topic 8 capital reconstruction 1

7/23/2019 Topic 8 Capital Reconstruction 1

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TOPIC 8

CAPITAL

RECONSTRUCTION


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Chapter Outline

Compromises and arrangement, S176 Company Act 1965.

Debt restructuring

Internal reorganization (S61,62,64 CA)

1. alteration of authorized capital.2. reduction of paid up capital.

3. issue of bonus shares.

4. redemption of preference shares.

External reorganization (S176 178 CA)1. sales of assets & liabilities to another company.

2. a scheme of arrangement with creditors.

3. business combination.

4. The devising of a scheme to avoid liquidation


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Reorganization & Reconstruction

When company incurring heavy losses and has been unable to pay

dividends for few consecutive years. The company has two options:

- Winding up (liquidate)

- Reorganization (turn around)

Reorganization - any alteration in the structure of the firm which

enables to adapt to changes in its environment.

Reconstruction reorganizing various aspects, from management,

finance, productions etc.

Reorganization can only be undertaken if the company has evidence of

making profits in the near future and able to pay dividends to its

shareholders.


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FINANCIAL DISTRESS COMPANY

RECONSTRUCTION LIQUIDATION

Either way:

COMPROMISE / ARRANGEMENT WITH:- Debenture holders

- Creditors

- Shareholders

TAKEOVERS


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Compromises and Arrangements

S. 176 of CA power to compromise with creditors and

members.

Arrangement been defined in S. 176(11) to include a

reorganisation of the share capital of a company by the

consolidation of shares of different classes or by the division of

shares into shares of different classes or by both these methods.

A company can enter into a compromise or arrangement with itscreditors or any class of them, or with its members or any class

of them without going into liquidation.


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Debt Restructuring

A debt restructuring scheme ensures that a business

survives if there is a reasonable prospect that it is viable.

There are various benefits associated with the retention ofviable businesses, as opposed to closure & liquidation

(quoted from Flynn, K. in Institute News, Akauntan Nasional, April

1999, p. 27).


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Debt Restructuring

Among the advantages:

a) stakeholders like lenders, creditors & shareholders

of companies in financial distress can benefitmutually from the programme.

b) help save jobs.

c) avert any possible contagion effects in the corporate

sector (i.e. co. A fails & cant pay co. B, B then cant

pay C & so on).


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Debt Restructuring

Basic steps in debt restructuring :

a) assess process management.

b) financial stock take.

c) assess future cash flows.

d) identify various alternatives available to increase its financial

situation.

e) negotiate with shareholders, creditors, employees,

customers & suppliers.

f) implement the plan which should lead to a win-win

outcome for both creditors & debtors.


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Debt Restructuring

Most common form of debt restructuring:

a) reduce the current interest rate .

b) forgive some of the accrued interest or principal.

c) modify some other term of the debt agreement.d) extend the maturity date of the original debt at a lower rate of

interest.

1. Modification of the debt term to alleviate the short-term cash needs

of the debtor. Example, creditors may:

2. Creditors acceptance of assets or equity with a FV less than the

amount of the debt.


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Two types of reorganization:

Internal reorganization (S61,62,64 CA)

- redefinition of rights of shareholders:

1. alteration of authorized capital.

2. reduction of paid up capital.

3. issue of bonus shares.

4. redemption of preference shares.

External reorganization (S176 178 CA)

changes in legal relationships with outsiders and accounting activitybeyond the company itself:

1. sales of assets & liabilities to another company.

2. a scheme of arrangement with creditors.

3. business combination.



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External Reorganization

Involves with outsiders in few ways:

1. Disposal of all part of undertakings.

2. The rearrangement of the capital structure.

3. Expansion through business combination.



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1. Disposal of all part of undertakings :

The sales of non current assets

Need approval from the shareholders in the generalmeeting

Includes the discontinuing operations (FRS 5)

After the disposal, the remaining balance of the sales

proceeds might be distributed to shareholders.

.


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2. The rearrangement of the capital structure:

May involve changes in debt capital

Power to rearrange companys debt capital by

redeeming debentures & unsecured notes will

depend on its articles & on the terms of the

contracts.


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KAF3063 FAR III A082 14


Example:On 1 April 2000, PQR Berhad issued 7% unsecured notes worth RM1

million convertible into RM0.50 ordinary share at par on 1 May 2005.

On the maturity date, 80% by value of the note holders opted to convert.

Entries on 1 May 2005:

Dr. Unsecured notes 1,000,000

Cr. Sundry noteholders 1,000,000

Dr. Sundry noteholders 1,000,000

Cr. Ordinary share capital 800,000Bank 200,000


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3. Expansion through business combination:

This type of reorganisation is motivated by a desire to

expand within the industry or to diversify by acquiring

businesses in other industries.

The possibilities of the combination are limitless (the terms

reorganisation, absorption,amalgamation, consolidation,

acquisition, merger & takeoverare used interchangeably orsometimes used in a very specific situation in the business

world).

FRS 3 Business Combinations.


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4. The devising of a scheme to avoid liquidation:

The scheme is devised in conjunction with creditors &

shareholders to avoid the last resort in financial

difficulties i.e. liquidation.


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Internal Reorganization

1. Alteration of authorized capital1. increase or reduce authorized capital.

2. change in the par value of shares.

3. conversion of shares into unit of stock or vice versa.

2. Reduction of paid up capital1. Extinguish or reduce share capital not paid up

2. Cancellation of capital loss

3. Return of excess capital to shareholders

3. Issue of bonus shares1. Recognition of the amount of capital required for operations.2. Relieving shareholders of liability.

3. tidying up the balance sheet.

4. Recognition of increases in the value of assets

4. Redemption of preference shares.


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1.Alteration of Authorized Capital

S62 CA several ways:1. increase or reduction in the amount of authorized

capital.

2. change in the par value of shares.3. conversion of fully paid shares into unit of stock or vice

versa.

Difference between shares & stock: relate to divisibility & ease of

recording. It is not possible to sell part of a share while stock can besold in any amount.

No entry in the ledger or journal would be required as there has

been no change in paid up capital.


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Alteration of Authorized Capital

Illustration 1:Selamat Berhad had been incorporated on 1 January 1993 with authorized

capital of 10,000,000 ordinary shares of RM1.00 par, had an issued and

paid up capital of 1,000,000 ordinary shares of RM1.00 each fully paid.

At the AGM held on 7 May 2005, the shareholders resolved:

1. To decrease authorized capital to RM7,000,000 by cancelling 3,000,000

unissued shares;

2. To alter the par value of the remaining unissued shares from RM1.00 toRM0.50; and

3. To convert the fully paid ordinary shares into stock units of RM20.00

each.


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Alteration of Authorized Capital

Solution to Illustration 1Stmt of capital presented at the meeting:

Authorized capital:

10,000,000 shares of RM1.00 each 10,000,000

Issued & paid up capital:

1,000,000 ordinary shares of RM1.00 each 1,000,000

Stmt of capital presented immediately after the meeting:

Authorized capital:

50,000 ordinary stock units of RM20.00 each 1,000,000

12,000,000 shares of RM0.50 each 6,000,000


50,000 ordinary stock units at RM20.00 each 1,000,000

RM

Authorized 10m

Issued 1m

Unissued 9m

Less 3m

Bal unissued 6m

RM6,000,000/0.50


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2. Reduction of Paid Up Capital

S64 CA - subject to confirmation by the Court & must beauthorised by its articles by special resolution to reduce its

share cap. 3 conditions:

1. Extinguish or reduce share capital not paid up2. Cancel any paid up capital which is loss or is

unrepresented by available assets.

3. Return of excess capital to shareholders

Pay off any paid up share capital which is an excess of theneeds of the company, and may, so far as is necessary, alter its

memorandum by reducing the amount of its share capital and

of its shares accordingly.


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Reduction of Paid Up Capital

1. Extinguish or reduce share capital not paid up:

BOD to decide & propose whether to retain the right to call

up or to give up that right by canceling the uncalled capital.

If the uncalled capital is cancelled, the resources available

to discharge liabilities are reduced just as effectively as

when capital is returned to shareholders by way of cash

payment.

The cancellation of uncalled capital reduces the par value of

the shares involved.


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Illustration 2:Sejahtera Berhad has the following related to its capital as at 30 June 2005:

Authorized capital:



3,000,000 ordinary shares of RM1.00 each paid to RM0.90 2,700,000

As the company has more assets than can be used profitable at present, thedirectors proposed to reduce paid up capital and return the RM0.40 per

share in cash to shareholders. Because they do not anticipate any growth

in the companys activities, the directors also proposed to cancel the

RM0.10 per share uncalled capital. In addition, they proposed that both of

these changes ought to affect authorized capital.


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Solution to Illustration 2Journal entries:

Dr. Ord. Sh. Capital 1,200,000

Cr. Capital reduction 1,200,000

(reduction in paid up capital by RM0.40 per share on the

3,000,000 issued shares as per court order)

Ordinary Share Capital

Sh. Distr. 1,200,000 Bal b/f 2,700,000

Bal c/f 1,500,000

======== =======

Shareholders Distribution

Bank 1.200,000 OSC 1,200,000

======== =======

Dr. Capital reduction 1,200,000

Cr. Cash/Bank 1,200,000

(the return of part of paid up capital)


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Stmt of capital after the distribution of surplus:

Authorized capital:


3,000,000 ordinary shares of RM0.50 each 1,500,0003,500,000



Par value RM1.00Return in cash RM0.40

Cancel uncalled RM0.10

New par value RM0.50


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2. Cancellation of capital loss:

known as Turnaround Situation.

Badly managed companies might suffer losses of some oftheir paid-up cap due to a large scale embezzlement or a

series of operating losses or a fire in uninsured building or by

an economic, political or technological changes.

Hence, companies might have to write-off or writing downthe accounts which contain the loss including adjusting their

paid-up capital.


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Example of capital loss:Issued & paid up capital 5,000,000

Less: Accumulated loss 3,000,000

2,000,000

The purpose of reduction for this type of loss is to generatea credit balance against which the debit balances

representing the loss of capital can be written off.


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Illustration 3:The directors of Salam Akhir Berhad presented the following information to a

meeting of shareholders:

(a) Balance Sheet

30 June 2005

Property Plant & Equipment 5,000,000

Other Assets 4,000,000

9,000,000

Financed by:

Authorised, Issued & Paid up Capital:

10,000,000 ord. shares of RM1.00 each 10,000,000

Less: Retained Earnings (loss) (3,000,000)

Shareholders fund 7,000,000

Long Term Liabilities 2,000,000

9,000,000


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(b) Market surveys indicate that trading conditions have improved so much

that future profits will be approximately RM1,000,000 per year.

(c) The market value of the PPE has recently fallen to RM2,500,000 and

the fall is expected to be permanent.

The directors proposed:

i) To reduce paid up capital by RM0.55 per share

ii) To write off the debit balance on Profit and Loss account; and

iii) To write the PPE account down to market value.

The proposals were approved.


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Solution to Illustration 3

Journal entries:



(reduction of paid up capital by RM0.55 per share on the10,000,000 issued shares as per court order)

Dr. Capital reduction 5,500,000

Cr. Retained earnings (loss) 3,000,000

PPE 2,500,000

(Losses written as per court order)


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000 000

Cap. reduction 5,500 Bal b/f 10,000

Bal c/f 4,500

====== ======

Retained Earnings

000 000

Bal b/f 3,000 Cap. Reduction 3,000

====== =====

PPE

000 000

Bal b/f 5,000 Cap. Reduction 2,500

Bal c/f 2,500===== =====

Capital Reduction

000 000

Ret. earnings 3,000 OSC 5,500

PPE 2,500===== =====


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The balance sheet after the reduction:

Property Plant & Equipment 2,500,000


6,500,000

Financed by:




6,500,000


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3. Return of excess capital to shareholders:

Some financial statements show that company is having

more financial resources available than can be used

profitably (e.g. idle cash in the banks & ineffectiveinvestment).

The SURPLUScan be used to:1. discharge liabilities

2. purchase income-producing assets such as shares &

debentures3. enter into some additional business activity

4. pay large dividends to shareholders (by distributing retained

earnings)

5. return to present shareholders some of the capital which had

been contributed in the past


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In choosing among the alternatives, the directors may

consider:

- the costs of the various types of finance available,

- the rates of return on other investments,- the long-term effects (including the incidence of

taxation) on the co. & its shareholders,

- the requirements of the law relating to company [e.g.

For alternative (5), need to satisfy S. 64 of CA, need to

get approvals etc.].

Could combine all the factors or combine several factors for an

arrangement scheme.


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Illustration 4:Harapan Berhad

Balance Sheet

30 March 2005

Cash at bank 5,500,000


7,000,000

Financed by:



Retained Earnings 100,000



7,000,000


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The company is operating in a declining industry and the directors have

considered how to use the surplus assets. They have discovered that no

profitable investment opportunity exists in the industry and that it would

be unprofitable to reduce liabilities by more than RM900,000. In addition,

they agreed that it would be unwise for the existing management to

attempt to move into other activities.

Therefore, after having obtained the appropriate approvals from creditors,

shareholders and the Court for reduction of capital, the directors put the

following reorganization into effect on 1 April 2005:

i) Pay off RM900,000 of the liabilities.

ii) Pay a dividend of RM0.02 per share; and

iii) Reduce the par value of all shares to RM0.45 and return RM0.55 per

share to shareholders.


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Journal entries:



(reduction in paid up capital by RM0.55 per share on the

5,000,000 issued shares as per court order)

Dr. Dividends payable 100,000

Capital reduction 2,750,000

Cr. Bank 2,850,000

Dr. Liabilities 900,000

Cr. Bank 900,000

Dr. Retained Earnings 100,000

Cr. Dividend payable 100,000(payment of dividend 5,000,000 x RM0.02)


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Extract of balance sheet after the reduction of capital:

Harapan Berhad

Balance Sheet

30 March 2005




3,250,000


Cap. reduction 2,750,000 Bal b/f 5,000,000

Bal c/f 2,250,000

======= ========


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In certain cases, reduction of capital may involve more

than one class of shareholders.

As each class of capital issued by a company must berecorded in separate, appropriately described, accounts,

a return of capital which affects more than one class of

shares involves more accounting entries.


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Illustration 5:Harapan Tinggi Berhad

Statement of Capital

31 December 2004

Authorised Capital 7,000,000

Issued & Paid up Capital:

2,000,000 8% preference shares of RM1.00 each 2,000,000


7,000,000

The directors, having obtained all the approvals necessary, proceed to the

following capital reduction:

1. reduce all preference shares to a par value of RM0.80 and return

RM0.20 per share.

2. reduce all ordinary shares to a par value of RM0.60 and return

RM0.40 per share.


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Journal entries:

Dr. Ordinary Share Capital 2,000,000

Cr. Capital reductionOrd. shares 2,000,000

(reduction of all ordinary shares to a par value of RM0.60 per

share by reducing paid up capital as per Court Order)

Dr. Preference Share Capital 400,000

Cr. Capital reduction - Pref. shares 400,000(reduction of all preference shares to a par value 0f RM0.80 per

share by reducing paid up capital as per Court Order)


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000 000

Cap. reduction 2,000 Bal b/f 5,000

Bal c/f 3,000

====== ======

Capital Reduction - OS

000 000

Bank 2,000 OSC 2,000

====== =====

Preference Share Capital

000 000

Cap. reduction 400 Bal b/f 2,000

Bal c/f 1,600===== =====

Capital Reduction - PS

000 000

Bank 400 PSC 400

===== =====


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Harapan Tinggi Berhad


31 December 2004



2,000,000 8% preference shares of RM0.80 each fully paid 1,600,000

5,000,000 ord. shares of RM0.60 each fully paid 3,000,000

4,600,000


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3. Issue of Bonus Shares

The issue of bonus shares does not add to the wealth of a

company, or vary the rights of the shareholders.

It is merely a means of reclassifying the elements of

shareholders funds by capitalising some of them (by

converting some part of distributable profits into paid up

capital).

The wealth of the shareholders may increase through

increase in the market value of shareholders investment,

even the share price may fall. It is assumed that the company

will maintain its traditional rate of cash dividends.


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Issue of Bonus Shares

Bonus issue often used as a defence against take-over bid by

way of:

o persuade the shareholders to retain the shares for the

dividends.

o the increase in number of shares to be acquired by

bidders.

Some internal reasons for the issue of bonus shares:

1. Recognition of the amount of capital required foroperations.

2. Relieving shareholders of liability.

3. tidying up the balance sheet.

4. Recognition of increases in the value of assets.


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(1) Recognition of the amount of capital required for

operations:

Most companies retain some of each years profit in way of

retained earnings, unappropriated profits & profit and lossappropriation (dividends paid not equal to reported profit).

These are regarded as permanent capital.

Argument: the balance sheet does not accurately describe thesituation and that all or most of the undistributed profit ought to

be converted into paid up capital through the issue of bonus

shares.


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Illustration 6:SerbaTinggi Berhad


30 March 2005




Retained earnings 5,500,000


The directors estimated that to maintain its present level of operations,

the company requires share capital and reserves of RM7 million. The

directors recommend a bonus issue of five shares for every two held.


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Solution to Illustration 6:

If articles permit the direct capitalization:

Journal entries:

If articles does not permit the direct capitalization:

Dr. Retained Earnings 5,000,000

Cr. Ordinary Share Capital 5,000,000

(bonus issue of five fully paid ordinary shares for every two

shares held out of retained earnings)

Dr. Retained Earnings 5,000,000

Cr. Dividend Payable 5,000,000

Dr. Dividend Payable 5,000,000

Cr. Ordinary Share Capital 5,000,000


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The statement of capital after the bonus issue:




Retained earnings 500,000



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(2) Relieving shareholders of liability:

It happens when company decides to capitalise

undistributed profits by paying up uncalled caprather than by making a bonus issue of fully paid

shares.

This has the effect of relieving shareholders of the

liability to pay the uncalled capital.


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Illustration 7:Sederhana Berhad


30 March 2005

Authorised Capital 20,000


10,000 ordinary shares of RM1.00 each paid to RM0.50 5,000


Shareholders fund 17,000

The directors resolve to pay up the uncalled capital out of retained

earnings.


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Journal entries:Dr. Retained Earnings 5,000

Cr. Ordinary Share Capital 5,000

(capitalization of retained earnings by eliminating

uncalled capital)

The statement of capital after the bonus issue:


Issued & Paid up Capital:10,000 ordinary shares of RM1.00 each fully paid 10,000




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(3) tidying up the balance sheet :

Bonus issue could tidy up a Balance Sheet by reducing

the no. of accounts appear under the category ofshare

capital & reserves.

4 types of the list of accounts:

1. Ac which relate to authorised, issued & paid-up cap

2. Ac which relate to undistributed profits

3. Ac which have been established under specific statutory

provisions (Share Premium Ac - S. 60(2)(3); Cap

Redemption Reserve - S. 61(5); Investment Fluctuation

Reserve - S. 327).

4. Ac which have been established under specific provisions in

the companys Articles.


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Hence the issuance of bonus shares will reduce those

many accounts into less number of accounts.

The presented statements will be easier to digest & will

look simpler.


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(4) Recognition of increases in the value of assets :

Revaluation of assets:

o Increaseupward revaluation (credit to revaluation

reserve)

o Decreasedownward revaluation (impairment, debit to

profit and loss)

Revaluation gains (realised or unrealised) can be used to issuebonus shares or to pay up uncalled capital.


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4. Redemption of Preference Shares

Basically, a company is prohibited from returning back or

distributing capital to its shareholders, except under the

resolutions in S. 64 discussed earlier.

However, company can create a class of share which carries:

o the right to a return of capitalin future, or

o the right to redeem this class of sharesat companys

option.

S. 61 - if authorised by its articles, company can issue

redeemable preference shares & the redemption shall be

effected only by the manner provided by the articles.


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Redemption of Preference Shares

WARNINGS in S. 61:

o The redemption shall not be taken as reducing the amount of

authorised share capital.

o The shares could only be redeemed:

- out of profits which would otherwise be available for

dividend; OR

- out of the proceeds of a fresh issue of shares made for the

purposes of the redemption; AND

- if they are fully paid-up.

Even though paid-up cap is not reduced, the value of assets &shareholders equity will decrease because the articles often require the

redemption atpremium (to compensate shareholders for the loss of

income in the future). Thus,premium on redemption must be provided

for redemption out of profits or out of Share Premium Account.


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Illustration 8:Inferior Berhad

Extract from Balance Sheet as at 30 June 2005

Authorized Share Capital 10,000,000

Issued & Paid up Capital:2,000,000 8 % redeemable pref. shares of RM1.00 each fully paid* 2,000,000

6,000,000 ordinary shares of RM1.00 each fully paid 6,000,000

8,000,000

Share premium 500,000

Retained earnings 2,200,000


* These shares are redeemable at the option of the company, but a premium equal to 5% of the

nominal value is payable if the shares are redeemed before 30 June 2007.

On 1 August 2005, the directors resolve to exercise the companys option to redeem

all the preference shares.


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I. Redeem out of retained earnings:

Journal entries:

Dr. Share premium 100,000Cr. Red. pref shareholders distribution 100,000

Dr. Retained earnings 2,000,000

Cr. Capital redemption reserve 2,000,000

Dr. Redeemable preference share capital 2,000,000

Cr. Red. pref shareholders distribution 2,000,000

Dr. Red. pref shareholders distribution 2,100,000Cr. Bank 2,100,000


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Redeemable Preference Share Capital000 000

R.P.S.Distr. 2,000 Bal b/f 2,000

====== ======

Share Premium

000 000

R.P.S.Distr. 100 Bal b/f 500

Bal c/f 400

====== =====Retained Earnings

000 000

C.Red. Res. 2,000 Bal b/f 2,200

Bal c/f 200

===== =====

Red. Pref. Shareholders Distribution

000 000

Bank 2,100 Share prem. 100

Red. PSC 2,000

===== =====

Capital Redemption Reserve000 000

Bal. c/f 2,000 R. Earnings 2,000

==== ====


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The statement of capital after the redemption:

RM000



6,000,000 ordinary shares of RM1.00 each fully paid 6,000

Capital redemption reserve 2,000

Share premium 400

Retained earnings 200



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II. Redeem out of proceeds of a new share:

Journal entries:

Solution to Illustration 6:Dr. Share premium 100,000Cr. Red. pref shareholders distribution 100,000Dr. Bank 2,000,000

Cr. Ordinary share capital 2,000,000

Dr. Redeemable preference share capital 2,000,000

Cr. Red. pref shareholders distribution 2,000,000

Dr. Red. pref shareholders distribution 2,100,000Cr. Bank 2,100,000


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Redeemable Preference Share Capital000 000

R.P.S.Distr. 2,000 Bal b/f 2,000

====== ======

Share Premium

000 000

R.P.S.Distr. 100 Bal b/f 500

Bal c/f 400

====== =====Ordinary Share Capital

000 000

Bal b/f 6,000

Bal c/f 8,000 Bank 2,000

===== =====

Red. Pref. Shareholders Distribution

000 000

Bank 2,100 Share prem. 100

Red. PSC 2,000

===== =====


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The statement of capital after the redemption:

RM000



8,000,000 ordinary shares of RM1.00 each fully paid 8,000

Share premium 400




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Referrence

Jane Lazar & Tan Lay Leng (2003), Company

Account & Reporting, 5 th Edition.

topic 8 capital reconstruction 1

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