Internal ReconstructionIPCC Paper 1 : Accounting Chapter V

CA. S.S. Prathap, FCA

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Learning Objectives

• To understand the concept of Internal reconstruction

• Learn to pass Reconstruction / Capital Reduction Journal Entries.

• Learn to do full fledged 16 marks exam sums .

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Internal Reconstruction – An Intro.

Internal Reconstruction - a kind of financial Re-engineering

When the company is having substantial accumulated losses it becomes a sinking ship. Banks, Financial Institutions Sundry Creditors will no more be willing to extend credit and there is no way for the company to pull itself back to good health; except through scarifies by the various stake holders• Preference and Equity Share Holders• Debenture Holders• Directors ......

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Internal Reconstruction – An Intro.

The sacrifices made by the stake holders are “Profits to the company” and have to be credited to a special a/c called • Reconstruction a/c ( old name is Capital Reduction a/c )

It is a nominal a/c and all gains of Internal Reconstruction will be credited to it and all expenses and losses will be debited to it .

If there is any credit balance in Reconstruction a/c it has to be transferred to Capital Reserve a/c .

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Steps

1• Carefully pass Journal Entries involving

reduction of capital , settlement of Liabilities and revaluation of assets.

2• Note the changes in the Balance Sheet which

have to come in after reconstruction .

3• The Balance Sheet after reconstruction should

always have the heading (And Reduced) as per Section 100 of Companies Act.

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Methods of Internal Reconstruction

Alteration of Share Capital as per Section 94,95 and 97 of the Companies Act.

Variation of Shareholders’ rights as per section 106 of the Companies Act,1956.

Reduction of Share Capital as per Section 100 to 105 of the Companies Act,1956

Surrender of Shares

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Illustration 1Vishnu Ltd has 20,000 Equity Shares of Rs.10/- each

= Rs.2,00,000The Equity Shares are to be reduced to Rs.4/- each

= Rs.80,000

JOURNAL ENTRY : Equity Share capital Dr. 2,00,000(Rs.10 Face Value)

To Equity share capital a/c 80,000(Rs.4 each)

To Reconstruction a/c 1,20,000

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Illustration 2Adwait Ltd has 5000 Equity share of Rs.100/- each fully paid up. They are to be divided into shares of Rs. 10/-each.

JOURNAL ENTRY :Equity Share capital a/c Dr. 5,00,000(5,000 * 100)

To Equity Share capital a/c 5,00,000(50,000 * 10)

(Being stock split)

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Illustration 2 - Continued

50 % of new share were surrender .

JOURNAL ENTRY :

Share Capital a/c Dr. 2,50,000(25,000 * 10)

To Reconstruction a/c 2,50,000

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Illustration No. 3 JSN Sum

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JSN Ltd

12,000,10% Preference share of Rs.100 each

12,00,000 Goodwill 90,000

24,000 , Equity shares of Rs.100 each

24,00,000 Land and building 12,00,000

10% Debentures 6,00,000 Plant & Machinery 18,00,000

Bank Overdraft 6,00,000 Stock 2,60,000

Sundry Creditors 3,00,000 Debtors 2,80,000

Cash 30,000

Profit & Loss 14,00,000

Preliminary expenses 40,000

51,00,000 51,00,000

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The following is the Balance Sheet of JSN Ltd as on 31.03.2012.

JSN Ltd (Contd...)• The equity Shares are to be reduced to shares of Rs.40

each fully paid and the preference shares to be reduced to fully paid shares of Rs.75 each.

• The debenture holders took over stock and debtors in full satisfaction of their claims.

• The land and Building to be appreciated by 30% and Plant and Machinery to be depreciated by 30%.

• The fictitious and intangible assets are to be eliminated.• Expenses of Reconstruction amounted to Rs.5,000Give Journal Entries incorporating the above scheme of Reconstruction and prepare the reconstruction Balance Sheet .

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JSN Ltd

Accounts to be opened :

1 . Reconstruction a/c2 . Cash a/c

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Steps

Record the sacrifice of Equity Share holders and Preference Share holders . Credit Reconstruction a/c with the gain.

Settlement of 10 % Debentures.

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Step - 2

Revaluation of Land , Building , Plant and Machinery.

Debit Reconstruction a/c with accumulated losses (P & L balance) , Goodwill a/c & Preliminary expenses .

Any remaining credit balance in Reconstruction a/c transferred to Capital Reserve.

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The Equity Shares are to be reduced to shares of Rs.40 each fully paidEquity share capital a/c(100) Dr. 24,00,000

To Equity Share capital a/c(75) 9,60,000To Capital Reduction a/c 14,40,000

(Being 24,000 equity shares of Rs.100 each reduced to Rs.40 each)

Reconstruction a/c

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By Equity share holder 14,40,000

Preference shares to be reduced to fully paid shares of Rs.75 each.10% Pref. Share capital a/c(Rs.100) Dr. 12,00,000

To 10% Pref.Share capital a/c(Rs.75) 9,00,000To Capital Reduction a/c 3,00,000

(Being 12,000 Preference share of Rs.100 each reduced to Rs.75 each)

Reconstruction a/c

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By Equity share holder 14,40,000

By 10% Pref.Share holders 3,00,000

The debenture holders took over stock and debtors in full satisfaction of their claims.

10 % Debentures a/c Dr. 6,00,000To Stock a/c 2,60,000To Debtor’s a/c 2,80,000To Capital Reduction a/c 60,000

( Being debenture holders given stock and debtors in full settlement of their claims )

Reconstruction a/c

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By Equity share holder 14,40,000

By 10% Pref.Share holders 3,00,000

By 10% Debentures 60,000

Land and Building to be appreciated by 30%

Land and Building a/c Dr. 3,60,000To Capital Reduction a/c 3,60,000

( Being Land and Building appreciated by 30 % )

Reconstruction a/c

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By Equity share holder 14,40,000

By 10% Pref.Share holders 3,00,000

By 10% Debentures 60,000

By Land & Buildings 3,60,000

Plant and Machinery to be depreciated by 30%.Capital Reduction A/c Dr. 5,40,000

To Plant and Machinery A/c 5,40,000(Being Plant and Machinery

depreciated by 30%)

Reconstruction A/c

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To Plant and Machinery

5,40,000 By Equity share holder 14,40,000

By 10% Pref.Share holders 3,00,000

By 10% Debentures 60,000

By Land & Buildings 3,60,000

Expenses of Reconstruction amounted to Rs.5,000Reconstruction a/c Dr. 5,000To Cash a/c 5,000

(Being expenses of reconstruction paid)

Cash A/c

Reconstruction A/c

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To balance B/d 30,000 By Reconstruction 5,000

To Plant and Machinery

5,40,000 By Equity share holder 14,40,000

To cash 5,000 By 10% Pref.Share holders 3,00,000

By 10% Debentures 60,000

By Land & Buildings 3,60,000

Cash a/c

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To balance B/d 30,000 By Reconstruction 5,000

By c/s balance 25,000

30,000 30,000

The fictitious and intangible assets are to be eliminated.Capital Reduction a/c Dr. 16,15,000

To Goodwill a/c 90,000To Profit & Loss a/c 14,00,000To Preliminary expenses a/c 40,000To Capital Reserve a/c(bal. fig) 85,000

(Being various losses written off , assets written down and balances in capital Reduction a/c transferred to Capital Reserve a/c)

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Reconstruction a/c

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To cash 5,000 By Equity share holder 14,40,000

To Plant & Mach 5,40,000 By 10% Pref.Share holders 3,00,000

To goodwill 90,000 By 10% Debentures 60,000

To Profit & Loss 14,00,000 By Land & Buildings 3,60,000

To Preliminary 40,000

To Capital Reserve 85,000

21,60,000 21,60,000

Reconstruction A/c

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To cash 5,000 By Equity share holder 14,40,000

To Plant & Mach 5,40,000 By 10% Pref.Share holders 3,00,000

To Goodwill 90,000 By 10% Debentures 60,000

To Profit & Loss 14,00,000 By Land & Buildings 3,60,000

To Preliminary 40,000

To Capital Reserve 85,000

21,60,000 21,60,000

Notes to Accounts - 11. Share Capital :

Equity share capital24,000 equity shares of Rs.40 9,60,000

Preference share capital12,000, 10% Preference

shares of Rs.75 each 9,00,000

TOTAL 18,60,000

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Notes to Accounts - 22. Reserves and Surplus :

Capital Reserve Rs.85,000

3. Tangible Assets :

Land and Building Rs.15,60,000Plant and Machinery Rs.12,60,000

TOTAL Rs.28,20,000

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Balance Sheet (And reduced)of JSN Ltd as on 31.03.2012 I. Equity and Liabilities

(1) Shareholder’s Funds(a) Share capital 1 18,60,000(b) Reserves and Surplus 2 85,000

(2)Current LiabilitiesShort term borrowings 6,00,000Trade Payables 3,00,000

TOTAL 28,45,000

Note No.

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Balance Sheet (And reduced)of JSN Ltd as on 31.03.2012

II. Assets(1) Non-Current assets

(a) Fixed Assets Tangible Assets 3 28,20,000

(2) Current AssetsCash and cash equivalents

(30,000 – 5,000) 25,000

TOTAL 28,45,000

Note No.

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Illustration No.4 Rocky SumMay 2002 (20 marks)

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Rocky SumThe following is the Balance Sheet of Rocky Ltd. As at March

31,2002 :Liabilities :Fully paid equity shares of Rs.10 each 500Capital Reserve 612% Debentures 400Debenture Interest Outstanding 48Trade Creditors 165Director’s Remuneration Outstanding 10Other Outstanding Expenses 11Provisions 33

1,173

31

Rs. In lacs

Rocky Sum (contd...)AssetsGoodwill 15Land and Building 184Plant and Machinery 286Furniture and Fixture 41Stock 142Debtors 80Cash at bank 27Discount on issue of Debentures 8Profits and Loss Account 390

1,173

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Rs. In lacs

Rocky Sum (Contd....)The following scheme of Internal Reconstruction was framed & approved by the Court & all the concerned parties:(i) All the equity shares be converted into the same

number of fully – paid equity shares of Rs.2.50 each.(ii) Directors agree to forego their outstanding

remuneration.(iii) The debentureholders also agree to forego outstanding

interest in return of their 12% debentures being converted into 13% debentures.

(iv) The existing shareholders agree to subscribe for cash, fully paid equity shares of Rs.2.50 each for Rs.125 lacs.

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Rocky Sum (Contd....)(v) Trade creditors are given the option of either to accept fully-

paid equity shares of Rs.2.50 each for the amount due to them or to accept 80% of the amount due in cash. Creditors for Rs.65 lacs accept equity shares whereas those for Rs.100 lacs accept Rs.80 lacs in cash in full settlement.

(iv) The Assets are revalued as under:Rs. in lacs

Land and building 230Plant and Machinery 220 Stock 120Debtors 76

Pass journal entries for all the above mentioned transactions and draft the company’s Balance Sheet immediately after the reconstruction.

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Rocky

Accounts to be opened :

1 . Reconstruction a/c2 . Bank a/c

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Steps

1• Open Reconstruction a/c and to its credit record the sacrifices of

• Equity Share holders , Directors , 12 % Debenture holders and trade creditors .

2• The Revaluation of assets should be passed through Reconstruction

a/c

3

• The balance left in Reconstruction a/c should be used to write off • Goodwill • Discount on issue of Debentures and • Accumulated Losses (P&L a/c)

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Journal Entries

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All the equity shares be converted into the same number of fully – paid equity shares of Rs.2.50 each.Equity Share Capital

(Rs.10 each) a/c Dr. 500To Equity Share Capital

(Rs.2.50 each) a/c 125To Reconstruction a/c 375

(Conversion of all the equity shares into the same number of fully paid equity shares of Rs.2.50 each as per scheme of reconstruction)

Reconstruction A/c

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By Equity Share Capital A/c 375

Rs. In lacs

Directors agree to forego their outstanding remuneration.Director’s Remuneration

Out Standing a/c Dr. 10To Reconstruction a/c 10

(Out Standing remuneration foregone by the directions as per scheme of reconstruction)

Reconstruction A/c

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By Equity Share Capital A/c 375By Director’s Remuneration O/s 10

Rs. In lacs

The debentureholders also agree to forego outstanding interest in return of their 12% debentures being converted into 13% debentures.12% Debentures a/c Dr. 400Debenture Interest

Out Standing a/c Dr. 48To 13% Debentures a/c 400To Reconstruction a/c 48

(Conversion of 12% debentures into 13% debentures ,Debenture holders forgoing outstanding debentureinterest)

Reconstruction A/c

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By Equity Share Capital A/c 375By Director’s Remuneration O/s 10By Debenture Interest Outstanding 48

Rs. In lacs

The existing shareholders agree to subscribe for cash, fully paid equity shares of Rs.2.50 each for Rs.125 lacs.Bank Dr. 125

To Equity Share Application a/c 125

(Application money received for equity shares)

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Rs. In lacs

Trade creditors are given the option of either to accept fully-paid equity shares of Rs.2.50 each

Equity Share Application a/c Dr. 125To Equity Share capital

(Rs.2.50 each) a/c 125(Application money transferred to share capital)

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Rs. In lacs

Trade creditors are given the option of either to accept fully-paid equity shares of Rs.2.50 each

Trade Creditors Dr. 165To Equity Share Capital a/c 65To Bank a/c 80To Reconstruction a/c 20

(Trade creditors for Rs.65 lakhs accepting shares for full amount and those for Rs.100 lakhs accepting cash equal to 80% of claim in full settlement)

Reconstruction A/c

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By Equity Share Capital A/c 375By Director’s Remuneration O/s 10By Debenture Interest Outstanding 48By Trade Creditors 20

Rs. In lacs

Use of old Capital ReserveCapital Reserve Dr. 6

To Reconstruction a/c 6(Capital Reserve being used for purpose of reconstruction)

Reconstruction A/c

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By Equity Share Capital A/c 375By Director’s Remuneration O/s 10By Debenture Interest Outstanding 48By Trade Creditors 20By Capital Reserve 6

Rs. In lacs

Revaluation of Land & BuildingLand and Building Dr. 46

To Reconstruction a/c 46(Appreciation made in the value of land and building as per

scheme of reconstruction)Reconstruction A/c

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By Equity Share Capital A/c 375By Director’s Remuneration O/s 10By Debenture Interest Outstanding 48By Trade Creditors 20By Capital Reserve 6By Land & Building 46

Rs. In lacs

Writing off accumulated losses & fictitious assets etc….Reconstruction a/c Dr. 505

To Goodwill a/c 15To Plant and Machinery a/c 66To Stocks a/c 22To Debtors a/c 4To Discount on issue of

Debentures a/c 8To Profit and Loss Account 390

(Writing off losses and reduction in the value of asset)

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Rs. In lacs

Reconstruction a/c

47

To Goodwill 15 By Equity Share Capital A/c 375To Plant & Machinery 66 By Director’s Remuneration O/s 10To Stock 22 By Debenture Interest Outstanding 48To Debtors 4 By Trade Creditors 20To Discount on issue of debentures 8 By Capital Reserve 6To Profit & Loss 390 By Land & Building 46

505 505

Note 1Equity Share capital as on 31.03.2002 (after reconstruction)

Equity Share Capital(Rs.2.50 each) 125(+) Fresh issue 125(+) Equity shares issued to creditors 65

315

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Rs. In lacs

Note 2Cash at Bank as on 31.03.2002(after reconstruction)Cash at Bank(before reconstruction) 27(+)Proceeds from issue of equity shares 125

152(-)Payment made to creditors 80

TOTAL 72

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Rs. In lacs

Balance Sheet (And reduced)of Rocky Ltd as at 31.03.2012 I. Equity and Liabilities

(1) Shareholder’s FundsShare capital 1 315

(2) Non - Current LiabilitiesLong term borrowings 400

(3)Current Liabilities Outstanding expenses 11Provisions 33

TOTAL 759

Rs. LakhsNote No.

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Balance Sheet II. Assets

(1) Non-Current assets(a) Fixed Assets

Tangible Assets 491

(2) Current AssetsStock 120Trade Receivables 76Cash and cash equivalents 2 72

TOTAL 759

Rs. In LakhsNote No.

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Ice sum(16 Marks, Nov 2011)

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Ice SumThe Balance Sheet of M/s Ice Ltd as on 31-03-2011 is given below:Liabilities Amount Assets Amount1,00,000 equity shares Freehold Property 5,50,000Rs 10 each fully paidup 10,00,0004,000,8% Pref. sharesRs 100 each fully paid 4,00,000 Plant and machinery 2,00,0006% Debenture Securedby freehold property

4,00,000 Trade Investments (atCost) 2,00,000Arrear Interest 24,000 4,24,000 Sundry Debtors 4,50,000Sundry Creditors 1,01,000 Stock-In-Trade 4,50,000Directors Loan 3,00,000 Deferred Advertisement

Expenses 50,000Profit & Loss Account 4,75,000

Total 22,25,000 Total 22,25,000•

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Ice Sum (Contd....)The Board of Directors of the company decided upon thefollowing scheme of reconstruction with the consent ofrespective stakeholders:•Preference shares are to be written down to Rs 80 each andequity shares to Rs 2 each.•Preference dividend in arrear for 3 years to be waived by 2/3rd

and for balance 1/3rd, equity shares of Rs 2 each to be allotted.•Debenture holder agreed to take one freehold property at itsbook value of Rs 3,00,000 in part payment of the holdings.Balance debentures to remain as liability of the company.•Arrear debenture interest to be paid in cash.•Remaining free hold property to be valued Rs 4,00,000

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Ice Sum(Contd....)• Investment sold out for Rs 2,50,000• 75% of Directors loan to be waived and for the balance,

equity share of Rs 2 each to be allotted.• 40% of sundry debtors, 80% of stock and 100% of

deferred advertisement expenses to be written off.• Company’s contractual commitments amounting to Rs

6,00,000 have been settled by paying 5% penalty ofcontract value.

Show the journal entries for giving effect to the internalreconstruction and drawn the Balance Sheet of thecompany after effecting the scheme.

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Approach to the sum The sacrifices of Preference

share holders , Directors have to be recorded and credited to Reconstruction a/c .

For all other movements Journal Entries to be passed .

The credit balance in Reconstruction a/c to be used to write off Profit and loss debit balance.

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Journal Entries

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Preference shares are to be written down to Rs 80each and equity shares to Rs 2 each.

8% Preference sharecapital a/c(Rs.100 each) Dr.

To 8% Preference share capital a/c (Rs.80 each)

To Capital Reduction a/c (Being the preference shares of Rs.100 each reduced to Rs.80 each as per the approved scheme)

Equity Sharecapital a/c (Rs.10 each) Dr.

To Equity Sharecapital a/c (Rs.2 each)

To Capital Reduction a/c(Being the Equity shares of Rs.10 each reduced to Rs.2 each)

4,00,000

10,00,000

3,20,000

80,000

2,00,000

8,00,000

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Preference dividend in arrear for 3 years to bewaived by 2/3rd and for balance 1/3rd, equityshares of Rs 2 each to be allotted.

Capital reduction a/c Dr. 32,000To Equity share capital a/c 32,000

(Being arrears of preference sharedividend of one year to be satisfied by issue of 16,000equity shares of Rs.2 each)

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Debenture holder agreed to take one freehold property at its book value of Rs 3,00,000 in part payment of the holdings.

6% Debentures a/c Dr. 3,00,000To Freehold property a/c 3,00,000

(Being claim settled in part bytransfer of freehold property)

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Arrear debenture interest to be paid in cash.

Accrued debenture interest a/c Dr. 24,000To Bank a/c 24,000

(Being accrued debenture interest paid)

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Remaining free hold property to be valued Rs 4,00,000.The opening Freehold property was Rs.5,50,000 . Of this3,00,000 was taken over by Debenture holders.The balance remaining property of Rs.2,50,000 has beenvalued upwards at Rs.4,00,000.

Freehold property a/c Dr. 1,50,000To Capital reduction a/c 1,50,000

(Being appreciation in the value of freehold property)

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Investment sold out for Rs 2,50,000.

Bank a/c Dr. 2,50,000To Trade investment a/c 2,00,000To Capital Reduction a/c 50,000

(Being trade investment sold on profit)

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75% of Directors loan to be waived and for the balance, equity share of Rs 2 each to be allotted.

Director’s Loan a/c Dr. 3,00,000To Equity share capital a/c 75,000To Capital Reduction a/c 2,25,000

(Being Director’s loan waived by 75% and balance discharged by issue of 37,500 equity shares of Rs. 2 each)

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40% of sundry debtors, 80% of stock and 100% ofdeferred advertisement expenses to be writtenoff.

Reconstruction a/c Dr. 4,70,000To Sundry Debtor’s a/c 1,80,000To Stock in hand a/c 2,40,000To Deferred 50,000

advertisement expenses a/c

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Company’s contractual commitments amounting to Rs 6,00,000 have been settled by paying 5% penalty of contract value.

Reconstruction a/c Dr. 30,000To Bank a/c 30,000

(Being penalty paid)

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Write off of accumulated lossesReconstruction a/c Dr. 7,73,000

To P & L a/c 4,75,000To Capital Reserve a/c 2,98,000

(Being Profit and loss account debit balance written off and balance transferred to capital reserve account )

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Notes to accounts1 . Share Capital :

1,53,500 Equity shares of Rs.2 each 3,07,0004,000 , 8% Preference shares of Rs.80 3,20,000

TOTAL 6,27,000

2 . Reserves and Surplus :Capital Reserve 2,98,000

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Notes to accounts3 . Long Term Borrowings :

6% Debentures 1,00,000

4 . Tangible Assets :Freehold Property 4,00,000Plant & Machinery 2,00,000

TOTAL 6,00,000

5 . Cash and Cash Equivalents :` Cash at Bank

(2,50,000-24,000-30,000) 1,96,000

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Balance Sheet (As reduced)of Ice Ltd

I. Equity and Liabilities (1) Shareholder’s Funds

(a) Share capital 1 6,27,000(b) Reserves and Surplus 2 2,98,000

(2)Non- Current LiabilitiesLong term borrowings 1,00,000

(3)Current LiabilitiesTrade Payables 1,01,000

TOTAL 11,26,000

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Rs. LacksNote No.

Balance Sheet (As reduced)of Ice Ltd

II. Assets(1) Non-Current assets

(a) Fixed Assets Tangible Assets 4 6,00,000

(2) Current Assets(a) Inventories 60,000(b) Trade Receivables 2,70,000(c)Cash and cash equivalents 5 1,96,000

TOTAL 11,26,000

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Rs. In LakhsNote No.

Lesson Summary• So we learnt how to handle an Internal Reconstruction

sum .• The first step is to pass Journal Entries , Credting

Reconstruction A/c with all gains and Debiting the various stake holders who are sacrificing

• The Assets and Liabilities should simultaneously be taken at their revised valuation

• The remaining credit balance in Reconstruction A/c should be transferred to Capital Reserve A/c.

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Thank You

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