-    Accounting entry for issuing of new shares against cash.

AccountDebitCredit
Business bank accountXXX 
Equity share capital A/C XXX

The debit impact of the transaction is the receipt of cash recorded in the business bank account. On the other hand, the credit impact of the transaction is the recording of the shares issued. For instance, if the company issues 20,000 shares amounting to $10 each share, the following entry can be posted.

AccountDebitCredit
Business bank account (20,000*$10)200,000 
Equity share capital A/C 200,000

2-    Accounting entry for consolidation of shares.

AccountDebitCredit
Equity share capital A/CXXX 
Equity share capital A/C XXX

The debit impact of the transaction is to remove shares small in value. Similarly, the credit impact is to add shares higher in the value. Further, it’s important to note that the total amount of the share capital remains the same. For instance, the following entries are posted in the accounting system when share capital amounting to $20,000 and $1 per share is consolidated in a proportion of 1 for 10.

AccountDebitCredit
Equity share capital A/C (20,000 shares amounting to $20,000, $ 1 per share )20,000 
Equity share capital A/C  (2,000 shares amounting to $20,000, $10 per share) 20,000

Division of shares is the opposite of consolidation. So, revers entries are posted in the accounting system in comparison with the consolidation.

3-    Accounting entry for cancellation of unissued share capital.

No entry is required to be passed for the cancellation of unissued share capital.

Accounting entries for variation of shareholders rights

The companies may have different types of equity issued like cumulative preference shares, non-cumulative preference shares, and normal equity, etc. Sometimes, there is a need to change the dividend rate on preference shares and convert cumulative preference to non-cumulative preference and vice versa. These conversions are covered in the variation of rights. Following sample, entries help to understand how variation is accounted for in the books of accounts.

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Entry to change rate of dividend on preference shares of the business.

AccountDebitCredit
Old % Cumulative preference share capital A/CXXX 
New % Cumulative preference share capital A/C XXX

The debit impact of the transaction is the removal of old rate cumulative preference shares, and credit impact is a recording of the new rate preference share. It’s important to note that the amount of the preference capital remains the same, and it’s just a variation in the interest rate.

Entry for converting cumulative preference shares to non-cumulative.

AccountDebitCredit
Cumulative preference share capital A/CXXX 
Non-Cumulative preference share capital A/C XXX

The debit impact of the transaction is the removal of the cumulative preference share, and credit impact is the recording of the non-cumulative preference.

Accounting entries for reducing share capital and other assets

1-    Entry for reducing share capital without any impact on face value.

AccountDebitCredit
Share capital A/CXXX 
Capital reconstruction A/C XXX

The debit impact of the transaction is the reduction of the share capital. On the other side, credit impact is the transfer of amount to the capital reconstruction account. This capital reconstruction account will be adjusted against capital reserves.

2-    Entry for reducing share capital with impact on face value.

AccountDebitCredit
Share capital A/C old balanceXXX 
Share capital A/C New balance XXX
Capital reconstruction A/C (Difference in the value due to changes in FV is recorded via this line item) XXX

The debit impact of entry is the removal of the old share capital balance. At the same time, the first credit records a new amount of the share capital. Any difference between old and new capital account is recorded via entry of share capital reconstruction.

3-    Entry when creditors agree to reduce their receivable from the business

AccountDebitCredit
Creditors A/CXXX 
Share capital reconstruction A/C XXX

The debit impact is the removal of the payable balances, and credit impact reflects its impact in the reconstruction.

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4-    Entry when the value of the asset appreciates

AccountDebitCredit
Asset A/CXXX 
Share capital reconstruction A/C XXX

Debit records increase in the value of assets and credit is used to reflect impact in the reconstruction account.

It’s important to note that we have credited the share capital reconstruction account as there has been an increase in the value of assets and a decrease in the liability. However, if there is an increase in the liability following entry will be posted in the books of account.

5-    Entry when the contingent liability of the business matures

AccountDebitCredit
Share capital reconstruction A/CXXX 
Liability A/C XXX

The balance of Share capital reconstruction A/C is debited as the liability of the business increases.

Debits and credits of the share capital reconstruction account are net off and utilized to write off accumulated losses and overstated assets. Following entry can be helpful in this regard.

6-    Entry when the balance of the share capital reconstruction account is utilized.

AccountDebitCredit
Share capital reconstruction A/CXXX 
Accumulated losses/ Profit and loss A/C XXX
Discounts on shares issued A/C XXX
Goodwill A/C XXX
Copy right/patents A/C XXX
Preliminary expenses A/C XXX

The fictitious/overstated assets in the business’s balance sheet are adjusted against the share capital reconstruction account. However, if some amount is left on the credit side, the balance is transferred to the capital reserves account as given in the following entry.

AccountDebitCredit
Share capital reconstruction A/CXXX 
Capital Reserves A/C XXX

The debit impact is removing the share capital reconstruction account as it was not a permanent account in nature, and any balance of the account is transferred to the capital reserves account by credit entry.

Difference between internal and external reconstruction

Following are some of the differences between the internal and external reconstruction of the business.

Internal reconstructionExternal reconstruction
Internal reconstruction does not result in the liquidation of the business.External reconstruction results in the liquidation of the business.
There is no formation of a new company in the internal reconstruction.A new company is formed as a result of the external reconstruction.
Assets and liabilities of the company remain in their place.Assets and liabilities of the company are transferred to the newly formed company.
Past losses of the business are offset against future profits of the company.Past losses cannot be adjusted against future profits because a new company/legal entity is formed.

Conclusion

If the business has to suffer from losses continuously, the debit balance of the losses is accumulated in the business’s balance sheet. Similarly, the issue of the shares and other preliminary expenses in the balance sheet might not indicate the real position of the company. So, the business may need to change the share capital structure, bring variations in the share rights, and do some structural changes like restructuring of liability, revaluation of assets, and recognition of contingent liability, etc.

Various accounting entries need to be posted in the books of accounts. These accounting entries reflect changes in the account balances. The changes are reflected in the reconstruction account and adjusted against capital reserves.

Frequently asked questions

What is the objective of internal reconstruction?

The main objective of the internal reconstruction is to present a true and fair view of the business balance sheet.

Does the company need to ensure compliance to implement internal reconstruction?

The company needs to ensure compliance with capital restructuring, capital issuance, and cancellation, etc.

What are the reasons for internal reconstruction?

Some of the reasons for internal consideration include complex internal structure, complicated capital structure, misrepresentation of the financial statement, and overcapitalization of capital etc.

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