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Internal & external recounstruction

difference between internal reconstruction and external reconstruction.

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Internal & external recounstruction

  1. 1. Internal and External Reconstruction 1 ARSHAD ISLAM; contact no.: 0092-313-9911865; Internal Reconstruction: Introduction A company might have suffered huge losses in the past or might have the problem of over capitalization or might have over valued its fixed assets because of inadequate provision for depreciation. Such a company faces the dangerof goingontoliquidationeithervoluntarilyorbecause of a petitionby any of its creditors or Debenture holders. In these circumstances companies have three options: a) To Liquidate the company (Liquidation) b) To Reconstruct Externally ( External Reconstruction) c) To Reconstruct Internally ( Internal Reconstruction) Meaning of Internal Reconstruction Internal Reconstructionisanarrangementmade bycompanieswherebythe claims of shareholders, Debenture holders,creditorsandotherliabilities are altered / reduced, so that the accumulated losses are written off, assets are valued at its fair value and the balance sheet shows the true and fair view of the financial position. Forms of Internal Reconstruction Internal Reconstruction may take any of the following two forms: a) Re-organization or Alteration of Share Capital b) Reduction of Share Capital and other Liabilities a) Re-organization or Alteration of Share Capital: Re-organization or alteration of share capital refers to the arrangement of the capital of the company and include the following: a. Increase the share capital by making fresh issue of shares b. Decreasing the share capital by cancelling the unissued shares. c. Conversion of shares into stock and vice versa d. Consolidation of shares of smaller amounts into shares of larger amounts e.Sub-divisionof sharesof largeramountsintoshare of smaller amounts. A company can alter its share capital if it is authorized by its Articles of Association. b) Reductionof Share Capital and other Liabilities: Reductionof Share Capital is an arrangement under which the capital of the shareholderandsometimeseventhe claimsof debenture holders and the creditors are reduced. The amount made available by capital reduction is utilized in writing off the accumulated losses, fictitious assets and the overvaluedportion of the other assets. A company can reduce its paid-up capital if a. It is authorized by its articles b. A special resolution is passed and c. A sanction of the court is obtained Differences between Internal Reconstruction and External Reconstruction a. No newcompanyisformedincase of Internal Reconstruction.A new companyis formed in case of External Reconstruction. b. In case of Internal Reconstruction, no company is liquidated. In case of External Reconstruction one company is liquidated c. Internal Reconstructionrequirescourt’sconfirmation.But External Reconstruction can be affected without court’s confirmation d. Internal Reconstructionisaslowandtediousprocess.But External Reconstruction can be carried out easily e. In the case of Internal Reconstruction, the company is able to set off its past losses against future profits. Whereas,inthe case of External Reconstruction, the past losses of the old company can’t be set off against the future profits of the new company.
  2. 2. Internal and External Reconstruction 2 ARSHAD ISLAM; contact no.: 0092-313-9911865; Amalgamation: Introduction Amalgamation means the merging of two or more than two companies for eliminating competition among them or for growing in size to achieve the economies of scale. Amalgamation is a broad term which includes mergers (uniting of two existing companies) and acquisition (one company buying out another company). There are twotypesof amalgamation:AccordingtoAS-14 amalgamationisdividedintothe followingtwo categoriesforaccountingpurposes: (A) Amalgamationinthe nature of merger;and (B) Amalgamationinthe nature of purchase. Objectivesof amalgamationofcompanies The followingare the mainobjectivesof amalgamationof companies: (a) To avoid competition:The mainpurpose of amalgamationof companiesisto avoidcompetitionamong themselves.Thiswill givethe companyanedge overitscompetitors. (b) To reduce cost: The amalgamatedcompanycan derive the operatingcostadvantage throughloweringthe cost of production.Thisispossible becauseof ‘economiesof large scale’. (c) To gain financially:The amalgamatedcompanycan derive financial gainwhichmaybe inthe formof tax advantage,highercreditworthinessandlowerrate of borrowing. (d) To achieve growth: The amalgamatedcompanycanpool itsresourcesto facilitate internal growthandto preventthe adventof a newcompetitor. (e) To diversifythe activities: The riskof a companycan be loweredbydiversifyingitsactivitiesintotwoormore industries.Attimes,amalgamationmayactas hedgingthe weakoperationwithastrongerone. External reconstruction: Introduction Reconstruction refers to certain arrangements made by financially unsound companies. The reconstruction arrangement made by a company, to come out of its financial difficulties, may be external or internal. External reconstructionrefersto closing/liquidating the company and starting again a new or a fresh. That is technically, a new companywill be floatedorformedtotake overthe existingcompany. Internal reconstruction refers to making internal arrangements for overcoming financial difficulties. Differences between amalgamation and external reconstruction 1. Amalgamation of companies involves liquidation of two or more companies, while external reconstruction involves liquidation of only one company, 2. Amalgamationof companiesresultsincombinationof companies,butexternalreconstructiondoesnot result in any such combination. Differences between absorption and external reconstruction 1. Absorption of companies does not involve formation of a new company; however, external reconstruction involves formation of a new company, 2. Absorptionof companiesresultsinliquidationof one ormore companieswhile external reconstructionresults in liquidation of only one company. 3. Absorption of companies involves combination of companies, whereas external reconstruction does not involve any combination.
  3. 3. Internal and External Reconstruction 3 ARSHAD ISLAM; contact no.: 0092-313-9911865; Purchase Consideration Purchase Considerationreferstothe considerationpayable bythe purchasing company to the vendor company for taking over the assets and liabilities of Vendor Company. Accounting Standard – 14 defines the term purchase consideration as the “aggregate of the shares and other securities issued and the payment made in the form of ach or other assets by the transferee company to the shareholdersof the transferorcompany”.Although,purchase considerationreferstototal paymentmade bypurchasing company to the shareholders of Vendor Company, its calculation could be in different methods, as explained below: a. Lump sum method b. Net Assets method c. Net Payment Method a. Lump sumMethod: Under thismethodpurchase considerationwill be paid in lump sum as per the valuation of purchasingcompaniesvaluation.E.g.,If it is stated that A Ltd. takes over the business of B Ltd. for Rs.15, 00,000 here the sum of the Rs.15, 00,000 is the Purchase Consideration. b. Net Assets Method: Under this method P.C. shall be computed as follows: Particulars Rs. Agreed value of assets taken over Less: Agreed value of Liabilities taken over XXX XXX Purchase Consideration XXX Note: i. The term “agreed value” means the amount at which the transferor company has agreed to sell and the transferee company has agreed to take over a particular assets or a liability Otherwise book value will be the agreed value. ii.Fictitiousassets(i.e.,preliminaryexpenses,underwritingcommission,discountonissue of shares,discounton issue of debentures and debit balance in P & L A/c) are not taken over. c. Net Payment Method: Under this method P.C. should be calculated by aggregating total payments made by the purchasing company. E.g.: A Ltd. had taken over B Ltd. and for that it agreed to pay Rs.5, 00,000 in cash 4, 00,000 EquitySharesof Rs.10 eachfullypaidat an agreedvalue of Rs.15 per share then the P.C. will be ascertained as follows: Particulars Rs. Cash 4,00,000 E. Shares of Rs.10 each fully paid, at Rs.15 per share 5,00,000 60,00,000 Purchase Consideration 65,00,000 Methods of accounting for amalgamation of Companies a. Purchase method b. Pooling of interest method Conditions for ‘Amalgamation in the nature of Merger’ in an Amalgamation’ According to AS14 on Accounting for Amalgamation, the following conditions must be satisfied for an amalgamation in the nature of merger: a. Afteramalgamation,all the assetsandliabilitiesof the transferorcompanybecomes the assets and liabilities of the transferee company. b. Shareholders holding not less than 90% of the face value of the equity shares of the transferor company become the equity shareholders of the transferee company by virtue of amalgamation.
  4. 4. Internal and External Reconstruction 4 ARSHAD ISLAM; contact no.: 0092-313-9911865; c. The businessof the transferorcompanyisintendedtobe carriedonafterthe amalgamationbythe transferee company. d. Purchase considerationshouldbe dischargedonlybyissue of equitysharesinthe transferee company except that cash may be paid in respect of any fractional shares. e. No adjustments are required to be made in the book values of the assets and liabilities of the transferor company,whentheyare incorporatedinthe financial statementsof the transferee company.If anyone of the condition is not satisfied in a process of amalgamation, it will not be considered as amalgamation in the nature of merger. Difference between Pooling of interest and purchase method of recording transactions relating to amalgamation: Basis Pooling of Interest Method Purchase Method a) Applicability The poolingof interest method is applied in case of an amalgamation in the nature of merger. Purchase methodisappliedinthe case of an amalgamation in the nature of purchase. b) Recording In the pooling of interest method all the reserves of the transferor Co. are also recorded by the transferee Co. in its books of account. In the purchase method the transferee Co. records in its books of accounts only the assets and liabilities taken over the reserves,exceptthe statutoryreservesof the transferor company are not aggregated with those of the transferee Co. c) Adjustment of the differences Under the pooling of interest method, the difference between the consideration paid and the share capital of the transferor company is adjusted in the general reserve or other reserves of the transferee company. Under the purchase method, the difference between the consideration and net assets taken over is treated by the transferee company as goodwill or capital reserve. d) Statutory reserves In this method, the statutory reserves are recorded by the transferee co. like all other Reserves without opening Amalgamation and Adjustment A/c. In the purchase method, while incorporating the statutory reserves, the transferee Co.hasto openamalgamation adjustment account debiting it with the amt. of the statutory reserves being incorporated. Difference between Amalgamation in the nature of purchase and Amalgamation in the nature of merger Basis of Distinction Amalgamation in the Nature of Merger Amalgamationinthe Nature of Purchase a) Transferof Assetsand Liabilities There is transfer of all assets & liabilities. There need not be transfer for all assets & liabilities. b) EquityShareholder’s holding90% Equity shareholders holding 90% equity shares in transferor company become shareholders of transferee company. Equity shareholders need not become shareholders of transferee company. c) Purchase Consideration Purchase considerationisdischargedwholly by issue of equity shares (except cash for fractional shares) Purchase consideration need not be discharged wholly by issue of equity shares.
  5. 5. Internal and External Reconstruction 5 ARSHAD ISLAM; contact no.: 0092-313-9911865; d) Same Business The same business of the transferor companyisintendedtobe carriedon bythe transferee company. The business of the transferor company neednotbe intendedtobe carriedon by the transferee company. e) Recordingof Assets& Liabilities The assets & liabilities taken over are recordedat their existing carrying amounts except where adjustment is required to ensure uniformity of accounting policies. The assets & liabilities taken over are recorded at their existing carrying amountsor the basis of their fair values. f) Recordingof Reservesof TransferorCo. All reserves are recorded at their existing carrying amounts and in the same form. Only statutory reserves are recorded at their existing carrying amounts. g) Recordingof Balance of Profit& Loss A/cof Transferor The balance of P&L A/c should be aggregatedwiththe corresponding balance of the transferee co. or transferred to the General. The balance of P&L A/clossesitsidentify and is not recorded at all.