Accounting for Internal Reconstruction

Internal reconstruction is the process which company changes the majority of its critical structure including the financial and operational aspects of the company. The process does not liquidate the previous company to form a new one.

The company main objective is to make a profit and maximize shareholders’ wealth. At any point in time, the company faces a difficult time when the operation does not go as planned. One or more of the company functions are not working properly, it becomes an obstacle for the company to archive its main goal.

Internal reconstruction is the reorganizing of the company without liquidation. Without reorganizing, the company may face bankruptcy.

Reasons for Internal Reconstruction

Internal Reconstruction is not always happened as it requires a lot of work and effort. It usually performs in the following condition:

  • Complex internal structure: The company may cover too many business functions which out of the control of top management. It means top management does not have enough skill and competence to control all business functions.
  • Complicate Capital Structure: The company may start from a family-owned which does not have a proper capital structure from the beginning. So when the company gets bigger, the capital structure will be getting worst.
  • Mispresented financial statement: The financial statements are mispresent due to overstating of assets, undervalue of liabilities, and fictitious assets that exist on the balance sheet. The income statement does not reflect the actual business performance.
  • Company overcapitalized: The company may build the asset but it capitalize more than the actual cost.

Objective of Internal Reconstruction

  • Reduce the debt: The purpose of internal reconstruction is to release the debt by negotiating with the creditor. The company may offer the conversion of debt into common shares with a discount.
  • Change the number of authorized share
  • To solve the problem of overcapitalizing

Method of internal reconstruction

There are two methods that the company can use to complete the internal reconstruction.

  1. Alteration of Share Capital
  2. Reduction of Share Capital

Alteration of Share Capital

Alteration of share capital is the process that company uses to change the capital structure. It includes the increasing of new shares, consolidating, and canceling the outstanding shares. The alteration of share capital requires only a resolution in the annual general meeting. A sanction from the court is not required.

There are four methods to alternate the share capital which include:

  1. Increase new share
  2. Reverse Stock Split
  3. Stock Split
  4. Change in authorized share
  • Increase in Share Capital

It is very simple for the company when they want to raise more capital, they simply issue new shares for additional cash. However, the purpose of the alternation of share capital is not for additional capital but to change the capital structure.

The current capital structure is too complex, management wishes to issue new shares and let a group of investors own the majority of shares. So that they can make the proper decision without any objection.

When the company issues new shares, they simply debit cash at the bank and credit share capital.

Account Debit Credit
Cash 000
Common Stock 000
Additional paid-in Capital 000

The transaction will increase company cash at the bank on the balance sheet. It also credits the common stock which is the par value of the total share issue. Additional paid-in capital is the difference between share price and par value. Both common stock and additional paid-in capital is the equity item so they will increase on the balance sheet.

After issuing a new share, the existing share will decrease the value. It is called share dilution, which means the exiting share will have less value as the company has increased the number of outstanding shares.

For example, company ABC currently has 1,000 shares outstanding, and there are 5 investors who hold 200 shares each. So it means that each investor own 20% of the company.

When the company issues additional 1,000 shares to the market. It means that the existing investors who hold 200 shares own only 10% of the company. If they want to increase ownership, they need to buy a new share.

This is the method the company wants to change the capital structure without forcing the existing shareholders to sell their shares. New investors can join the company and own a huge portion of the company.

  • Reverse stock split

The reverse stock split is the method that company decrease the number of share outstanding in the market in order to change the share structures. The management consolidates the existing number of shares by a certain proportion. They divide the total number of shares by a number.

The existing shareholders will own fewer shares than before, but their ownership will remain the same.  Their number of share will reduce by the same number as the total shares.

When the company consolidates the stock, the price will increase based on the ratio of combination. If they consolidate two shares for one, the price will be double. When the price increase, it will attract the big investors who are only interested in the expensive stock.

It will allow the company to manage the stock more easily as the number decrease. It also allows them to issue more stock in the future.

When the company consolidates the stock, it will not impact the financial statement. The equity items will remain the same. The commons stock and additional paid-in capital remain the same.

There is no journal entry record as the total equity does not change.

  • Stock Split

Opposite from the above explanation, a stock split is the method that company increases the number of outstanding share by multiplying by certain numbers. The investors will see an increase of a number of shares, but their total amount remain the same.

The price will decrease by the same proportion to keep the company at the same value. The company share price is too high which is hard for the small investors, so they decide to split them.

Again, the stock split will not impact the Equity section. The company does not receive any additional cash from the split. There is also no journal entry to be recorded in the financial statement.

  • Change the number of authorized share

Authorized share is the maximum number of shares that company can issue, this figure has present in the company article of incorporation. The company has predicted the maximum number of share in the initial stage which allow them to issue share in the subsequent period.

These shares are not issued yet, they are a possible maximum numbers that the company can issue in the future.

The company can increase the authorized share to increase the maximum number before issuing a new share. On the other hand, they can reduce it to prevent any new share issues in the future. It is the plan that they have to predict ahead.

To revise the authorized share, the company need to change the article of the corporation which need approval from the board of director in the general meeting.

Decrease of share capital

The alteration of shares will not change the company share equity, they just change the number which can impact the share price.

The decrease of share capital will impact both number of shares and the share equity balance. The company can reduce share capital share repurchase.

It is the transaction of the company buyback their own share from the capital market. The repurchase share will be recorded as the treasury stock on the balance sheet under the Equity section.

In this method, there will be an impact on company financial statement, so there will be a journal entry as well.

The company needs to record debit treasury stock and credit cash from balance sheet.

Account Debit Credit
Treasury Stock 000
Cash at Bank 000

This transaction will decrease cash from balance sheet. It also decreases the equity as the treasury stock is the debit balance of equity.

Different Internal and External Reconstruction

Internal Reconstruction External Reconstruction
The company keeps the same outlook. The company needs to liquidate and start a new one.
Balance sheet items need to be revalued. No modification of the company balance sheet
Revalue the company’s assets and liabilities. Assets and liabilities will be transferred to the new company.
Require approval from the court. Not require approval from the court.