Topic 6 company reconstruction

COMPANY RECONSTRUCTION

TOPIC 6 :

LEARNING OUTCOME

Student will be able to understand :

1. Internal reconstruction or capital reduction2. External reconstruction

INTRODUCTION A company’s paid up has to be maintained except in

circumstances such as:a) share buybackb) capital reconstruction

There could be circumstances where company may reduce its capital share:a) Have more than its optimum level of capital.b) Paid – up capital was eroded by heavy losses.

Reconstruction takes place when a co. makes material and formal changes on its capital structure.

2 types of reconstruction :a) Internalb) External

INTERNAL RECONSTRUCTION OR CAPITAL REDUCTION

Internal reconstruction may be undertaken by a company that has surplus or whose capital was eroded by trading losses.

Such a company may apply to the courts to reduce its capital.

Section 64 of the CA 1965 permits a company to reduce its capital provided the following conditions are satisfied:a) the scheme must be confirmed by the court.b) the AOA of the company provides for a reduction of capital.c) special resolution was passed by the company.

Section 64 of the CA 1965 allows a company to reduce its

capital in any of the following 3 situations: • Eg : Co. with 10 mil ordinary shares of par value RM1 each, issued but paid to 80 sen each, decides to reduce the ordinary shares to 80 sen each fully paid.

To reduce or write off the

uncalled capital on its

shares.• Eg : Co. with 10 mil issued and

fully paid ordinary share of RM1 each, decides to reduce it shares to 70 sen each fully paid; and to refund 30 sen per share to the shareholders.

To refund any surplus capital

• The paid up capital is reduced to reflect the net assets of the co.

To cancel paid-up capital

not represented

by assets

Section 64 of the CA 1965 allows a company to reduce its capital in any of the following 3 situations: a) To reduce or write off the uncalled capital on its

shares.For e.g co. with 10 mil ordinary shares of par value RM1 each, issued but paid to 80 sen each, decides to reduce the ordinary shares to 80 sen

each fully paid. b) To refund any surplus capital (memulangkan lebihan modal.

For e.g: a company with 10 mil issued and fully paid ordinary share of RM1 each, decides to reduce it shares to 70 sen each fully paid; and to refund 30 sen per share to the shareholders.c) To cancel paid-up capital not represented by assets.

The paid up share capital is reduced to reflect the net assets of the co.

A co. may have capital in excess of its need & at the same time its shares may only be partly called up.

To reduce or write off uncalled capital, co. should has sufficient capital and does not wish to make calls at all.

There must no accounting transactions – no fund leave or enter the company.

A memorandum entry is made to recognise the change in the par value of the shares.

All legal and regulatory requirements have to be complied with even though there is no change to the present financial position of the co. by reducing or writing off uncalled capital.

Reduce or Write Off the Uncalled Capital on Its Share

When co. has excess financial resources and is not utilising it.

Reasons to refund surplus capital :a) Existence of excess of cash balances b) Low return on capital.c) Having excess capital may be detrimental (danger) to the company as it may not be able to meet the shareholders’ expectation of higher return, dividend or earning per share.

One option is for the company to reduce the par value of the shares and refund the surplus capital to the shareholders.

Accounting entries:Dr. OSC xx Cr. Bank xx

Refund Any Surplus Capital

Section 64 of the CA 1965 protects the interest of creditors where the proposed scheme of capital reductions(i) to reduce or write off the uncalled capital on its shares.(ii) to refund any surplus capital.

The creditors of the co. have the right to object to the proposed capital reduction.

The court will confirm the capital reduction only after the creditor’s claim are satisfied, settled or secured and their consent obtained to the reduction of capital.

Protection of Creditors

One common reason why co’s capital is eroded is when the company has incurred heavy losses and unable to pay dividends to its shareholders for a number of years.

The aim of reconstruction is to save the co. or normally known as “turn around”.

Co. face heavy losses have 2 course of action.a) wind up the company (tutup syarikat)b) reconstruction

Capital Reduction where Capital is Not Represented by Available Assets

(Turnaround Situation)

Liquidation of a co. involves: a) the disposal of the assetsb) settlement of the liabilitiesc) distributing the remaining assets to the

shareholders. Reconstruction will be undertaken only when

the co. has evidence that it can make profits in the near future and to be able to pay dividends to its shareholders.

The accumulated trading losses will be written off and carrying value of assets will be adjusted to reflect the recoverable amount if the carrying amounts are more than the recoverable amount.

ILLUSTRATION

RM

Non-current tangible assets 200,000

Intangibles 20,000

Current assets 30,000

250,000

Ordinary shares of RM1 each 600,000

Accumulated loss (400,000)

200,000

Current liabilities 50,000

250,000

CR Sdn Bhd

Statement of Financial Position as at 31 December x4

The accumulated losses of RM 400,000 have eroded the paid-up capital. The recoverable amount of the assets may be less than carrying value.

There is also a cash flow problem as there is negative working capital.

The net tangible asset cover per share is 30 sen. The value of the shares has reduced (or depreciated) but in the books of accounts no entries have been made to reflect the ‘actual’ situation.

In such a situation, the company can:a) Continue to be in business and face further erosion

of capital;b) Wind up its business; orc) Reorganise

Internal reconstruction will involve taking positive steps to earn profits with potential dividend payments, adjusting the carrying amounts of the assets, writing off the accumulated losses and reducing the paid-up capital.

It may also involve the securing of additional funds to trade and expand.

The company may issue additional shares to raise funds.

The capital reduction scheme will be devised to ensure that the capital that is lost is written-off against claims of various parties affected by the adverse financial situation faced by the co. [capital against claims]

Normally ordinary shareholder will be the ones to absorb the largest amount of losses.

Other such as preference shareholders, debenture holder and even creditors may be willing to absorb the losses by the co.

Devising a Scheme of Capital Reduction

The factors to be considered in determining the amount of capital that is lost and how this loss should beallocated: Determine the total amount to be written-off

a) The accumulated losses have to be eliminated.b) Assets have to be revalued and written down/up to fair values.

The rights of the various creditors must be considered.a) Sometimes, debenture holders and trade and other creditors may accept a reduction on their claims or be willing to convert their claims into shares.

The ordinary shareholders should take the major loss as they are the risk bearers.

Factors to be Considered

Preference dividends arrearsa) Preference dividends may be arrears, and the preference shareholders may be willing to waive their rights to the dividends in arrears.Determine the amount of loss the preference share could bear.a) The preference shareholders may be willing to accept a reduction in their paid-up capital especially if they do not have any preferential rights to the prepayment of capital over the ordinary shares.b) The amount to be written-off the preference shares must not be as large as for ordinary shares. By reducing the nominal value of the preference shares, the preference shareholders will be receiving reduced amount of dividends in the future.The scheme devised should be equitable to all affected parties.

EXAMPLE 1 (PG 263)

RM

Land and building 100,000

Motor vehicles 50,000

Plant 50,000

Inventories 50,000

Trade receivables 40,000

290,000

Ordinary shares of RM 1 each 300,000

Accumulated losses (180,000)

120,000

Trade payables 80,000

Bank overdraft 90,000

290,000

Below is the SOFP of Reduction Bhd as at 31 December x9

The following values are applicable to the assets of the co.

Land and building

Motor vehicles

Plant

Inventories

Trade receivables

40,000

30,000

50,000

40,000

100,000

20,000

30,000

5,000

30,000

As a going concern (Value in use)

If liquidate (Selling price)

RM RM

100,000

Take this value for the computation of

loss

Determine the loss.

As there is 1 class of shares, all losses may be borne by the ordinary shareholders. The OSC could be reduced by RM 210,000 (reduce the OS to 30 sen each fully paid, 70 sen written-off)

RM

Assets at revalued amounts



Plant 30,000

Inventories 50,000


260,000

Less:

Current liabilities (80,000 + 90,000) (170,000)

Net assets (300,000 x 30 sen) 90,000

Paid-up capital 300,000

Loss of capital (300,000 x 70 sen) 210,000

ACCOUNTING ENTRIES The accounting entries to:

a) record the assets at fair valueb) writing-off the accumulated lossesc) reduce the share capital with the lost capital

In order to record all entries, capital reduction account is opened.

Normally, capital reduction a/c will be balance and NO carried forward amount.

In practice, it is seldom possible to have no remaining balance in the capital reduction a/c after implementing capital reduction scheme.

If the balance were CREDIT, it is transferred to a CAPITAL RESERVE ACCOUNT.

If DEBIT balance, it considered as a loss on reorganisation which could be charge off as reorganisation expense in SOCI

Pro Forma JournalRM RM

a) Amount written-off share capital

Dr. Share capital accounts xx

Cr. Capital reduction account xx

b) Reserves utilised for the scheme

Dr. Reserve accounts xx


c) To write off accumulated losses

Dr. Capital reduction account xx

Cr. Accumulated loss xx

d) Amount written-off assets


Cr. Relevant assets xx

e) Surplus on relevant assets

Dr. Relevant assets xx


f) Shares issued in settlement of liabilities

Dr. Relevant liability xx

Cr. Share capital account xx

g) Issue of new shares in lieu of preference dividends in arrears


Cr. Share capital account xx

h) Expenses of capital reduction


Cr. Cash / Bank account xx

i) Surplus on capital reduction account


Cr. Capital reserve account xx

EXAMPLE 2 (PG 266)

Facts are the same as in Example 1 above. OS were reduced to 30 sen fully paid up and the

existing ordinary shareholders have agreed to take up 2 fully paid OS for every 1 held.

Part of the cash raised by this issue is to be used to settle the bank overdraft.

A special resolution was passed, and the approval of the court was obtained for the scheme of capital reduction.

Required: a) Journal entries b) Capital reduction accountc) SOFP of the co. immediately after the capital

reduction

AnswerRM RM

a) Ordinary shares written down by 70 sen per share

Dr. OSC (300,000 x 70 sen) 210,000

Cr. Capital reduction 210,000

b) Written-off accumulated losses

Dr. Capital reduction 180,000

Cr. Accumulated losses 180,000

c) Assets written-down to current values


Cr. Motor vehicles 10,000

Cr. Plant 20,000

d) Cash received for 600,000 OS of 30 sen each

Dr. Bank (600,000 x 30 sen) 180,000

Cr. OSC 180,000

e) Settlement of overdraft

Dr. Bank overdraft 90,000

Cr. Bank 90,000

RM RM

Profit and loss bal 180,000 Ordinary shares 210,000


Plant 20,000

210,000 210,000

Capital reduction

RMLand and building 100,000


Plant 30,000

Inventories 50,000


Cash at bank (180,000 - 90,000) 90,000

350,000

900,000 (300,000 + 600,000) ordinary shares of 30 sen each 270,000


350,000

Reduction Bhd.

Statement of Financial Position as at 31 December x9

(after the internal reconstruction)

EXAMPLE 3 (PG 268)RM

Authorised capital:

200,000 5% cumulative preference shares of RM 1 each 200,000

800,000 ordinary shares of RM 1 each 800,000

1,000,000

Issued and paid up capital

100,000 cumulative preference shares 100,000

500,000 ordinary shares 500,000

600,000

Share premium 50,000

650,000


300,000

8% debentures 100,000

Current liabilities


Loan from directors 20,000

Bank overdraft 32,000

492,000

Research and development 105,000



Fixtures and fittings 35,000

Investments 30,000

Inventories 40,000


Cash in hand 2,000

492,000

Notes:a) Arrears on preference dividends were RM 20,000b) There is contingent liability for damages of RM

30,000 which has not been provided.

A capital reduction scheme duly approved by the court was set out as follows:1. The preference shares to be reduced to 50 sen per

share, and the ordinary shares reduced to 25 sen each.2. The preference share holders to receive 1 ordinary

share for every RM 1 preference dividend in arrears.

3. Share premium account to be utilised for the scheme.

4. The accumulated losses and all intangible assets are to be written off.

5. To write off RM 10,000 of inventories and RM 5,000 of trade receivables as bad debts.

6. Assets were revalued as follows:RM

Land and building 235,000Fixtures and fittings 30,000Investment 32,000

7. The directors agreed to accept ordinary shares in place of their loans, and also agreed to subscribe for RM 40,000 in ordinary shares of 25 sen per share.

8. Cost of reconstruction amounted to RM 2,0009. Another special resolution was passed to restore

authorised capital.Subsequently the following transactions took place:i) The trade investments were sold for RM 32,000ii) The contingent liability materialised to the amount stated and the co. settled the full amount.

Required:a) The journal entriesb) The necessary ledger accountsc) The statement of financial position of co. after the

capital reduction had been completed.Ignore taxation.

RM RM

a) 5% CPS of RM 1 reduced to 50 sen each fully paid

Dr. Preference share capital (100,000 x 50 sen) 50,000


b) Ordinary shares written-down to 25 sen per share

Dr. Ordinary shares (500,000 x 75 sen) 375,000


c) 20,000 OS issued in full satisfaction of preference div. in arrears of RM 20,000


Cr. OS ( 20,000 x 25 sen) 5,000

d) Share premium utilised for the scheme

Dr. Share premium 50,000


a) Journal entries

e) Accumulated losses written-off


Cr. Accumulated losses 350,000

f) Assets written-down to fair value


Cr. Fixtures and fittings 5,000

Cr. Inventories 10,000

Cr. Research and development 105,000

Cr. Trade receivables 5,000

g) Assets written-up to fair value

Dr. Land and building 35,000

Dr. Investments 2,000


h) 80,000 OS issued in exchange for loans outstanding

Dr. Directors' loans 20,000

Cr. OSC (80,000 x 25 sen) 20,000

i) 160,000 OS issued for cash to the directors of the co.

Dr. Bank 40,000

Cr. OSC 40,000

j) Expenses of reorganisation


Cr. Bank 2,000

k) Trade investments sold

Dr. Bank 32,000

Cr. Investments 32,000

l) Liability recognised


Cr. Contingent liability 30,000

m) Settlement of contingent liability

Dr. Contingent liability 30,000

Cr. Bank 30,000

RM RM

Preference dividends - OS 5,000 Preference share capital 50,000

Accumulated losses 350,000 OSC 375,000

Research and development 105,000 Share premium 50,000

Fixtures and fittings 5,000 Land and building 35,000

Inventories 10,000 Investments 2,000


Contingent liability 30,000

Cost of reorganisation (Bank) 2,000

512,000 512,000

Capital reduction

b) Ledger accounts

RM RM

Capital reduction 50,000 Bal b/ d 100,000

Bal c/ d 50,000

100,000 100,000

Preference share capital

RM RM

Capital reduction 375,000 Bal b/ d 500,000

Preference dividends 5,000

Directors' loan 20,000

Bal c/ d 190,000 Bank 40,000

565,000 565,000

Ordinary share capital

RM RM

Non-current assets



Fixtures and fittings 30,000

315,000

Current assets

Inventories 30,000


Cash in hand 42,000 97,000

412,000

Emergency Bhd.

Statement of Financial Position

as at 31 December x9

(immediately after the capital reduction)

c) Statement of financial position

Authorised capital:

400,000 5% cumulative preference shares of 50 sen each 200,000

3,200,000 ordinary shares of 25 sen each 800,000

1,000,000

Issued and paid-up capital:

100,000 5% cumulative preference shares 50,000

760,000 ordinary shares 190,000

240,000

Non-current liabilities


Current liabilities


Bank overdraft 32,000 72,000

412,000

EXTERNAL RECONSTRUCTION

An alternative to internal reconstruction is to undertake external reconstruction.

Common among smaller co (especially within family control)

A new co. is formed by existing shareholders to take over the assets and liabilities of the problem co.

The consideration paid is usually in shares of new co.

The old co. is wound up (close down). The shareholder basically the same

shareholder from problem co. To public, look like new establishment as

name is different, & different management. Cost much expensive since need to form

new company.

Closing entries in the old books same as co. being liquidate under amalgamation & absorption (chapter 7).

The realisation account is replaced with realisation and reconstruction account.

The realisation and reconstruction account is debited with all the assets disposed and credited with the purchase consideration.

Books of the Old Company

The balances in the various reverse accounts are transferred to the realisation and reconstruction account instead of to the sundry members account.

This is to determine the full amount of loss sustained by the co.

The loss determined is then borne by OS, PS and other if any by crediting the realisation and reconstruction account and debiting the sundry members account.

EXAMPLE 4 (PG 273)

Given below is the statement of financial position of Construction Bhd. As at 31 December x9.

RM

Non-current assets 200,000

Current assets 100,000

300,000

6% preference shares of RM 1 each 100,000

Ordinary shares of RM 1 each 300,000

400,000


200,000



300,000

The following scheme of reconstruction was agreed to by all parties and the required approvals received:

A new co. named Reconstruction was to be formed with an authorised capital of RM 700,000 made up of 200,000 8% preference shares of RM 1 each and 500,000 ordinary shares of RM 1 each.

Reconstruction was to acquire all the assets of Construction for the following consideration: 1. RM 50,000 9% loan stock in Reconstruction will

be issued to satisfy the claims of the debenture holders of Construction Bhd.

2. The trade payables will be paid RM 20,000 in cash and the balance in 9% loan stock.

3. To issue 4 8% PS for every 5 PS in Construction.4. The ordinary shareholders to receive 1 OS in

Reconstruction for every 3 OS in Construction.5. The non-current assets were valued at RM

210,000 and the current assets at RM 70,000.

Required :Close the books of Construction Bhd.

Determine the purchase consideration.

RM

To the ordinary shareholders

1 OS for every 3 shares held (1/ 3 x 300,000) 100,000

To the preference shareholders

4 PS for every 5 shares held (4/ 5 x 100,000) 80,000

To the debenture holders

9% loan stock 50,000

To the trade payables

Cash 20,000

9% loan stock 30,000

280,000

RM RM

Non-current assets 200,000 Reconstruction 280,000

Current assets 100,000 Loss on realisation c/ d 20,000

300,000 300,000

Bal b/ d 20,000 Sundry members account:

Accumulated losses 200,000 Preference 20,000

Ordinary 200,000

220,000 220,000

Realisation and reconstruction account

RM RM

Realisation and reconstruction 20,000 Bal b/ d 100,000

Preference shares in 80,000

reconstruction

100,000 100,000

Sundry members - Preference

RM RM

Realisation and reconstruction 200,000 Bal b/ d 300,000

Ordinary shares in 100,000

reconstruction

300,000 300,000

Sundry members - Ordinary

RM RM

Realisation and reconstruction 280,000 Trade payables

- cash 20,000

- 9% loan stock 30,000

Debenture holders

- 9% loan stock 50,000

Sundry members

- Preference 80,000

- Ordinary 100,000

280,000 280,000

Reconstruction

Business

Topic 6 company reconstruction