Internal Company Reconstruction-Capital Reduction Where Capital Is Not Represented by Available Assets

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Situations In Capital Reduction Where Capital Is Not Represented by Available Assets:-
  1. large amount of accumulated losses and or
  1. some of the assets are overvalued/overstated
  1. some of the assets are fictitious
Illustration:
Balance Sheet Of XYZ Ltd

$
Total Assets 500,000
Less:Current liabilities

(450,000)
Net Assets 50,000
Ordinary Share of $1 each 600,000
Accumulated Losses (550,000)
Equity/Shareholder Funds 50,000

The above illustrates that XYZ Ltd has unwisely eroded its paid up share capital from $600,000 to $50,000.

So what next should XYZ Ltd do? XYZ Ltd can either:

  • continue to be in business and face further erosion of capital vide it continuing trading losses
  • wind up its business
  • re-organize

By embarking on an internal reconstruction, XYZ Ltd should have the following intention:

  • ability to start afresh to regain profitability
  • adjust any unrepresented assets
  • writing off the accumulated losses by reducing its paid up capital
  • subsequently to issue additional shares to raise funds for its new plans.
The Need To Have A Properly Design Capital Reduction Scheme
In any Capital Reduction Scheme, it is imperative that the capital “lost” should be absorbed equitably by the various parties hence the careful need to design the proper scheme. Needless to say, the ordinary shareholders who are the risk taker need to bear the largest amount of reduction of capital. Next, it can be the preference shareholder, debenture-holders and creditors to share in the absorption of the losses.
The following are some of the factors to consider when determining the amount of capital that is lost and how this loss should be allocated:

  1. Determine the total amount to be written off
    • the debit balance of the accumulated profit & loss needs to be eliminated
    • overvalued assets need to be written down
    • fictitious assets like preliminary expenses, recorded goodwill, patent, trademarks and other intangible assets need to be written off
  1. The rights of the various stakeholders need to be considered
  • debenture holders, trade and other creditors
  • preference shareholders

3. Ensure that the ordinary shareholder should bear the major brunt of the losses as they are risk takers in the business

4. At the end, ensure that the scheme is equitable to all affected parties.
See the next article on Accounting Entries Used For Capital Reduction

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