o FinAcc 6thEd StudyText Chapter10

7/27/2019 o FinAcc 6thEd StudyText Chapter10

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Capital reduction,reorganisation andreconstruction

chapter 10

contents

1 Introduction

2 Distributable profits

3 Bonus issues

4 Reduction of capital5 Redeemable shares and the purchase by

a company of its own shares

6 Failure, losses and capital erosion

7 Liquidation

8 Capital reconstruction

learning outcomes

This chapter covers the syllabus section entitled Capital reduction, reorganisation and

reconstruction. After reading and understanding the contents of the chapter, working through

allthe Worked Examples and Practice Questions, you should be able to:

Show a knowledge of the provisions of the Companies Act relating to the calculation of

distributable profit and apply the rules to a set of financial facts.

Understand the nature and purpose of a bonus issue of shares and be able to incorporate

the financial effects of an issue into the content of the balance sheet.

Explain the nature and role of the concept of permanent capital and explain the

circumstances in which a reduction of capital must take place.

Demonstrate an understanding of the effect of a share purchase or redemption on the

content of the balance sheet.

Outline the causes of business failure and explain the effect on the financial stability of a

business of a series of operating losses.

Prepare a statement showing the allocation of resources available on liquidation among the

stakeholders in an enterprise.

Prepare a scheme of capital reconstruction and incorporate its effects on the content of a

business balance sheet.

10_CH10.QXD:IC8235 ch01.qxd 12/5/09 12:55 Page 239


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1 Introduction

A company should have a balanced capital structure when it is established, that is, itsassets should be funded by the appropriate types of finance. Long-term sources, such asequity capital and debentures, should cover the investment in fixed assets and provide

sufficient excess to make a significant contribution towards the funding of currentassets. If the oft-quoted ideal working capital ratio of 2:1 is desired, then half the valueof current assets should be financed by long-term capital, and the remainder financedby short-term sources such as trade credit.Within long-term sources of funds, a satis-factory relationship should be created between the varioustypes available,the optimumstructure depending on such factors as the nature of the trade undertaken and the likelystability of profits.

Once a company starts to trade, the financial structure established at the outset isaffected bythe results of trading and the passage of time.The initial equity investment isincreased bythe amount of profit earned and retained in thebusiness,and is reducedbythe amount of any losses. As time passes, the repayment date for long-term loans getscloser and, near to the very end of their term, such sources must be classified as currentliabilities.The rate at which customers pay and suppliers are paid affects the balance

between current assets and liabilities, as do credit purchases of additional stock requiredto expand a successful company. In the longer term, success may encourage the acquisi-tion of extra production capacity that must be funded by an appropriate type of financeif the capital structure of the business is to remain balanced.

The financial position of a business is subject to continuous change unless thecompany is dormant and does not trade. Flows of resources take place with tradingand these have an impact on the enterprise, which can be beneficial or detrimental.The result is that the business may be either a success or a failure. A very successfulbusiness, in this context, is one that manages to expand, while survival, with anadequate level of return but no expansion, is regarded as a satisfactory performance.If a company goes into liquidation,or has to be reconstructed, it is a failure.There arecertain courses of action that may be followed as a result of the success or failure of abusiness. It is the purpose of this chapter to examine these alternatives and the

accounting entries that are needed to reflect them.

2 Distributable profits

The rules for the calculation of distributable profits differ between private andpublic limited companies. Identification of the particular category into which a

company falls into is a simple matter: public limited companies are identified by thedesignatory letters plc, whereas Ltd after a companys name indicates that it is aprivate company. There are many differences between these two types of company,

perhaps the most notable is that public companies have a minimum share capitalrequirement of 50,000 and private companies are not allowed to make a public

issue of shares or debentures.The 2006 Companies Act (section 830) defines distributable profits of private

companies as: accumulated realised profits minus accumulated realised losses,where:

240 COMBINING AND REORGANISING BUSINESS ENTITIES

test your knowledge 10.1

Identify the two asset categories that must be funded from long-term sources

of finance.

distributable profitsDistributable profits consist

of accumulated realised

profits minus accumulated

realised losses.



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Accumulated realised profits are realised profits that have not already been distrib-

uted as dividends or capitalised.

Accumulated realised losses are realised losses that have not been previouslywritten off in either a reduction or reorganisation of capital.

For this purpose, profits or losses may either be capital or revenue in their origin.

The effect of these rules is that a company is legally entitled to declare a dividend out ofrealised profits brought forward but, if there are accumulated losses brought forward,

these losses must first be made good before a dividend can be paid.A company withlarge accumulated realised losses may therefore find it convenient to undertake a reduc-

tion of capital if it wishes to avoid a long delay before it can pay a dividend out of theprofits accruing as the result of an improvement in trading conditions.

The Act does not define realised and unrealised profits and losses, but it doesprovide some guidance regarding the treatment of particular items.

Provisions (i.e. liabilities of uncertain timing or amount) are to be treated asrealised losses.

Any additional depreciation,which is charged as the result of an upward revaluationof fixed assets, may be added back to reported profits for the purpose of computing

distributable profits.This provision was introduced to avoid discouraging companiesfrom revaluing their assets where they considered such a course appropriate.

Development expenditure, shown as a fixed asset, is to be treated as a realised lossfor the purpose of computing distributableprofit, unless there arespecial circum-

stances justifying capitalisation, in which case the expenditure may be carriedforward. Special circumstances are not defined in theAct, but the capitalisation of

development expenditure that complies with the conditions laid down inaccounting standards is probably acceptable.

In those circumstances not specifically covered by the Act, the determination ofwhether a profit or loss has been realised must be made in the light of prevailing

accounting standards.

10 CAPITAL REDUCTION, REORGANISATION AND RECONSTRUCTION 241

worked example 10.1

The following summarised information is provided relating to the affairs of Tree plc and Branch plc, both

public limited companies.

1 Summary Balance Sheets at 31 December 20X4

Tree plc Branch plc

000 000

Ordinary share capital 6,000 3,000

Reserves 5,000 1,300

11,000 1,700

Net assets 11,000 1,700



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worked example 10.1 continued

2 Build-up of Reserves at 31 December 20X4

Tree plc Branch plc

000 000Retained realised profit (loss) at 1 January 20X4 1,900 2,300

Realised profit for 20X4 (see 3) 1,300 1,000

Unrealised loss on revaluation of all fixed assets

Realised capital profit 600

Unrealised profit on revaluation of assets 1,200

5,000 1,300

3 Tree owns a freehold property which cost 500,000 (including land 100,000) some years ago. It was

revalued at 1,700,000 (including land 400,000) on 1 January 20X3. Since that date the building has been

depreciated at 5 per cent per annum, based on the revalued figure in arriving at realised profit for the year.

Required:

(a) Define distributable profit in accordance with the provisions of the Companies Act. Indicate the points

that must be looked for when calculating the maximum distributable profits of a limited company.

(b) Calculate the maximum distribution that can be legally made by Tree plc and Branch plc on the basis of

the above information.

Answers

(a) The Companies Act 2006 defines distributable profits as accumulated realised profits minus accumulated

realised losses, where accumulated realised profits have not already been distributed as dividends or

capitalised and accumulated realised losses are realised losses which have not been previously written off

in either a reduction or re-organisation of capital.

Profits or losses may be either capital or revenue in their origin. The distributable profits are not

therefore confined to the results of the current period but must take account of accumulated realised

profits or losses brought forward.

Provisions as defined by the Companies Act, e.g. provision for depreciation, are to be treated as realised

losses for the purpose of calculating distributable profit. Any additional depreciation charged as the result

of an upward revaluation of fixed assets may be added back in computing distributable profit.

In circumstances not specifically covered by the Act, the determination of whether a profit or loss has

been realised must be made in the light of the provisions contained in accounting standards.

(b)

Tree plc Branch plc

000 000

Retained profit/loss at 1 January 1,900 2,300

Profit for 20X4 1,300 1,000

Realised capital profit 600 1,00

Depreciation relating to revaluation* 90 1,00Maximum distribution 3,890 1,300

Branch is unable to make a distribution.

*1,300,000 (revised value of building) 400,000 (historical cost) 5 per cent 2 years.


Define distributable profit in accordance with the provisions of the Companies

Act 2006.



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3 Bonus issues

Bonus issues of shares are also referred to as Scrip Issues orCapitalisation Issues.Tomake such an issue, a company allots fully paid shares to its existing members and capi-

talises the corresponding value from its reserves.The company does not receive any

consideration for the issue. Every shareholder receives bonus shares in proportion totheir existing stake in the company. For instance,the holder of 10 per cent of the equityshares would receive 10 per cent of any bonus issue. A company must have adequate

reserves to makea bonus issue, andthese will be possessed bya successfulcompany thathas retained a significant portion of its profits.A bonus issue may alternatively be madefrom any credit balance of a Share Premium Account or Capital Redemption Reserve.

A company can make a bonus issue if authorised by its Articles which usuallycontain a requirement fora general meeting to approve the directorsrecommendation

for a bonus issue before it may be made. A further consideration is that there must besufficient authorised,but unissued, capital to enable the issue to take place.


bonus issue

A bonus issue of shares

involves allotting fully paid

shares to its existingmembers in proportion to

their existing holdings by

capitalising the

corresponding value from

its reserves.

worked example 10.2

The Good Company Ltd has traded successfully for a number of years and has ploughed profits back into

the company. Its authorised share capital consists of four million shares of 1 each and its balance sheet at

31 December 20X1 is:

000

Fixed assets 960

Working capital 350

1,310

Equity:

Ordinary shares of 1 each 200

Share premium 200

Retained profit 9101,310

It has decided to make a bonus issue of shares, four bonus shares being given for each share currently held. The

issue is to utilise the balance on the share premium account, with the remainder taken from retained profit.

Required:

The balance sheet of the Good Company Ltd as it will appear after the bonus issue.

Answer

Good Company Ltd Balance Sheet 31 December 20X1

000

Fixed assets 960

Working capital 350

1,310

Equity:

Ordinary shares of 1 each 1,000

Retained profit 310

1,310



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It canbe seen that the bonus issue has not brought any new resources to the company;the

only effect is an alteration in the composition of the shareholders equity, the total of

which remains unchanged at 1,310,000.There is also no effect on the relative interest

of each member in the company. Prior to the issue,a holder of 40,000 shares owned 20

per cent of the company with a carryingvalue of 20 per cent1,310,000 = 262,000;

after the issue the holding has risen to 200,000 shares, which is still 20 per cent of theissued shares and it has the same carrying value.

If the directors do not wish to increase the amount of profit distributed, they must

take steps to reduce proportionally the dividend per share. For example, to maintain aconstant total cash distribution, after a three forone bonus issue,a company would have

to reduce the dividend per share to one quarter of its former amount.However, as eachshareholder after the issue has four times as many shares as previously, each receives an

unchanged dividend in cash terms.The increase in the number of shares in issue doesnot affect the value of thecompany, as is shown bythe case of a public limited company,

with quoted shares, where the change in the market price per share should bear aninverse relationship to any increase in the number of shares on the market.

Again, the total value of the shares and the dividend received remain unchanged.It is therefore clear that the effect of a bonus issue is simply to increase the number

of shares a company has in issue. This raises the question: Why would a companywish to make such an issue? Possible reasons are:

Theoretically, the balance on retained profit is distributable as cash dividends; inpractice, this course may not be open to the company as the funds have been

permanently invested in the substance of the business. For instance, in WorkedExample 10.2, the Good Company Ltd could not distribute the retained profits


worked example 10.3

Traction plc is a listed company and has an issued share capital of 10 million ordinary shares with a nominal

value of 1 each. The market value of each share is 6.

Required:

Illustrate the expected effect of a two for one bonus issue and a cut in the dividend per share from 12p to 4p on:

(a) the market value of one share;

(b) the market value of the entire company and the dividend it pays;

(c) the market value of a holding of 5,000 shares and the dividend received by the shareholder.

Answers

(a) Whereas one share is held before the bonus issue, three are held after it. The value of the single share was

6 and the total value of the three shares into which it is converted is 6. Therefore, the value of a singleshare after the bonus issue is 2.

(b)

Value Dividend Paid

Before bonus issue 10m 6 60m 10m 0.12 1.2m

After bonus issue 30m 2 60m 30m 0.04 1.2m

The gratuitous issue of an extra 20 million shares reduces the share price proportionally and the total value of

the company and the cash dividend remain unchanged.

(c)

Value Dividend Received

Before bonus issue 5,000 6 30,000 5,000 0.12 600

After bonus issue 15,000 2 30,000 15,000 0.04 600



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without liquidating a substantial portion of its fixed assets. A bonus issue recog-

nises the companys inability to distribute retained profits and brings the balancesheet into line with this economic reality.

The creation of an enlarged permanent equity capital base makes the company

more attractive to potential investors and creditors as the level of gearing cannot

be increased by the withdrawal of profit that has been capitalised. A bonus issue is sometimes taken as an indication of the fact that the directors

intend to increase the overall level of dividend. If the investors believe this will

happen, the shares become more attractive and the price will fall less than wouldbe expected otherwise. In Worked Example 10.3, the share price might finish up

above 2.

The larger number of shares in circulation should help create a more active market

as holdings are made more easily divisible.

A listed company that has a high and unwieldy share price may makea bonus issue

to create a lower price per share.This is useful where, for example, a companyacquires other companies by share exchanges and wishes to make the value of

each of its own shares closer to that of likely acquisitions.

A successful company with substantial accumulated profits may receive favourable

publicity from their capitalisation.The bonus issue draws attention to the successthat has created the profits to enable the issue to take place.

Thereduction in the dividend per share may help avoid any unfavourablepublicityattached to the declaration of apparently high rates of dividend.

4 Reduction of capital

The Companies Act 2006 (Part 17, Chapter 10) allows a company to reduce its sharecapital in any way it considers appropriate.The ability given in the Act is therefore a

general one, but specific instances are also stated (section 641):

(a) Share capital that is lost or unrepresented by available assets may be cancelled(Worked Example 10.4 below).

(b) Share capital in excess of the needs of the company may be repaid (WorkedExample 10.5 below).

(c) A company may extinguish or reduce the liability on any of its shares in respectof share capital not paid up.

In each of these cases, the right to reduce can be exercised only if certain conditionsare met:

The company must be authorised to reduce its share capital by its Articles ofAssociation.

The reduction must be agreed by a special resolution of the members, that is, aresolution passed by a majority of at least 75 per cent.

The reduction must be confirmed by the court. This requirement is particularlyimportant in relation to (b) and (c) above.The repayment of capital (b) actually

reduces the assets of the company, while the reduction or cancellation of liabilityon unpaid share capital (c) reduces the funds on which a company can call if

required. A creditor of a company, which decides to reduce its capital, such as abank with which the company has an overdraft, may consider that its likelihood of

repayment is jeopardised by thereduction.Such a creditor may object to the court,which can direct either that payment of the debt is secured or that an agreed

amount is set aside to meet it.



Explain the effect of a bonus issue on the market price of company shares.

reduction of capital

Reduction of capital involves

the repayment or writing

down of a companys share

capital as a result of either

an excess of funds without

profitable uses or large

accumulated losses.



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The cancellation of share capital unrepresented by available assets and the repayment

of share capital to members are each likely to have a substantial effect on the contentof the balance sheet.

When a company has either been trading unprofitably for a number of years or

suffers abnormally large losses in a single year, it may have accumulatedlosses.Despite

these losses, which have eroded capital, a company may still be viable and be able toearn profits in the future. In these circumstances, it is reasonable to recognise thatsome of the capital has been lost and to reduce its value accordingly. A further reason

for engaging in capital reduction is that the Companies Act 2006 prohibits the distri-bution of current profits before past losses have been made good, but allows past

losses to be removed from thecalculation of distributable profits if they are written offin a capital reduction.Thus, a capital reduction scheme enables dividends to be paid

from current profits despite thefactthat losses havebeen made in thepast that have notbeen made good.Also, a reduction scheme that removes accumulated losses makes the

company more attractive to prospective investors and providers of credit.

In this example, the existing shareholders retain three shares out of every four shares

previously held. Alternatively, the company could keep one million shares in issueand reduce the nominal value of each share to 75 pence.

A company may find that it has assets in excess of its requirements. For instance, itmay dispose of a division of its business but not wish to reinvest thecash received. Thescale of the undertakings activities is reduced, with the result that its share capital isnow toolarge for itsnew, smaller level of operations. It may be decided that it is appro-priate to reduce the size of the companys share capital by repaying to the shareholdersthe amount in excess of requirements.


worked example 10.4

Getting Better Ltd is an old-established company which, after trading profitably for a number of years, incurred

substantial losses. Its balance sheet at 31 December 20X1 is:

000

Fixed assets 520

Working capital 230

750


Accumulated loss 250

750

The company has rationalised its methods of production and distribution and has returned to profitability. Itwishes to raise additional equity capital and, as a preliminary step, decides to reduce its share capital to

eliminate the debit balance on the profit and loss account by cancelling one out of every four ordinary shares in

issue.

Required:

Prepare the companys balance sheet, after the capital reduction has taken place.

Answer

Getting Better Ltd Balance Sheet 31 December 20X1 after capital reduction

000

Fixed assets 520

Working capital 230

750




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5 Redeemable shares and the purchase by a company

of its own shares

The CompaniesAct 2006 (Part 18,Chapter 3) contains provisions that allow compa-nies to issue redeemable shares of all types and to purchase their own shares For the

purpose of the Financial Accounting examination, candidates will be expected to befamiliar only with the main provisions and able to work simple examples. The

complications that arise when the original issue of shares was made at a premium arespecifically excluded. In sections 5.15.3 we consider the position where a public

limited company redeems some of its shares; the rules for a company purchasing itsown shares are largely the same and are dealt with in section 5.4. In all cases the

company must have the appropriate powers in its Articles of Association.


worked example 10.5

Smaller Ltd has sold to a competitor, for cash, a substantial number of its retail outlets. The bulk of the

companys shares are owned by the directors, the balance being held by members of their families. The

companys balance sheet after the sale at 31 December 20X1 is:

000

Fixed assets 200

Working capital requirements 150

Surplus cash 750

1,100


Retained earnings 100

1,100

The directors are nearing retirement age and, as they have no successors, decide to run the company at its

reduced size and return the surplus assets to the shareholders. The reduction of capital is to be achieved by

reducing the nominal value of each share to 25 pence and repaying 75 pence per share to the shareholders.

Required:

Prepare the companys balance sheet after the capital reduction has been carried out.

Answer

Smaller Ltd Balance Sheet 31 December 20X1 after capital reduction

000

Fixed assets 200

Working capital 150

350

Ordinary shares of 25 pence each 250


350


Identify three statutory requirements that must be met in order for a company to

engage in a reduction of capital.

redeemable shares

Redeemable shares are

preference and ordinary

shares which are specifically

redeemable under the terms

of their issue.



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5.1 The legal provisions

The intention of the Act is that the permanent capital of a company that redeems

some of its shares should be maintained in value, and not diminished as a result ofthe redemption. A companys permanent capital consists of its issued share capital

plus any reserves which are not distributable by way of dividends; for example, a

revaluation reserve is part of permanent capital, while any balance of retained profitsis not.To achieve the objective of permanent capital maintenance, the Act containsdetailed instructions to be applied when shares are redeemed.

These rules, in so far as they are within the syllabus, are:

The shares must be fully paid.

Companies must not convert shares into creditors; the terms of redemption mustprovide for payment on redemption.

Redeemable shares may only be redeemed out of distributable profits of thecompany or out of the proceeds of a fresh issue of shares made for the purpose of

the redemption.

Any premium payable on redemption must be provided out of distributable profits.

A transfer to a capital redemption reserve must be made, computed as follows:

(i) Where the redemption is made entirely out of profits, a sum equal to thenominal value of the shares redeemed must be transferred from profit to thecapital redemption reserve.

(ii) Where the redemption is made wholly or partly out of a new issue, the sumto be transferred from profit to the capital redemption reserve is the amount,

if any, by which the nominal value of the shares redeemed exceeds theproceeds of the new issue.

Redeemed shares must be treated as cancelled.

5.2 Redemption met entirely out of distributable profits

Where the redemption is met entirely out of distributable profits, thenominal value ofthe permanent capital repaid on redemption is replaced by an equivalent transfer

from distributable profits to the non-distributable capital redemption reserve. Anypremium payable on redemption must be met from distributable reserves.


permanent capital

Permanent capital consists

of a companys issued share

capital plus any reserves

which are not distributable

by way of dividends.

capital redemption reserve

Capital redemption reserve

is an undistributable reserve

arising from the redemption

of shares or the purchase by

a company of its own shares.

The purpose of the capital

redemption reserve is to

protect the creditors by

preventing what would

otherwise effectively be a

reduction in permanent

capital.

worked example 10.6

The following extracts are taken from the balance sheet of Redeemer plc at 31 December 20X6:

000


Redeemable shares of 1 each 100

Share premium account 400

Permanent capital 1,100

Distributable profits 300

Net assets (including cash) 1,400

The company intends to redeem the 100,000 redeemable shares making no new issue.

Required:

Prepare balance sheet extracts, in the same format as above, to show the effect of the redemption in each of

the following cases:

(a) The shares were issued and redeemed at par.

(b) The shares were issued at par and are redeemed at 1.10 per share, i.e. at a premium of 10p per share.



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5.3 Shares redeemed wholly or partly out of the proceeds of anew issue

A fresh issue of shares may be made to help finance the redemption. In this case, theprocedure appliedto maintainthe value of permanent capital is slightlymore complex

than when no such issue is made.The transfer from distributable profit to the Capital

Redemption Reserve need be sufficient only to replace that part of the permanentcapital redeemed which is not covered by the new permanent capital introduced.



Answers

Revised Balance Sheet extracts

Case A Case B000 000

Ordinary shares of 1 each 600 600

Share premium account 400 400

Capital redemption reserve 100 100

Permanent capital 1,100 1,100

Distributable profits 200 190

Net assets (including cash) 1,300 1,290

Workings: 000 000

Transfer from share capital to capital redemption reserve

(nominal value of capital redeemed) 100 100

Reduction in distributable profit and net assets (amountpaid on redemption) 100 110

Note that in both cases the redemption is met out of distributable profits and the amount by which the

companys issued capital is diminished is transferred to the capital redemption reserve. The permanent capital

is thereby maintained intact at 1,100,000 as the result of applying the relevant provisions of the Act.

worked example 10.7

Assume the same balance sheet for Redeemer at 31 December at 20X6 as in Worked Example 10.6.

The company intends to redeem the 100,000 redeemable shares at a premium of 20p per share.

Required:

Prepare balance sheet extracts, in the same format as above, to show the effect of the redemption in each of

the following cases:

(a) Redemption partly financed by the issue of 50,000 ordinary shares of 1 each at par.

(b) Redemption partly financed by the issue of 50,000 ordinary shares of 1 each at 1.50 per share.

Answer

Revised Balance Sheet Extracts

(a) (b)

000 000

Ordinary shares of 1 each 650 650

Share premium account 400 425

Capital redemption reserve 50 25

Permanent capital 1,100 1,100

Distributable profits 230 255

Net assets (including cash) 1,330 1,355



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5.4 Purchase by a company of its own shares

The Act allows a company to purchase its own shares, subject to certain conditions,whether or not they are redeemable. This ability benefits both public and private

companies.Publiccompanies are able,for example, to return to members any funds inexcess of requirements, to avoid the need for a capital reduction exercise and to revise

more easily their capital structures to bring them into line with current requirements.This procedure has also been used by quoted companies, especially in the UnitedStates, to increase the share price by reducing the number of shares on the market.

The arrangement also has the effect of leaving on the market fewer shares betweenwhich profits are to be shared and so increases the value of earnings per share (see

chapter 11, section 6).The main advantage to owners of shares in private companiesis the ability to realise their investment by selling their shares to the company, thereby

overcoming any difficulty that would previously have been experienced, in transfer-ring their shares. For instance, close control of family companies may be retained by

using the companys resources to acquire the shares of a member who dies and/orretires.However, the company is not bound to purchase its own shares, and can do so

only if it has the resources available.The conditions that a company must satisfy to purchase its own shares are largely

similar to those which apply to redeemable shares.



Note that the permanent capital is maintained intact at 1,100,000 as the result of applying the provisions of

the Act.

Workings (000): Case A Case B

000 000

Nominal value of shares redeemed 100 100

Less: Proceeds of new issue 50 75

Shortfall transferred from distributable profit to capital

redemption reserve 50 25


(a) Define the permanent capital of a company.

(b) Explain the effect on the balance sheet of a company redeeming shares out of

cash available surplus to operating requirements.

(c) Explain how one would compute the transfer to capital redemption reserve

where a redemption of shares is partly financed out of the proceeds of a new

issue of shares.



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6 Failure, losses and capital erosion

It is a fact that some companies fail and then have to be liquidated. Management and

owners are often unwilling to face the likelihood of failure and attempt to struggleon until they are forced to accept the reality of the situation by, for example, theappointment of a receiver. Companies in financial difficulties need to obtain further

finance, and the bank manager is often the first person approached for theseresources.

The optimistic attitude typically displayed by business management, often withlittle regard to the actual circumstances, is that the firms position will improve and

failure will be avoided provided it can survive for a further short period of time. It istherefore in the interests of potential providers of finance to be able to judge which

companies are merely going through a period of temporary difficulty and whichcompanies are going to fail. It is important to ensure, as far as possible, that toopessimistic an assessment is not made, since the withdrawal of an existing financial

provision by the bank may cause the failure of a company which would otherwise


worked example 10.8

The following is the summarised balance sheet of Beacons Ltd, a long established family company, at

31 March 20X0:

000


Revaluation reserve 150


Net assets including cash 850

Ninety per cent of the shares are owned by the directors, the balance being held by their distant relatives. The

directors wish to concentrate ownership of the company in their own hands and, as the company has surplus

cash, made an offer for the company to purchase the shares held by the distant relatives. The offer values each

share at 2.50.

The offer was accepted by all the shareholders concerned and was put into effect on 1 April 20X0.

Required:(a) State the value of Beacons Ltds permanent capital at 31 March 20X0.

(b) Prepare the balance sheet of Beacons Ltd on 1 April 20X0 immediately after it has purchased its own shares.

(c) State the value of Beacons Ltds permanent capital at 1 April 20X0 after the purchase has been completed.

Answer

(a) The permanent capital is 450,000 (300,000 share capital + 150,000 revaluation reserve)

(b) 000

Ordinary shares of 1 each 270 (W1)

Revaluation reserve 150

Capital redemption reserve 30

Retained earnings 325 (W2)

Net assets including cash 775

Workings:

W1 300 (original share capital) 30 (capital redeemed 10 per cent 300)

W2 400 (original balance) 30 (transfer to capital redemption reserve) 45 (premium on redemption)

(c) The permanent capital is 450,000 (270,000 shares + 150,000 revaluation reserve + 30,000

capital redemption reserve)



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have recovered. Success or failure cannot be forecast with certainty, but there are a

number of indicators that have been observed in failed companies and which can belooked for in companies suffering from financial difficulties in order to see whetherthey too are likely to fail.

6.1 The causes of failureThe prime factor that causes companies to fail is inadequate management, whichmay misjudge costs,prices or markets,or base decisions on insufficient or out of date

information.These shortcomings eventually cause the company to become insolventand force it into liquidation.The causes of failure are therefore the factors that erode

the liquidity of the company and leave it unable to attract further external finance orgenerate sufficient internal finance to continue in operation.When a financial insti-

tution is approached with a request for a loan or overdraft and the companysaccounts reveal a poor liquidity position,the causes of the low liquidity ratio must be

sought. If the causes are of a permanent nature, the provision of additional financewill merely postpone liquidation as the company will suffer another liquidity crisis

as soon as the new funds have been used up.

The causes of liquidity problems may be complex, but can be sought in such areas as:

Finance costsInterest charges on debt represent a fixed cost. They do not vary with the rate ofoutput. A company with a high proportion of debt finance has to meet substantial

interest payments, and it is possible for these to prove too great a burden, especially ifthere is a downturn in trading profit. Small companies often rely heavily on over-drafts for finance, and an increase in the rate of interest charged, particularly if it

coincides with a fall in trading profits, can cause great difficulties.

Operating costsThe high fixed costs associated with capital-intensive production methods can prove

an excessive drain on resources, particularly if there is a fall in the level of activity.

Fixed costs do not respond to changes in the level of output, and may be completelyoutside the control of management; for example, local authorities collect rates fromthe occupiers of business premises and these must be paid by businesses irrespective

of their profitability. Also, the variable cost per unit of output may rise, for example,as the result of a pay increase granted to employees. If a firm cannot increase its

selling price to recover increased operating costs, its profit margins are eroded oreven converted into losses, thereby reducing the level of cash flow into the business.

Over-tradingA company may be profitable but management takes the unwise step of financing long-term developments with short-term funds, that is, they use money needed to meet

operating costs to acquire fixed assets or to fund long-term activities such as research.

Market failureIt is possible fora company to be efficient and, initially, to have a correctlybalanced capital

structure. However, it will still fail if it cannot sell its product at a price high enough to

cover costs.The inability to charge an adequate price may be due to competitors having

lower prices or simply the fact that there is no longer a demand for the companys partic-

ular product.

Adverse currency movementsWhen the value of the home currency of an exporter rises relative to other currencies,

the value of its sales in overseas markets falls when the proceeds are remitted. Forexample, a company based in Upland, where the currency is the U, exports goods to

Lowland, where the currency is the L.The customers of Lowland pay a price stated in Ls

and, in both 20X0 and 20X1, the company collected L100,000 from sales in Lowland.




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In 20X0,the exchange rate was 4L1U. In 20X1, the U strengthened and the exchange

rate became5L1U.Whenexchanged,the 20X0sales yield 100,0004U25,000,while the 20X1 sales produced only 100,000 5U20,000.The company has to pay

its costs in Us and the reduced receipts may be insufficient for that purpose.Where symptoms such as those described above appear, a decision must be made

whether they canbe rectified in sufficient time andat a small enough cost to enable thecompany to continue in existence. If it is fairly certain that the company is going to

fail, commercial losses are minimised by injecting no further finance.The likelihoodof a firm, which appears to be failing, avoiding eventual liquidation depends to a largeextent on the ability of management.To have reached the position where failure is a

distinct possibility can be evidence of poor management, and a condition of financialhelp could be the injection of new managerial expertise.Any lendersevaluation of the

prospects of survival is likely to be based on forecasts made by management,and thesemust therefore be checked carefully for realism and compared with past results to see

if they are consistent.

6.2 Losses and capital erosion

Losses are caused by the failure to recover all costs through sales.The solution lies in thecompanys ability to raise prices, cut costs or produce a new product that can be sold

profitably. A company that makes losses suffers an erosion of capital, which produces acorresponding reduction in net assets.Theimpactof losses on the viability of a company

depends on their size relative to the companys resources, and on their duration.A rela-tively small annual loss is unlikely in itself to have a significant effect; the company still

has a positive cash flow from trading if its depreciation charge is greater than the loss.The accumulation of a series of losses, even if individually small, has a more

serious impact in the longer term. In these circumstances the cash flow representedby depreciation is used to finance running costs and the firm will probably be unable

to attract finance when it is time for plant replacement.A company that continuallymakes losses is heading for likely failure;the size of the losses merely determines howlong the process takes.The effect of large significant losses is more immediate and

precipitates the crisis more quickly.



Describe four possible causes of business failure.

worked example 10.9

The balance sheet of Going Ltd at 31 December 20X0 is:

000

Fixed assets at written-down value 400

Working capital 350

750

Share capital 500


750

The fixed assets are expected to last a further five years and to keep pace with inflation it is forecast that

20,000 per year must be invested in additional working capital.



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The Act requires any director of a public company to call an extraordinary general

meeting on becoming aware of the fact that, as a result of business losses, thecompanys net assets are worth half or less of its called-up share capital.The meeting

must be convenedwithin 28 days of theloss becomingknown and must be held within56 days.This meeting is instructed to consider whether any, and if so what, measures

should be taken to deal with the situation. For this purpose, the net assets of a companyare defined asthe aggregate of its assets less the aggregate of its liabilities, and so their

value is revealed by the balance sheet. The speed with which the erosion becomes

apparent will therefore depend on the frequency of preparation of balance sheets.The objective of this provision is to make the shareholders aware of the fact that

the company has sufferedmajor losses. Once this has been done,theyare able to meetto consider possible courses of action to prevent the accumulation of further losses.

However, the legal requirement to call a meeting may give rise to problems.The factthat a meeting has been called may cause a withdrawal of finance by, for example,

banks and trade creditors, thereby bringing about a failure which might have beenaverted. Assets are valued for accounting purposes on the assumption that the busi-

ness is a going concern. In the circumstances that lead to the calling of a meetingunder the Act, the liquidation basis may be more appropriate.The use of liquidation

values would,although prudent, possibly reinforce the assumption that the companyis bound to fail and hasten its end.



Required:

Prepare the balance sheet of Going Ltd at 31 December 20X5 on the alternative assumptions that in each of

the next five years it suffers a loss after charging depreciation of:

(a) 20,000

(b) 60,000

Comment on the results.

Answer

(a) (b)

000 000

Fixed assets at written down value

Working capital 450 450

Surplus cash 200 W1 W2

650 450

Share capital 500 500

Retained earnings 150 250

650 450

Workings (000):

5 years losses 5 years 5 years additional Surplus cash

depreciation working capital 31 December 20X5

W1 100 400 100 200

W2 300 400 100 0

No dividends have been paid throughout the five years, and in neither case does Going Ltd have enough cash

at the end of 20X5 to replace the exhausted fixed assets. The continual losses make it most unlikely that new

external finance can be obtained. In case (b), the losses have eroded the book value of the share capital, while

annual losses in excess of 60,000 would deplete working capital and therefore reduce the volume of trade

the company is able to undertake.



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7 Liquidation

Liquidation is usually caused by a company being unable to pay its debts as they falldue. In determiningthe companys ability to pay its debts, theAct requires all contingent

and prospective liabilities to be taken into account.Therefore, a company may currently

be solvent but may be forced into liquidation if it is apparent that it will be unable tomeet some futureobligation.When a company goes intoliquidation,the administrationof its affairs passes from the board of directors to an official known as aliquidator. It is

the duty of theliquidator to realise theassets of thecompany for as much as possible andto use the proceeds to pay its creditors and members in a specified order.

The order of repayment is as follows:

Debts secured with a fixed charge on an asset have first priority and are repayable

out of the proceeds received from thesale of that asset.It is unlikely that therealisedvalue of the asset will be exactly equal to the amount of the debt, and any surplus is

used by the liquidator to meet the companys other liabilities. Great care must beexercised when there is a deficit,that is, thevalue of thesecured asset is less than the

debt. In these circumstances, the secured debt effectively divides into two separate

parts; the first is covered by the secured asset to the extent of its value, and thesecond part ranks alongside, and therefore is added to, the unsecured creditors.

The costs of liquidation.

Preferential debts, which include certain taxes and sums due to employees.

Debts that carry a floating charge,that is, they are secured on the companys assetsin general.

Unsecured creditors.

Shareholders. The priority for repayment where there exist different classes of

shares is determined by the terms on which the shares were issued. Preferenceshares are normally repaid in full before the ordinary shares, while the Act gives

priority, within their particular class, to redeemable shares and any which thecompany has agreed to purchase but has not acquired by the time of liquidation.


liquidation

Liquidation is the process

whereby the assets of a

company are realised anddistributed to its

shareholders and creditors.

worked example 10.10

The liquidator of Gone Ltd has sold all of the companys assets for 250,000 in cash.

The financial obligations of the company are:

000

Cost of liquidation 30

Preferential debts 20

Debts with floating charges 100

Unsecured creditors 200

Ordinary shareholders 250

Required:

(a) Calculate how much is received by each class of creditor and shareholder, showing clearly the order of

priority.

(b) Calculate the sum received by an unsecured creditor owed 2,500.



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Each category must be paid in full before the next group receives any payment what-

soever.Thus, all preferential debts must be paid before creditors with floating chargesreceive anything and they in turn must be fully settled before any payment is made to

unsecured creditors. A company that is insolvent when it is wound up is unlikely tobe able to pay the full amount due to all its creditors and classes of shareholders; some

receive less than the amount due, and others receive nothing.Within the class, wherethe liquidator runs out of money, the debts abate equally, that is,each creditor or classof shareholder receives the same proportional payment.

A receiver may be appointed to enforce theterms ofa secured debt if a company defaultsin the payment of interest or capital when due, or behaves in a manner that threatens

secured assets.The receiver takes control of the assets covered by the charge and realisesthem to provide funds to satisfy the terms of the loan. If the company remains solvent

after the receivership is complete, management reverts to the directors. However, theappointment of a receiver is usually an indication that the company is failing and so

liquidation, under the control of the liquidator, normally follows receivership.

8 Capital reconstruction

Liquidation is not the inevitable outcome of a companys insolvency. It may be worth-while to attempt to rescue the company by employing a capital reconstruction

where the insolvency is due to specific, curable factors. For example, a company mayhave over-traded, and, if it is basically profitable,an injection of additional capital may

save it.Alternatively, a company may need time and finance to cease the production ofunprofitable lines and bring to the market new, profitable products. In these circum-

stances, meetings of creditors and members are called to consider the acceptance ofvariations in their rights.To be acceptable, the proposed reconstruction must be more

attractive to all parties than the alternative of liquidation.



Answers

(a) The funds available are distributed as follows:

Order of Priority 000

Received from sale of assets 250

1 Less: cost of liquidation 30

220

2 Less: Preferential debts 20

200

3 Less: Debts with floating charges 100

4 Available for unsecured creditors 100

Unsecured creditors are owed 200,000 and each receives 50 pence in the pound.

5 Ordinary shareholders receive nothing

(b) An unsecured creditor owed 2,500 receives 50 pence 2,500 = 1,250.


List the order of priority of repayment to parties with claims against a company

on liquidation.

capital reconstruction

Capital reconstruction is a

changein thecapital

structure of a company

involving, for example, a

reduction of capital, changes

in therights of classes of

shareholders, the formation

of a newcompany, with the

aimof givingthe existing

company a fresh start.



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8.1 The variation of rights

The objective of a reconstruction scheme is to enable the company to continue as a

going concern by the removal of the burden of immediate debts, the attraction ofadditional funds and the creation of a viable financial structure.The reconstruction can

be carried out by altering the rights of creditors and members in the existing

company, or the activities of the old company may be taken over by a newlyestablishedcorporate entity which accepts revised obligations to the old companys creditors andmembers, with the old company being wound up or dissolved.

It is possible to vary rights in a number of ways on reconstruction:

Thenature of the debt may be changed; for example,debentures may be converted

to share capital or creditors to secured loans.

The value of the liability may be changed; for example, the nominal value of ordi-

nary shares, which are likely to be of little or no value on liquidation, can begreatly reduced, or creditors may agree to forgo part of their debt.

The return on the debt may be varied.Trade creditors could be offered interest todelay their claims, or debenture holders given higher interest to extend the term

of the debenture.

A combination of the three points above can be applied. For example, 8 per centdebentures with a face value of 100,000 repayable in one years time may becancelled in exchange for 75,000 ordinary shares of 1 each and 50,000

debentures carrying 12 per cent interest and repayable in ten years time.

The rights of creditors and members cannot be varied in an arbitrary manner; the

Companies Act 2006 provides for meetings of all classes to be called and, if each ofthese approves of the proposed arrangement by a majority of at least 75 per cent,

then, with the sanction of the court, it becomes binding on all the interested parties.



The following is the balance sheet of File Ltd on 31 December 20Xl:

000 000

Fixed assets at written down value 180

Goodwill 50

Inventories 90

Receivables 85

175

Payables 85

Bank overdraft 40

125

Working capital 50

280

8 per cent secured debentures repayable 31 December 20X8 130

150


Accumulated loss 100

150

The companys activities have been partially reorganised and a number of loss-making branches closed. It is

forecast that profits will be made in the future, but reconstruction is necessary to enable the company to raise

the further equity capital needed to complete the reorganisation The following scheme has been accepted by

all interested parties:



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1 The assets are to be written down to realistic current values:

000

Fixed assets 80

Goodwill

Inventories 70

Receivables 80

2 The accumulated loss is to be eliminated.

3 The existing 8 per cent debentures are to be cancelled. In return, the debenture holders are to receive 12

per cent debentures with a nominal value of 90,000 together with 35,000 ordinary shares of 1 each

fully paid.

4 The payables are to be reduced by 25,000 and these suppliers agree, in return for an interest payment, to

wait two years for their money.

5 Each existing ordinary share of 1 is to be written down to two pence. The two pence shares are to be

consolidated into shares with a nominal value of 1 each. The ordinary shareholders agree to subscribe in

cash for 60,000 shares of 1 each at par.

Required:

(a) Prepare the Reconstruction Account of File Ltd to put the scheme into effect.

(b) Prepare the Balance Sheet of File Ltd after the scheme has been given effect.

Answers

(a) Reconstruction account

000 000

Fixed assets (1) 100 8 per cent Debentures (3) 130

Goodwill (1) 50 Payables (4) 25

Inventories (1) 20 Ordinary shares (5) 245

Receivables (1) 5

Accumulated loss (2) 100

12 per cent Debentures (3) 90

Ordinary shares (for debenture holders) (3) 35

400 400

Note

The number in brackets after each entry in the reconstruction account refers to the step in the reconstruction

scheme given in the question.

(b) Balance Sheet after Reconstruction

000 000

Fixed assets 80

Current assets

Inventories 70

Receivables 80

Cash (W2) 20 170

250

Non-current liabilities

12 per cent debentures 90

Payables deferred for two years 60 150

100

Financed by:

Ordinary share capital (W1) 100



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8.2 Implementation of a scheme of reconstruction

When a company is reconstructed, it is common to revalue the assets at realistic

amounts and eliminate the debit balance on the income statement, if any. When thereconstruction does not involve the creation of a new company, a Reconstruction

Account is opened to complete the bookkeeping double entries for the adjustmentson reconstruction.This account is debited with reductions in the value of assets, the

adverse income statement balance, and the creation of liabilities; it is credited withreductions in liabilities and increases in the value of assets.

The corresponding entries are in the appropriate asset or liability account.InWorked Example 10.11, the amounts written off assets together with the removal

of the accumulated loss were exactly balanced by adjustments to the claims fromvarious providers of finance. The credit balance, which sometimes remains on the

reconstruction account after the adjustments have been made, is a capital reserve and isshown in the balance sheet as part of equity.

8.3 The evaluation of reconstruction schemes

The providers of finance, when asked to participate in a scheme of reconstruction,shouldweigh the benefits they might obtain from its implementation with the alterna-

tive,which is usually liquidation.A first step in the review of any scheme is to considerthe rights of each class on liquidation and reconstruction.The likely outcomes must be

based on forecasts and so cannot be guaranteed as accurate but, because liquidation ismore immediate, its results are open to less doubt.

The timing of any prospective payments is also important when assessing the

merits of a reconstruction scheme. For example, if the trade creditors were asked towait a year before payment, they would expect some compensation for this delay. On

liquidation, they would be paid in the near future and the cash received could be

invested.To wait a year, they would require reimbursement of the interest forgone,plus perhaps an additional amount for the risk of leaving their money in a companythat has been on the brink of failure.When the payment of sums of money is offered

on different dates, an adjustment for interest is needed to enable comparison. Forexample, if funds can be invested at 10 per cent per annum and a creditor is offered

the choice between 1,000 on immediate liquidation or 1,050 in one years time,liquidation is preferable since 1,000 could be invested for a year at 10 per cent to

give 1,100 at the end of the year.Some of the costs and benefits associated with reconstruction schemes are intan-

gible and hence difficult to quantify. They should be considered nevertheless. Forexample, a financial institution may wish to avoid unfavourable publicity that might

result from putting a customer into liquidation, such as unemployment, and thisshould also be considered, together with the benefit of future custom that will come

from the firms continued existence.



Workings:

W1 Ordinary share capital 000

Issued to debenture holders 35Ordinary shareholders (reduced) 5

Issued for cash 60

100

W2 Cash

Overdraft 40

Cash from issue of shares 60

20



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Sutherland Ltd is a private company. Three-quarters of the issued share capital is held by the directors or

members of their families. The companys draft balance sheet as at the end of 20X5 was as follows:

Balance Sheet at 31 December 20X5

Non-current assets

Intangible assets: Development costs 85,000

Goodwill 60,000

Tangible assets: Land and buildings 270,000

Plant and machinery 326,000

741,000

Current assets

Inventories 426,000

Receivables 531,000

957,000Current liabilities

Payables 393,000

Bank loans and overdrafts 687,000

Net current liabilities 1,080,000

123,000

Total assets less current liabilities 618,000

Equity

Called up share capital (800,000 shares of 1 each) 800,000

Share premium account 50,000

Accumulated loss 232,000

618,000

Bank loans and overdrafts consist of a 10 per cent loan of 400,000 repayable in 20X6 carrying a fixed charge

on the companys land and buildings, and an unsecured overdraft of 287,000.

The demand for the companys products fell drastically in recent years, owing to the import of high quality,

and cheaper, products from South-East Asia. The development costs appearing in the balance sheet above

relate to a new product that has been perfected to a marketable stage and for which there is believed to be a

strong demand. The costs have been properly capitalised in accordance with the provisions of IAS 38. The

company is in urgent need of capital to meet existing liabilities and the necessary new investment in plant and

working capital.

A scheme for financial reorganisation has been drawn up for the consideration of shareholders and creditors.

The terms are as follows:

1 The shares of 1 each are to be written down to 20p per share and subsequently every five shares of 20p

each are to be consolidated into one fully paid share of 1.

2 The existing shareholders are to subscribe for a rights issue of two new 1 ordinary shares, at par, for every

share held after the proposed reduction and consolidation.

3 A major supplier agrees to exchange a debt of 180,000, included in payables, for 180,000 ordinary

shares of 1 each fully paid.

4 In full satisfaction of the 687,000 owing, the bank agrees to accept an immediate payment of 87,000

and to consolidate the balance of 600,000 into a loan carrying interest of 13 per cent per annum

repayable in five equal annual instalments commencing 31 December 20X7. The loan is to be secured by a

fixed charge on the land and buildings and a floating charge on the companys remaining assets.



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5 The credit balance on share premium account and the accumulated loss and goodwill, considered

valueless, are to be written off.

The assets listed below are to be restated at the following amounts:


Inventories 210,000

Receivables 500,000

Land and buildings 320,000

A group of dissatisfied shareholders plan to oppose the scheme because: We have to bear the whole burden of

the reorganisation whereas the bank loses nothing.

The company has received a cash offer of 1,120,000 for its fixed and current assets.

Required:

(a) The revised balance sheet of Sutherland Ltd at 1 January 20X6 giving effect to the proposed scheme for

reorganising the company.

(b) A report for the group of dissatisfied shareholders explaining whether they should accept or oppose the

scheme.

(c) A report for the bank explaining the matters to be taken into account in deciding whether it would be

better to support the scheme or press for immediate liquidation of the company.

Note

Assume you are making the calculations and writing the reports on 1 January 20X6 and that no other changes occur.

Answers

Revised Balance Sheet at 1 January 20X6

Non-current assets 000 000

Intangible assets: Development costs 85

Tangible assets: Land and buildings 320

Plant and machinery 125

530

Current assets

Inventories 210

Receivables 500

Bank balance (320,000 87,000) 233

943

Current liabilities

Payables (393,000 180,000) 213

Net current assets 730

1,260

Non-current liabilities

13 per cent bank loan 600

660

Equity

Called up share capital 660 (W1)

W1 Called up share capital:

Original shares (reduced by 80 per cent) 160

Rights issue 320

Issued to major supplier 180

660



24/28



(b) The report for shareholders should cover the following points:

(i) The holders of ordinary shares own the equity of the company; they benefit from any increase in the

value of the concern as the result of trading and must in turn bear the losses.

(ii) If the company is liquidated, liabilities totalling 1,080,000 must first be met out of the cash offer.

This leaves just 40,000 for the shareholders (ignoring liquidation expenses), which is far less than

the nominal value of the shares allocated to them on reconstruction.

(iii) The shareholders are required to make a substantial cash injection which they should do only if they

are confident about the companys future prospects.

(iv) Provided prospects are sound, the shareholders will benefit from the reorganisation as they retain

ownership of nearly three-quarters of the equity shares and this entitles them to a similar proportion

of future profits.

(v) Past losses are eliminated and so the company can pay dividends as soon as profits are made.

(c) The report for the bank should cover the following points:

(i) On liquidation, the bank would receive the full amount due as the cash offer exceeds total liabilities

by a sum that is probably sufficient to meet liquidation expenses.

(ii) If the scheme is given effect, the bank will receive 87,000 immediately, but the remaining

600,000 will be recovered over a five-year period.

(iii) The bank will receive a higher interest rate and better security to help compensate for the need to wait

longer for its money.

(iv) The social and financial effects of liquidation, such as the loss of a customer and the associated

publicity, must be assessed.

(v) Adequate security should be arranged; a fixed charge on the land and buildings and a floating charge

on the remaining assets would be appropriate.

(vi) Prospects need to be sound for the bank to support the scheme.


(a) In what circumstances is a capital reconstruction worthwhile?

(b) Why would a creditor prefer repayment to be made immediately rather than in

one years time?

chapter summary

This chapter deals with procedures designed to ensure,

as far as possible, that capital is maintained intact and,

where a company gets into difficulties, the accounting

and financial consequences of liquidating the companyor undertaking a capital reconstruction in order to enable

the organisation to continue in business.

You need to achieve an understanding of the difference

between accounting profit and distributable profit and be

able to compute the latter in accordance with the relevant

basic regulations.

The accounting and financial consequences of a bonus

issue of shares need to be understood.

The circumstances in which a company is obliged to

reduce its capital should be memorised.

You must be able to record the effect on the balance

sheet of a redemption or repurchase of shares whether

financed from the companys existing cash resources,

from a new issue of shares or from a combination of thesetwo possibilities.

A clear understanding of possible causes of business

failure is expected, as is the impact of a succession of

losses on a companys financial position.

You must be able to identify the resources available for

distribution, on liquidation, and the order of priority of

claims against the available resources.

You should be able to prepare a scheme for capital

reconstruction, be able to make appropriate adjustments

to the business balance sheet and assess the rights of the

various groups who are party to a reconstruction scheme.



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practice questions

10.1

State the basic rule for the calculation of the profitsavailablefor distributionby limited companies. (4marks)

10.2The liquidator of Errant Ltdhas sold all of the companys assets for500,000 in cash. The financial obligations of the

company are:

000

Cost of liquidation 60

Preferential debts 40

Debts withfloatingcharges overall the assetsof ErrantLtd 200

Unsecured creditors 800

Ordinary shareholders 500

Required:

Calculate how much is received by each class of creditor and shareholder, showing clearly the order of priority of

payment. (4 marks)

10.3

The summarised balance sheet of Restructure Ltd as at 31 December 20X4 is as follows:

Balance Sheet

Sundry assets 593,000

Equity and liabilities



Retained profit 293,000

Equity 513,000

10 per cent convertible debentures 80,000

593,000

The ordinary shares balance includes 70,000 redeemable shares of 1 each issued at par value. The balance of retained

profit is legally available for distribution.

Required:

A series of revised balance sheets for restructure at 1 January 20X5 taking separate account of each of the following schemes

under consideration by the directors.(a) The company makes a bonus issue to existing shareholders, at par, of one new ordinary share, fully paid, for every share

presently held. (3 marks)

(b) The company makes a rights issue of two new ordinary shares for every five shares presently held, at a price of

1.50 per share. (4 marks)

(c) The debenture holders exercise their right to convert their loan stock into ordinary shares. The conversion is to be

made at the rate of four ordinary shares for every 5 of debenture stock. The ordinary shares are currently valued

at par. (4 marks)

(d) The redeemable ordinary shares are redeemed at 1.60 per share. (4 marks)

(e) The redeemable ordinary shares are redeemed at 1.60 per share. The company issues 20,000 8 per cent redeemable

preference shares at par to help finance the redemption. (5 marks)



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10.4

At a meeting between the directors and creditors of Eastgate Ltd held on 20 April 20X1, it was decided to liquidate that

company. Certain facts and estimates were examined by the meeting. These included:

(i) Balance Sheet of Eastgate Ltd at 19 April 20X1

000 000

Goodwill at cost 22,000

Freehold property at cost 45,000

Plant and machinery at cost less depreciation 48,000

115,000

Quoted investments (market value 16,000) 12,000

Current assets

Inventories 108,000

Receivables 194,000

302,000

Current liabilities

Payables 209,000

Bank overdraft 68,000

277,000

Working capital 25,000

152,000

12 per cent debenture 50,000

102,000

Share capital (1 shares) 100,000

Reserves at 31 December 20X0 70,000

Loss for 20X1 to date 68,000 2,000

102,000

(ii) The following asset values were considered to be relevant in a liquidation:


Inventories 47,000

Receivables 160,000

There was significant disagreement regarding the likely value of freehold property. The majority accepted a valuation of

60,000 recently obtained from a firm of surveyors. A minority argued that, in view of development potential in the area

where this property is located, a sale figure of 150,000 is likely to be much nearer the mark.

(iii) Eastgate Ltds bank holds a fixed charge on the freehold property as security for the overdraft.

(iv) Of the 209,000 payables, 57,000 was estimated as being preferential.

(v) The debenture is secured by a floating charge over the assets of Eastgate Ltd, other than the freehold property. There areno arrears of debenture interest.

(vi) Liquidation expenses are estimated at 6,000.

Required:

(a) Calculations of the amounts that would be received by each of the providers of finance, assuming that the majority view

regarding the value of the freeholds is correct and that the other information proves accurate. You should show clearly

the order of priority for repayment. (10 marks)

(b) An indication of the effect on the findings under (a), if the minority view regarding the value of the freeholds proves to be

correct. (10 marks)

Note

Ignore taxation.



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10.5

The following draft balance sheet relates to the affairs of Gonedes Ltd at 31 December 20X2.

Balance Sheet at 31 December 20X2

000 000

Tangible fixed assets


Plant and machinery 4,040 7,200

Intangible assets

Goodwill 1,300

Development expenditure 750 2,050

9,250

Current assets

Inventories 1,900

Receivables 1,700

3,600

Current liabilities

Payables 1,820

Bank overdraft (unsecured) 1,100

Bank loan (secured on land and buildings) 4,000

6,920

Net current liabilities (3,320)

Total assets less current liabilities (5,930)

Equity

Called up share capital (1 ordinary shares) 6,000


Accumulated loss (2,070)

(5,930)

The company has made a succession of losses in recent years, but recent board changes and the development of a new

product line are believed to have significantly improved the companys future prospects. The following scheme for financial

reorganisation has been prepared for the consideration of shareholders and creditors. The existing ordinary shares to be

written down to 10p each and then consolidated into 1 shares.

The existing shareholders to subscribe to a rights issue of three new shares at par for every one share held after making

the changes set out in 1 above.

The companys major supplier has agreed to convert the amount outstanding, of 1,000,000, into fully paid ordinary

shares issued at par.

The bank requires immediate repayment of the overdraft but has agreed to convert the loan, presently repayable on

demand into an advance carrying 10 per cent per annum interest and repayable in four equal annual instalments

commencing 31 December 20X4.

The balances on the share premium account, accumulated loss and goodwill account (considered valueless) to be

written off.

Development expenditure to be written off.

The remaining assets to be restated at the following fair values.

000



Inventories 1,500

Receivables 1,700



28/28


Some of the existing shareholders plan to oppose the scheme on the grounds that We are being expected to suffer the entire

burden of past losses. They believe that they would be better off accepting a cash offer of 7,000,000 that has been received

from a competitor for all the companys assets.

Required:

(a) The revised balance sheet of Gonedes Ltd as at 31 December 20X2, giving effect to the scheme for reorganisation

outlined above. (10 marks)

(b) A report for the shareholders explaining whetheror not theyshould support the scheme. (10marks)

Note

Ignore taxation.


o FinAcc 6thEd StudyText Chapter10

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