The act of placing a company into voluntary liquidation and then selling its assets to another company with the same name and same stockholders, but with a larger capital base. It is the complete overhaul of the capital of a distressed company to save it from liquidation. The object of it is to enable the company to continue as a going concern by the removal of the burden of immediate debt, the attraction of additional capital and the creation of a viable financial structure.
The reconstruction of capital, which is also known as capital reconstruction, is defined as the plans made by a company for the restructuring of its capital base. Capital reconstruction involves major alterations in the capital base of a company. It is related to the term capital restructuring.
A company gains the agreement of its shareholders and creditors to vary the rights of its members and creditors, by altering the capital structure in a way that allows the existing company to continue in business.
Types of Capital Reconstruction:-
There are two types of capital reconstruction. These are splits and consolidations. Split is an easy principle to understand.
Under the principle of splits, a company basically splits its capital base. For instance, a company may split its base of capital by issuing two new shares for every one share held by the shareholder. For example, if the company has 50, 000, 000 shares at its disposal, it can split its base of capital to 100, 000, 000 shares. Capital reconstruction may or may not include a return on capital.
On the other hand, consolidations are the opposite of splits. In the above example, the company split its 50, 000, 000 shares into 100, 000, 000 shares. In the case of consolidations, however, the company may consolidate the 100, 000, 000 ordinary shares at its disposal into 50, 000, 000 ordinary shares by giving shareholders only one new shares for every two shares they hold.
The process of re-engineering the capital base of a company could be done internally or externally. Internal construction is a process where capital is reconstructed within the existing shareholder, while external is where capital is reconstructed among the existing and prospective shareholders.
Accounting for Capital Reconstruction
Rationale for Capital Reconstruction
To eliminate 3 issues that prevent a distressed company from recovering
1. Negative retained earnings
* Companies with accumulated losses are not allowed to pay dividends. One reason is that it prevents the shareholders from withdrawing money and leaving the debt holders high and dry. * This discourages potential investors from investing in the company. * The company will find it difficult to obtain debt financing as well. 2. Overdue interest and debt
* Distressed companies are cash strapped. Needing to pay interest puts burden on the company, and prevents it from committing necessary capital to turn around the business. * The debt and interest also results in high gearing and low interest coverage ratios, which again prevents the company from obtaining additional debt financing. 3. Overdue dividends on cumulative preference shares
* Same reasons as per debt, since preference shares are essentially debt.
Types of Entity Construction Schemes (accounting speak)
1. Capital reduction
3. Liquidation via a new company
Capital Reduction Scheme
This addresses the 1st point above. A capital reduction scheme essentially recognizes the loss that the equity holders have incurred by adjusting equity reserve accounts. A company * Resets any negative retained earnings account by offsetting it with equity reserve accounts (e.g. share premium account first, followed by share capital account) * Writes off any unpaid share capital by reducing the value...
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