Steps for Reconstruction Scheme | Capital

The following steps are taken into consideration for drafting a scheme, in brief: 

1. Losses to be written off are to be determined by adding accumulated losses, fictitious assets, overvaluation of assets, under-provision of liabilities, preliminary expenses etc. The total amount of losses to be written off is thus determined and is reduced from the profit on revaluation of assets etc.

Alternatively, to find out the amount to be written off is to add the present value of assets and deduct there from the amount of contingent liabilities. The resulting figure is the value of net assets; and the amount of paid up capital and reserves, if any, deducted from the value of net assets will show the amount to be written off.

2. To write off the losses, it is necessary to ascertain the parties who will have to bear the loss. SECURED CREDITORS will not normally sacrifice anything unless the value of securities is inadequate. They are treated as ordinary creditors to the extent they are not covered and they may have to accept some sacrifices in connection with that portion along with ordinary creditors.

DEBENTUREHOLDERS may be fully secured as above and hence their case should also be considered on the above line. When Debenture has a floating charge on assets so that assets remaining after payment of secured debts and preferential creditors are applicable, the holders of such debentures may accept reduction in the rate of interest if better security is offered. UNSECURED CREDITORS will not agree to sacrifice anything unless the Company is insolvent, that is, assets are not sufficient to pay off outside liabilities. They may consider the prospect of higher income as compared with the immediate benefit to be derived from liquidation.

When the Company has a bright future and if the creditors are given some share in the Equity capital, they may agree to sacrifice to some extent. PREFERENTIAL SHAREHOLDERS are preferential both regarding dividend and repayment of capital in liquidation. When they cannot be paid in full in liquidation, they will be normally agreeable to sacrifice some capital claim for early prospect of dividend.

EQUITY SHAREHOLDERS have to bear substantial portion of the loss. If the Company is reorganised by Capital Reduction as an alternative to liquidation, the equity shareholders must be interested to keep their control over the company. When equity shares are issued to other parties against their sacrifice, the control of the existing equity shareholders may be lost. Under this situation, existing equity shareholders are to come forward with fresh investment in equity capital to keep their control intact.

3. Arrangements is to be made for liquid resources for purchasing machinery, etc. urgently required, for meeting immediate commitments and for working capital by means of further call, fresh issue of shares, sale of investments, arrangement of overdraft and the like.

Illustration 1:

The following is the Balance Sheet of Hopeful Ltd. as on 31st December, 2006:

The following scheme of re-organisation is sanctioned:

(i) Fixed assets are to be written down by 33.33%.

(ii) Current assets are to be revalued at Rs. 27, 00,000.

(iii) Preference shareholders to forego their right to arrears of dividend, which are in arrears for three years.

(iv) The taxation liability of the company is settled at Rs. 4, 00,000.

(v) One of the creditors of the company, to whom the company owes Rs. 25, 00,000, decides to forego 50% of his claim. Others for Rs. 5, 00,000 were allotted 1, 00,000 equity shares of Rs. 5 each in satisfaction of balance of their claims.

(vi) The rate of interest on debentures is increased to 11%. The debenture holders surrender their existing debentures of Rs. 100 each and exchange the same for fresh debentures of Rs. 75 each.

(vii) All existing equity shares are reduced to Rs. 5 each.

(viii) All preference shares are reduced to Rs. 75 each.

Pass journal entries and show the Balance Sheet of the company after giving effect to the above.

Solution:

Illustration 2:

Bad Ltd. has just recovered from great financial difficulty.

Its Balance Sheet as on 31-12- 2006 was as following:

A New Company, Good Ltd. was formed to take over Building at Rs. 3, 00,000, Plant at Rs. 1, 40,000 and Stock at Rs. 60,000. Purchase consideration is to be satisfied by the issue of 6% Preference Shares of Rs. 100 each and Equity Shares of Rs. 10 each in the ratio of 3: 2. Preference shareholders are to be settled in full by the allotment of new preference shares.

Sundry debtors- realised Rs. 1, 50,000 and Rs. 1, 10,000 was paid to the creditors in full settlement. There is no current asset except stock and debtors. Cost of winding up amounted to Rs. 10,000. Show the Ledger accounts in the books of Bad Ltd. And Journal entries in the books of Good Ltd.

Illustration 3:

The following is the Balance Sheet of Bad Luck Limited as on 31st March 2006:

 

The Company having now turned the corner, the Directors expect it to earn good profit in future. You are asked to submit a scheme of reconstruction.

Solution:

It is suggested that the 7,000 shares paid up value to be reduced by Rs 60 so that the amount of reduction comes to Rs 4, 20,000. Of this amount, Rs 3, 70,000 can be applied in eliminating the Goodwill, Preliminary Expenses and Profit and Loss Account. The balance of Rs 50,000 may be applied in writing down the sundry assets.

Since the Directors expect a good profit from the Company, shareholders may not object to the reduction in paid up capital. For further working capital, shareholders may be asked to pay the uncalled amount of the shares or unissued shares may be issued as right shares.