Internal and External Reconstruction: the Distinction That Decides Everything
Chapter Two
Syllabus topic 2, "Distinction between internal and external reconstructions"
Pages 4 to 5 of 85
In one line
In an internal reconstruction the company survives and only its capital is rearranged; in an external reconstruction the company is wound up and a new company takes over its business.
The one question to ask
Is there a second company?
If the scheme happens inside one company, it is internal. If a new company is formed, or an existing one takes over, it is external. Everything else follows from that.
Internal reconstruction
The company stays alive. Its name, its registration, its contracts and its legal identity are untouched. What changes is the figure at which its capital and some of its liabilities are stated.
The shareholders agree to accept less. The amount they give up is collected in the Capital Reduction Account and spent writing off the fictitious assets, the overvaluation and the accumulated loss. When the write-off is finished the account is closed and a fresh Balance Sheet is drawn.
No cash moves. No business is sold. Nobody is liquidated.
This is the whole of Module I, and it is authorised by ss.48, 61, 64 and 66 of the Companies Act 2013.
External reconstruction
The company is wound up. A new company is formed, usually with a similar name, and it purchases the business of the old one. The purchase price is settled mostly in the new company's shares, which are issued to the old company's shareholders.
The result looks similar from the outside: the same business, carried on, with the losses gone. But legally two companies have been involved, one of which no longer exists.
Because a business has passed from one company to another, this is an amalgamation within the meaning of AS 14, and it is almost always an amalgamation in the nature of purchase. It is accounted for in the books of the transferee company by the purchase method, which is Module II's subject: see [Amalgamation in the Nature of Purchase] and [The Purchase Method, Worked in the Transferee's Books].
The comparison, set out
| Internal reconstruction | External reconstruction | |
|---|---|---|
| Does the company survive? | Yes | No, it is wound up |
| How many companies? | One | Two, an old and a new |
| Is there a liquidation? | No | Yes, of the old company |
| What is rearranged? | The capital of the existing company | The ownership of the business |
| Governing provision | Companies Act 2013, ss.48, 61, 64, 66 | Companies Act 2013 read with AS 14 |
| Approval needed | Members, and the Tribunal for a reduction under s.66 | Members of both companies, and the Tribunal |
| Key account opened | Capital Reduction Account | Realisation Account, in the old company's books |
| Whose books carry the entries? | The one company's | Both: the transferor's and the transferee's |
| Is goodwill or capital reserve created? | No | Yes, on the purchase |
| Accounting standard | None | AS 14 |
| Studied in | Module I | Module II |
Internal and External Reconstruction: the Distinction That Decides Everything
What the question will say
A question is internal when it says the company resolved to reduce its capital, that shares of Rs 10 are to be treated as shares of Rs 4, that a scheme of reconstruction was sanctioned, and then gives you a list of write-offs to make. There is one Balance Sheet at the start and one at the end.
A question is external when it says a new company was formed to take over the business, that the purchase consideration was so much, that the old company was wound up or went into liquidation, and that shares in the new company were issued to the old company's shareholders. There are two sets of books.
The phrase external reconstruction may not appear at all. "A new company, X Ltd., was formed to acquire the business of Y Ltd." is an external reconstruction whether or not it is called one.
A trap worth naming
Students see the word reconstruction and reach for the Capital Reduction Account. In an external reconstruction there is no Capital Reduction Account. The old company opens a Realisation Account, transfers its assets and liabilities to it, and the difference is a profit or loss on realisation. The new company records a purchase.
The reverse trap also exists: in an internal reconstruction there is no purchase consideration, no Realisation Account and no goodwill, because nothing has been bought.
In short
- One question separates them: is there a second company?
- Internal, one company, no liquidation, capital restated, Capital Reduction Account, Module I.
- External, two companies, the old one wound up, business purchased, Realisation Account and purchase consideration, AS 14, Module II.
- The question will tell you which, but often without using either name.
- The accounts opened are different, and using the wrong one loses the whole answer.
Answer in one sentence
Distinguish internal from external reconstruction. In an internal reconstruction the existing company continues and only the stated figures of its capital and liabilities are rearranged, under ss.48, 61, 64 and 66 of the Companies Act 2013, the sacrifices being collected in a Capital Reduction Account; in an external reconstruction the existing company is wound up and a newly formed company purchases its business for a consideration discharged mainly in shares, the transaction being an amalgamation accounted for under AS 14.
Is external reconstruction an amalgamation? Yes. A business passes from one company to another, so it falls within AS 14, and because the conditions of a merger are not satisfied it is accounted for as an amalgamation in the nature of purchase.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.