Difference Between Internal and External Reconstruction

Internal vs external reconstruction:

Financially unsound companies often go for reconstruction arrangements to come out of financial difficulties. Reconstruction involves reorganizing or reconstituting the financial structure of an existing company. It may be done in two ways:

1) Internal reconstruction

2) External reconstruction

In this blog, we are discussing the meaning of these two methods of reconstruction and how they are different from each other. External reconstruction involves the formation of a new company to take over the operations of the previous company, whereas internal reconstruction involves the reduction of share capital to cancel any paid-up share capital that is lost or unrepresented by available assets. This is done to write off the company’s past accumulated losses.

Meaning of Internal reconstruction

In internal reconstruction, neither a company is liquidated nor any new company is created. Only the internal shape of a company is altered by the alternation and reduction of its share capital. This method of capital reduction is especially preferable for a company that has substantial accumulated losses and assets that are overvalued.

Internal reconstruction helps to achieve the following objectives:

• Elimination of fictitious assets of the company, for example, preliminary expenses, discount on issue of shares, etc.
• Reducing the share capital of the company so as to bring it up to its real worth
• Building up confidence amongst the shareholders by providing them a fair return on their investment
• Presenting the true and fair view of the company’s state of affairs and financial position

In essence, the scheme of capital reduction involves owners or shareholders, debenture holders, and creditors making sacrifices on their part and using the amount so saved to write off losses and scale down the assets to their true worth. For doing this, a “capital reduction account”, also known as an “internal reconstruction account”, is created. The amounts sacrificed or foregone by various interests are credited to this account, and the balance in this account is then used to write off losses.

For reducing the amount of paid-up share capital, the following journal entry is passed:

Share capital A/c Dr.

To Reconstruction A/c

If losses have accumulated to such a point that a portion of the borrowed capital is also lost, then the debenture holders and creditors will be sacrificing as well. The journal entry would be:

Debentures A/c Dr.

Creditors A/c Dr.

To Reconstruction A/c

For utilizing the amount of reconstruction account to write off losses, the journal entry would be:

Reconstruction A/c Dr.

To Goodwill A/c

To Accumulated Losses A/c

To Excess Portion of Assets A/c

To Fictitious Assets A/c

Any credit balance of the reconstruction account will be transferred to Capital Reserve.

The items that are written off as part of capital reduction usually include the following:

• Goodwill: For a company that has lost capital, it doesn’t make any sense to have goodwill appearing on its Balance Sheet. Therefore, this item is normally written off.
• Fictitious assets: Fictitious assets such as a discount on the issue of shares and debentures, preliminary expenses, and other deferred expenses are not to be kept on reconstruction. Hence, they are also written off.
• Losses: Accumulated losses that appear on the Balance Sheet in the form of any debit balance of profit and loss account need to be written off.
• Overvalued assets: Sometimes assets may be showing up at inflated books values that are unreasonable, either on account of insufficient depreciation or technological changes or due to any other reason. Such assets must be brought down to their real values.  

Internal reconstruction can be done through the following modes:

• Alteration in share capital [This can be through a) increase in share capital, b) consolidation of shares, c) sub-division of shares, d) cancellation of unissued shares, and e) conversion of shares into stock.]
• Reduction in share capital [This can be through a) reducing the liability in respect of the uncalled amount of shares, b) paying off unpaid capital which is in excess of the need of the company, and c) cancelling the paid-up capital which is already lost or not represented by available assets.]

Meaning of External reconstruction

External reconstruction is not exactly the same as amalgamation. In external reconstruction, an existing company is wound up by selling its operations to a newly established company that is often identically named or owned by the same shareholders. That is technically speaking, a new company will be established or formed to take over the existing one. It differs from amalgamation in the sense that amalgamation results in a combination of two or more companies but external reconstruction does not.

In simple words, when a business has been making losses for several years and is in financial trouble, it can sell its assets to a newly formed company. The new business is actually constituted to take over the previous company’s assets and liabilities. External reconstruction is the name given to this technique.

Thus, external reconstruction involves the liquidation of one company and the formation of a new one. The liquidated company is known as “Vendor Company”, while the new company is known as “Purchasing Company”. The vendor company’s stockholders become the shareholders of the purchasing company.

This kind of external reconstruction is usually covered by AS 14 under the category of “amalgamation in the nature of purchase or merger”.

And the steps in accounting for external reconstruction are outlined below:

• Ascertainment of discharge of purchase consideration that is payable by the purchasing company to the vendor company for taking over the vendor company’s assets and liabilities.
• Closing the books of the vendor company or transferor company. This is the company that is being liquidated and taken over. The journal entries are passed using a “Realization Account”.
• Passing opening entries in the books of the purchasing company or transferee company. This is the new company formed.

A comparison table showing differences between the two

The table given below summarizes the key differences between internal and external reconstruction:

Basis	Internal reconstruction	External reconstruction
Capital reduction	Rearrangement and reduction of share capital are done here. The external liability holders waive their claims.	It implies the reorganization of an existing company to set off its huge losses. There is no reduction of share capital.
Set-off of losses	Internal reconstruction reduces the share capital to its true value, and the same amount is utilized to eliminate accumulated losses, and fictitious assets, and write down the inflated assets of the company.	In the case of external reconstruction, the past losses of the previous company cannot be set off against the future profits of the new company.  This is so because the old company ceases to exist.
Formation of a new company	No new company is established in this case. Only the rights of shareholders and creditors are changed.	A new company gets formed in the case of external reconstruction.
Liquidation	There is no liquidation and hence, no company is liquidated in the case of internal reconstruction. It allows the existing company to be continued.	In external reconstruction, a company is liquidated.
Ease	It is a slow and tedious process. It requires authorization by Articles of Association and the passing of a special resolution.	It can be carried out more easily.
Terminology	The Balance Sheet of the company after undergoing reconstruction contains the specific words “And Reduced”.	No such specific terminology is used in this case.
Tribunal’s approval	Approval of the Court or Tribunal is a must.	No approval from the Court is required.
Transfer of assets & liabilities	There is no transfer of assets and liabilities.	The assets and liabilities of the existing company are transferred to the new company.
Governing section	Internal reconstruction is governed by Section 66 of the Companies Act 2013.	External reconstruction is governed by Section 232 of the Companies Act 2013.

Summarizing internal and external reconstruction:

In the case of external reconstruction, the basic objective is to reorganize the company so that the huge losses suffered by it can be set off. The existing company is wound up and is merged into a newly formed company with the same name and the same shareholders. But internal reconstruction is altogether a distinct form of a business combination. Here, the company continues to maintain its legal entity and is only internally reorganized during the process. In this case, the share capital is reduced to its true value in order to write down the overvalued assets of the company.

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