A Complete Worked Scheme: Old Balance Sheet to New

Step 3. Capital Reduction Account

Step 4. Reconstructed Balance Sheet

Balance Sheet of Ashwin Ltd. as at 31st March, after reconstruction

A second scheme, at the difficulty MU actually sets

Ashwin Ltd. above has six adjustments and every one of them is a straight reduction or write-off. A real paper is harder than that. MU's own TYBCom Financial Accounting paper of October 2024 set a reconstruction with eight adjustments, including a preference share conversion, an asset sold at a profit inside the scheme, arrears half waived and half paid in cash, and an asset handed to debenture-holders with fresh debentures for the balance.

None of those appears above, so here is a second scheme that carries all of them. Work Ashwin first; work this one until it is easy.

The Balance Sheet of Vikram Ltd. stood as follows.

The preference dividend is in arrears for two years. The following scheme was sanctioned. (1) The equity shares are to be reduced to Rs 4 each fully paid. (2) The 12 per cent cumulative preference shares are to be converted into an equal number of 10 per cent preference shares of Rs 70 each fully paid. (3) The investments are to be sold at a profit of 10 per cent. (4) The preference shareholders agreed to waive half the arrears of dividend, the remaining half being paid in cash. (5) The debenture-holders agreed to accept the plant and machinery at Rs 2,60,000 and 400 new 15 per cent debentures of Rs 100 each in full settlement of their claim. (6) The debenture-holders agreed to forgo half the outstanding interest, the balance being paid in cash. (7) Goodwill, the Discount on Issue of Shares and the debit balance of Profit and Loss are to be written off in full. (8) Any balance is to be transferred to Capital Reserve.

Working notes

On WN 4 and WN 5, which is the trap. The arrears of preference dividend are not in the books: a preference dividend is payable only when declared, so unpaid arrears are a contingent item disclosed by note. Waiving them therefore produces no entry at all. What does produce an entry is the half that is paid, and because the company is paying a sum it never owed in its books, the debit goes to the Capital Reduction Account. A student who credits Capital Reduction with the waived Rs 48,000 has invented a liability in order to forgive it.

On WN 6. The debenture-holders' claim is Rs 3,00,000. They take plant valued at Rs 2,60,000 and Rs 40,000 of new debentures, which settles it exactly. But the plant leaves the books at Rs 3,20,000, so Rs 60,000 of value has gone for nothing and that loss is a charge on Capital Reduction.

Journal entries

Capital Reduction Account

Balance Sheet after the scheme

Balance Sheet of Vikram Ltd. after reconstruction

The bank overdraft. It began at Rs 60,000, was reduced by the Rs 88,000 received for the investments, and increased by the Rs 48,000 of arrears and the Rs 18,000 of interest paid: Rs 60,000 less Rs 88,000 plus Rs 48,000 plus Rs 18,000 is Rs 38,000. A scheme that moves cash always moves the overdraft, and forgetting it is the commonest reason a reconstructed Balance Sheet does not balance.

Plant and Investments are gone from the assets because both left the company: one to the debenture-holders, one to a buyer.

The seven things this scheme teaches that Ashwin Ltd. does not

1. A preference share converted, not merely reduced: the class, the rate and the face value all change in one entry, and the sacrifice is the fall in face value.
2. An asset sold at a profit inside the scheme: the profit is a capital gain and is credited to Capital Reduction, not to Profit and Loss.
3. Arrears half waived and half paid: the waiver produces no entry and the payment is a debit to Capital Reduction.
4. An asset handed over in part settlement with fresh securities for the balance, and the shortfall between book value and agreed value charged to Capital Reduction.
5. A liability that IS in the books being partly forgiven and partly paid, which behaves quite differently from the arrears in point 3.
6. Discount on Issue of Shares written off, a fictitious asset Ashwin Ltd. did not carry.
7. Cash movements changing the bank overdraft, which must be tracked to the last rupee.

What has actually happened

The Balance Sheet total has fallen from Rs 11,00,000 to Rs 7,30,000, a fall of Rs 3,70,000, which is exactly the amount written off.

Nothing left the company. No cash was paid to anyone. The freehold property, the stock, the debtors and the bank balance are untouched, and the business trades on with the same assets it had the day before.

What has gone is the fiction: Rs 80,000 of goodwill nobody would buy, Rs 2,50,000 of accumulated loss masquerading as an asset, and Rs 40,000 of plant value that was not there. The capital has been written down to match, and the company now shows a small Capital Reserve instead of a large accumulated loss.

It can now pay a dividend out of the next year's profits, because there is no debit balance to absorb them first. That was the point of the whole exercise, and a closing sentence saying so is worth writing.

Marks to be sure of

• Show the working notes and number them. Cite the number in the narration.
• Balance the Capital Reduction Account and show its total. A debit balance means an error, not a loss.
• Do not transfer the surplus to Profit and Loss. It is a Capital Reserve.
• Carry forward every figure the scheme did not touch. Freehold, stock, debtors, cash and the debentures come across unchanged, and a Balance Sheet that omits them will not balance.
• State the authority once: reduction under s.66, confirmed by the Tribunal; any sub-division or consolidation under s.61; notice to the Registrar under s.66(5).

In short

• Working notes, journal, Capital Reduction Account, Balance Sheet. In that order.
• The fall in the Balance Sheet total equals the total written off.
• The reconstructed Balance Sheet must balance; if it does not, check the Capital Reduction Account first.
• Say at the end what the company has gained: a clean Balance Sheet and the ability to pay a dividend.

Answer in one sentence

Set out the order of a reconstruction answer. Numbered working notes computing each sacrifice and each write-off; the journal entries with narrations citing those notes; the Capital Reduction Account showing the sacrifices credited, the write-offs debited and the surplus carried to Capital Reserve; and the reconstructed Balance Sheet.