ALWADI INTERNATIONAL SCHOOL

ACCOUNTING GRADE 12

NOTES

COMPANIES CAPITAL REDUCTION AND RECONSTRUCTION

The Companies Act 1985 permits companies to reduce their share capital provided the
interests of creditors are preserved. Losses on the income statement lead to a reduction of
capital and, if the situation appears to be permanent, it will be necessary to recognise the fact
by undertaking a scheme of capital reduction. A Capital Reduction account is opened in the
books for this purpose.
Sample answer 1:
The following is the balance sheet of Cherry Ltd. at 31 December 2011:
$
Non Current Assets
Current Assets
(-) Current Liabilities

$
50,000

36,000
(24000)
12000
62000

Share Capital and Reserves:

100,000 Ordinary shares of $1
Retained earnings (debit balance)

100,000
(38000)
62000

No provision has been made for Depreciation of the non current assets which at the date of the
balance sheet, were estimated to be worth $8000 and it has been discovered that a major
customer, owing $4,000 has become bankrupt. However, the directors are of the opinion that
the company will begin to make a profit of $5,000 per annum from now on.
Required:
(a) Journal entries to record the scheme of Capital reduction.
(b) A Balance Sheet as it will appear after the scheme put into effect.
Answer:
The shares are worth $0.62 ($62,000 / 100,000) on balance sheet values. After taking the
realisable values of the assets into account, the value of the shares is $(42,000 + 8,000) /
100,000 = $ 0.50. The accounting entries will require the use of a Capital Reduction Account:

Journal
Dr.
$
COMPANIES RECONSTRUCTION

Cr.
$
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ALWADI INTERNATIONAL SCHOOL

Capital reduction Account
Non current Assets
Trade receivables
Retained earnings
(Reduction in asset values)
Ordinary share capital
Capital Reduction account

ACCOUNTING GRADE 12

NOTES

50,000
8,000
4,000
38,000
50,000
50,000

Cherry Ltd.
Balance Sheet as at 31 December 2011
$
Non current Assets
Current Assets
(-) Current Liabilities

$
42,000

32,000
(24,000)
8,000
50000

Net Assets
Share Capital and Reserves:
100,000 Ordinary shares of $0.50

50,000

Notes:

The share holders have not lost anything as a result of the reconstruction of the Capital of
the Company as their shares had already lost $0.50 of their value; the reconstruction merely
recognise this fact.

The debit balance has been eliminated from the retained earnings account. If the Profit of
$5,000 is achieved, it will be equivalent to a dividend of 10% payable to the shareholders
immediately; they will not have to wait 8 years ($38000/5000), for a dividend.

Sample answer 2:
Plant Ltds summarised Balance Sheet at 31 September 2011 is as follows:
Non Current Assets:
Goodwill
Properties
Plant and Equipment
Motor vehicles
Net Current assets
Equity:
1,600,000 ordinary shares of $1
COMPANIES RECONSTRUCTION

$000
100
600
250
50
350
1350
1600
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ALWADI INTERNATIONAL SCHOOL

ACCOUNTING GRADE 12

Retained earnings (debit balance)

NOTES

(250)
1350

Further Information:
(i)

Good will is now considered to be valueless.

(ii)

The non current assets are considered to be overvalued and have been valued more
realistically as follows:

$000
420
150
30

Properties
Plant and equipment
Motor vehicles

(iii) Inventory has been over valued by $125,000. A major customer owing $25,000 has
become bankrupt.
The company has not paid any dividends for some years but the directors believe that the
company can become profitable again and start paying dividends once more. They purpose to
carry out a scheme of capital reduction with the agreement of the shareholders.
Required:
(a)

Journal entries to record the scheme of Capital Reduction.

(b)

Redraft the Balance Sheet of Plant Ltd. as it will appear immediately after the completion
of the Capital Reduction.
Answer:
The Balance Sheet value of the shares in $0.84375 [$(1,600,000 250,000) 1,600,000]
After taking the overvaluation of the assets into account, the value of the shares is $0.50.
$000
1,600
(250)
(100)
(180)
(100)
(20)
(125)
(25)
800

Nominal value of share capital

Less:
Debit balance on retained earnings account
Reductions in value of : Goodwill
Properties
Plant and equipment
Motor vehicles
Inventory
Trade receivables
Real value of Ordinary Share capital
($800,000 1,600,000 = $0.50)
(a)

Journal
$000

COMPANIES RECONSTRUCTION

$000
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ALWADI INTERNATIONAL SCHOOL

ACCOUNTING GRADE 12

Capital Reduction account

Retained earnings
Goodwill
Properties
Plant and equipment
Motor vehicles
Inventory
Bad debit written off
(Reduction in asset values and writing off Goodwill)
Ordinary Share Capital account
Capital Reduction account
(Reduction of share capital)

NOTES

800
250
100
180
100
20
125
25
800
800

The balance on the Share Capital account has now been reduced from $1,600,000 to 800,000,
but the shareholders still hold share certificates for 1,600,000 share of $1. The directors may
correct this situation in various ways, but the two most likely are:

To give the shareholders certificates for One Ordinary share of $0.50 for every share of $1
they already hold.
To give the shareholders a certificate for One Ordinary share of $1 for every two shares they
already hold.

(b)
Plant Ltd
Balance Sheet immediately after the capital reduction
Non current assets:
$000
Properties
420
Plant and equipment
150
Motor vehicles
30
Net current assets
200
800
1,600,000 Ordinary shares of $0.50*
800
* Alternatively, 800,000 Ordinary shares of $1

Net Asset Value

When a company is closed down and its assets are sold, this is called liquidation. If a company
was to go into liquidation, investors would like to know whether the companys assets would be
worth anything, and if so, how much of these net assets would attach to each share. The first
piece of information can be read directly from the balance sheet, and requires no further
analysis.
Capital (Net assets) = All assets - All liabilities

COMPANIES RECONSTRUCTION

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ALWADI INTERNATIONAL SCHOOL

ACCOUNTING GRADE 12

NOTES

This figure tells the investors what their investment is worth. To find the value per share, simply
divide by the number of shares.
Net asset value per share =

Net Assets____________________________
Number of ordinary and preference shares

Sample answer 3:
Knotsogood Limited has been trading unprofitably for the past few years. The court has
recently approved a scheme of Capital reconstruction. A balance sheet at 31 August 2006
showed the following position:
Non Current Assets
Intangible: Goodwill
Tangible: Freehold land
Premises
Vehicles

Cost
$000
110
80
310
220
720

Investments
Current Assets:
Inventory
Trade receivables
Cash & cash equivalents (cash)
(-) Current Liabilities:
Trade payables
Cash & cash equivalents (Bank)

Depn.
$000
50
160
210

NBV
$000
110
80
260
60
510
210

40
56
4
100
80
100
(180)

Net Current Assets

Capital Employed
(-) Non Current liabilities:
8% Debentures (2021) (Secured on the freehold land)
Net Assets
Share Capital and Reserves:
Ordinary shares of $1 each
8% Preference shares of $1 each
Share Premium account
COMPANIES RECONSTRUCTION

(80)
640
(100)
540
500
200
250
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ALWADI INTERNATIONAL SCHOOL

ACCOUNTING GRADE 12

NOTES

Retained earnings (Debit balance)

Share holder funds

(410)
540

Note: The Preference shares are cumulative and the dividends on the shares are 3 years in
arrears. The approved scheme for the reduction of capital was implemented as follows:

The Preference shares were reduced to $0.50 per share.

The Ordinary shares were reduced to $0.25 per share.

Two new Ordinary shares for every $1 of gross Preference dividend in arrears. The
share premium account was utilised for the issue.

Goodwill was written off.

Inventory costing $6000 had been included in the final accounts at its selling price of
$10000.

A debt of $21000 was written off as bad.

The Debenture holder took over the Freehold land at an agreed valuation of $125000. The
Balance was paid to the company.

The investments were sold for $235000.

Required:
(a)

Prepare Journal entries from the above transactions.

(b)

Prepare a Capital Reconstruction Account.

(c)

The summarised balance sheet of Knotsogood Limited immediately after the completion of
the scheme of capital reconstruction.

(d)

Calculate the net asset value of each Ordinary share before and after the implementation
of the scheme.

(e)

Identify and explain one factor that the court would consider before agreeing to the
scheme of capital reconstruction.
[NOV 06 P4]

Answer:
(a)
(i)
(ii)
(iii)

Journal
Preference share Capital (200 x 0.50)
Capital Reconstruction account
Ordinary share Capital (500 x 0.75)
Capital Reconstruction account
Share premium

COMPANIES RECONSTRUCTION

Dr.
$000
100

Cr.
$000
100

375
375
24
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ALWADI INTERNATIONAL SCHOOL

(iv)

(vii)

(viii)

ACCOUNTING GRADE 12

Ordinary share capital (48000 x 2 = 96000 x 0.25)

Capital Reconstruction account
Goodwill
Inventory
Trade receivables
Retained earnings
8% Debentures
Bank
Freehold Land
Capital Reconstruction account
Bank
Investments
Capital Reconstruction account

(b)
2006
31 Aug
Goodwill
Retained earnings
Inventory (10 6)
Trade receivables
(c)

NOTES
24
545
110
4
21
410
100
25
80
45
235
210
25

Capital Reconstruction Account

$000
2006
31 Aug
110
Preference share capital
410
Ordinary share capital
4
Freehold Land (125 80)
21
Investments (235 210)
545

$000
100
375
45
25
545

Knotsogood Ltd.
Balance Sheet as at 31 August 2006

Non Current Assets:

Intangible: Goodwill
Tangible: Freehold land
Premises
Vehicles
Investments
Current Assets:
Inventory (40 - 4)
Trade receivables (56 21)
Cash & cash equivalents (235 + 25 100 + 4)
(-) Current liabilities:
Trade payables
Net Current Assets
Capital Employed
(-) Non Current Liabilities:
8% Debentures (2021) (Secured on the freehold land)
Net Assets
Share Capital and Reserves:
COMPANIES RECONSTRUCTION

$000

$000
260
60
320
-

36
35
164
235
80
155
475
475

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ALWADI INTERNATIONAL SCHOOL

ACCOUNTING GRADE 12

596000 Ordinary shares of $0.25 each (500 375 + 24)

200000 8% Preference shares of $0.50 each (200 100)
Share Premium account (250 24)
Retained earnings
Share holder funds

NOTES
149
100
226
475

(d) (i) Net asset value of each Ordinary share before the scheme:
Net assets Preference shares
No. of Ordinary shares
340000* = $0.68 per share
500000
(ii) Net asset value of each Ordinary share after the scheme:
375000* = $0.63 per share
596000
* Note:
By issuing Preference shares Net Assets value increases. To calculate Net asset value of
each Ordinary share we need to deduct Preference shares value from net assets.
(e)

The share holders have not lost anything as a result of the reconstruction of the Capital of
the Company as their shares had already lost $0.75 of their value; the reconstruction
merely recognise this fact.
The debit balance has been eliminated from the retained earnings. If the business
achieves Profits in future years, profits would be payable to the shareholders immediately;
they will not have to wait for several years to get dividends.

COMPANIES RECONSTRUCTION

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