Reading a Reconstruction Question: Finding the Scheme in the Prose
Chapter Twelve
Syllabus topic 3, "Methods including alteration of share capital ... and accounting treatment for same"
Pages 28 to 29 of 85
In one line
Before posting anything, turn the examiner's paragraph into a numbered list of separate instructions, and check each one against the Balance Sheet it is meant to change.
Why this is worth a chapter
Here is how a scheme actually arrives in an examination paper.
The following scheme of reconstruction was approved and duly sanctioned. The equity shares of Rs 10 each are to be reduced to shares of Rs 4 each fully paid. The preference shareholders agreed to forgo their arrears of dividend of Rs 90,000 and to accept a reduction of 20 per cent in the paid-up value of their shares. The debenture-holders agreed to take over the freehold property at Rs 2,50,000 in part satisfaction of their claim. Goodwill and the debit balance of the Profit and Loss Account are to be written off in full, plant is to be written down by Rs 60,000, and a provision of Rs 15,000 is to be made for a claim against the company. The balance, if any, is to be transferred to Capital Reserve.
That is one paragraph and eight separate instructions. Written out as prose it invites a student to work down it in order, posting as they go, and the eighth instruction cannot be obeyed until the other seven are complete.
The method
Step 1. Number the instructions. Split the paragraph at every full stop and every "and" that introduces a new act. Write them as a list before touching a ledger.
Step 2. Mark each one as a sacrifice or a write-off. This is the step that makes the arithmetic work, because the two sides must meet in the Capital Reduction Account.
| No. | Instruction | Sacrifice, or write-off? |
|---|---|---|
| 1 | Equity Rs 10 shares reduced to Rs 4 | Sacrifice |
| 2 | Preference arrears of dividend forgone | Sacrifice |
| 3 | Preference paid-up value reduced by 20 per cent | Sacrifice |
| 4 | Freehold property taken by debenture-holders | Neither, see step 4 |
| 5 | Goodwill written off | Write-off |
| 6 | Profit and Loss debit balance written off | Write-off |
| 7 | Plant written down by Rs 60,000 | Write-off |
| 8 | Provision for a claim, Rs 15,000 | Write-off |
Step 3. Notice what the arrears of dividend actually are. Arrears of preference dividend are usually not a liability in the books at all; they are a contingent item disclosed by way of note, because a preference dividend is payable only when declared. If they are not in the books, forgoing them produces no entry. If the question has capitalised them or shown them as a liability, forgoing them is a sacrifice and does produce one.
Read the Balance Sheet before deciding. This single point separates a correct answer from a plausible one.
Step 4. Separate the settlements from the sacrifices. Instruction 4 is neither. The debenture-holders are taking an asset in part satisfaction of a debt. That is a settlement between two book figures: the asset leaves, the liability falls. Any difference between the asset's book value and the amount credited against the debt is a gain or loss and goes to Capital Reduction, but the transfer itself is not a sacrifice by anybody.
Reading a Reconstruction Question: Finding the Scheme in the Prose
Step 5. Leave the balancing instruction until last. Instruction 8 says the balance goes to Capital Reserve. It cannot be obeyed until every other entry is posted, because it is the balance. A student who tries to compute it early will compute it wrong.
The checks to run before writing the answer out
Does every sacrifice have a matching reduction in a capital or liability account? A sacrifice by equity shareholders reduces Equity Share Capital. A sacrifice by creditors reduces Creditors.
Does every write-off correspond to something actually on the Balance Sheet? A scheme that writes off Rs 60,000 from plant needs plant on the Balance Sheet at more than Rs 60,000.
Does the Capital Reduction Account close? The sacrifices credited must at least equal the write-offs debited. Any surplus goes where the scheme says, usually Capital Reserve. A debit balance left in the account means an error, not a loss: the scheme was designed to absorb the write-offs.
Does the reconstructed Balance Sheet balance? If it does not, the error is upstream, and the fastest place to find it is the Capital Reduction Account.
What the question will not tell you
It will not tell you which section authorises each step. That is what the "legal provisions" half of MU's topic 3 wants, and the mapping is:
| Instruction | Provision |
|---|---|
| Reducing the paid-up value of a share | s.66(1)(b)(i) |
| Sub-dividing or consolidating first | s.61(1)(d) or (b) |
| Treating a class differently from another | s.48 |
| Filing afterwards | s.66(5), or s.64 for an s.61 alteration |
In short
- Turn the paragraph into a numbered list before posting anything.
- Mark each instruction as a sacrifice, a write-off, or a settlement; they behave differently.
- Arrears of preference dividend are usually not in the books, so forgoing them may produce no entry. Read the Balance Sheet.
- An asset handed to a creditor is a settlement, not a sacrifice; only the difference reaches Capital Reduction.
- Do the balancing instruction last, because it is the balance.
- A debit balance left in the Capital Reduction Account is an error, not a result.
Answer in one sentence
How should a scheme of reconstruction be approached? By listing the scheme's instructions separately, classifying each as a sacrifice by a class of stakeholders, a write-off of an asset or loss, or a settlement between existing book figures, posting the sacrifices and write-offs through the Capital Reduction Account, and computing any balancing transfer only after every other entry has been made.
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.