Amalgamation and Internal Reconstruction — Practice

Question 1

State the five conditions for an amalgamation in the nature of merger, and explain what the five conditions taken together describe. A scheme satisfies four of them but pays 15% of the consideration in cash. Classify it.

Accepted Answer

The five conditions are: all assets and liabilities of the transferor company become those of the transferee after amalgamation; shareholders holding not less than ninety per cent of the face value of the equity shares of the transferor, other than shares already held by the transferee or its subsidiaries or their nominees, become equity shareholders of the transferee; the consideration receivable by those shareholders is discharged wholly by the issue of equity shares, except that cash may be paid for fractional shares; the business of the transferor is intended to be carried on after the amalgamation by the transferee; and no adjustment is intended to the book values of the assets and liabilities of the transferor when incorporated in the transferee's statements, except to ensure uniformity of accounting policies. Taken together they describe a situation in which nothing of substance has changed except the corporate wrapper: the same assets, the same shareholders in substantially the same proportions, the same business, carried at the same values. That is why pooling is appropriate — no purchase has occurred and the accounting should not pretend otherwise. The scheme described fails condition three, since 15 per cent in cash is far beyond the narrow permission for fractional shares. All five conditions must be satisfied, so failing any one makes it an amalgamation in the nature of purchase, and the purchase method applies.

Question 2

Contrast the pooling of interests method with the purchase method on four points: the values at which assets and liabilities are recorded, the treatment of the transferor's reserves, the treatment of the difference on consideration, and the treatment of statutory reserves.

Accepted Answer

On values, pooling records the assets and liabilities of the transferor at their existing book values, while the purchase method records them at book values or at fair values as agreed under the scheme. On reserves, pooling carries forward all the reserves of the transferor, which appear in the transferee's financial statements retaining their identity, so a general reserve remains a general reserve; under the purchase method the transferor's reserves are not carried forward at all, with the sole exception of statutory reserves. On the difference between the purchase consideration and the share capital of the transferor, pooling adjusts it against reserves, since no acquisition is regarded as having taken place; under the purchase method the difference between the consideration and the net assets acquired is recorded as goodwill where the consideration is higher, or as capital reserve where it is lower, and goodwill so arising is amortised over a period not exceeding five years unless a longer period can be justified. On statutory reserves, pooling carries them forward as part of all the reserves; the purchase method carries them forward only for the period for which the statutory requirement subsists, with a corresponding debit to an Amalgamation Adjustment Account shown as an asset, reversed when the requirement lapses.

Question 3

Explain why an Amalgamation Adjustment Account arises under the purchase method, what it represents, and when it is reversed.

Accepted Answer

Under the purchase method the transferee does not take over the transferor's reserves, and its books reflect only the assets and liabilities acquired against the consideration given. Statutory reserves are the exception, because they exist not by choice but because tax or other legislation required them to be created and required them to be maintained for a stated period, and that requirement does not disappear merely because the company that created them has been amalgamated. AS 14 therefore requires statutory reserves such as an Investment Allowance Reserve or a Development Allowance Reserve to be carried forward in the transferee's books for as long as the statutory requirement subsists. That creates a bookkeeping problem: a credit is being recorded for a reserve the transferee did not acquire and did not pay for, and there is no corresponding credit to balance it. The Amalgamation Adjustment Account is the balancing debit, presented on the assets side of the balance sheet under the head to which it relates. It is not an asset in any economic sense, and the standard is candid about its being a presentational device. When the statutory requirement lapses and the reserve is no longer required to be maintained, the reserve is reversed and the Amalgamation Adjustment Account is reversed with it, both disappearing together.

Question 4

A scheme provides that the transferee will issue 4 lakh shares of ₹10 valued at ₹25, pay ₹30 lakh cash to shareholders, discharge the transferor's ₹80 lakh debentures by issuing its own debentures, pay ₹5 lakh of the transferor's liquidation expenses, and take over trade payables of ₹45 lakh. Compute purchase consideration and justify each exclusion.

Accepted Answer

Purchase consideration is defined by AS 14 as the aggregate of the shares and other securities issued and the payment made in the form of cash or other assets by the transferee company to the shareholders of the transferor company. The words to the shareholders carry the whole difficulty of this question. Include the shares issued to shareholders, 4 lakh at 25, that is 100 lakh, and the cash of 30 lakh paid to shareholders, giving a purchase consideration of 130 lakh. Exclude the discharge of the debentures of 80 lakh: debenture holders are creditors, not shareholders, and the issue of the transferee's own debentures to them is a settlement of a liability taken over rather than consideration for the business. Exclude the trade payables of 45 lakh for the same reason, they being liabilities assumed rather than payments to shareholders. Exclude the liquidation expenses of 5 lakh, since these are the transferor's own costs of winding up, and even though the transferee is paying them, they are not received by the shareholders; they would enter the consideration only if the scheme expressly stated that the transferee bears them as part of the consideration. Amounts paid to discharge liabilities are the single most common addition candidates wrongly make.

Question 5

A transferor's balance sheet shows fixed assets ₹300 lakh, inventories ₹90 lakh, receivables ₹60 lakh, cash ₹12 lakh, preliminary expenses ₹8 lakh and a debit balance of profit and loss ₹40 lakh; liabilities are debentures ₹100 lakh and trade payables ₹50 lakh. The transferee takes over all assets except cash, and all liabilities except the debentures. Fixed assets are agreed at ₹340 lakh and inventories at ₹84 lakh. Compute purchase consideration by the net assets method.

Accepted Answer

Under the net assets method the purchase consideration is the agreed value of the assets taken over less the agreed value of the liabilities taken over, using book values where the scheme specifies none. Assets taken over: fixed assets at the agreed value of 340; inventories at the agreed value of 84; receivables at book value of 60, no agreed value having been specified. Cash is expressly not taken over and is excluded. Preliminary expenses of 8 lakh and the debit balance of profit and loss of 40 lakh are fictitious assets, representing no resource from which future economic benefits will flow, and are never taken over in any amalgamation question; they are written off against the Equity Shareholders' Account in the transferor's books. Total assets taken over are therefore 340 plus 84 plus 60, that is 484 lakh. Liabilities taken over are trade payables of 50 lakh only, the debentures of 100 lakh being expressly excluded and left for the transferor to discharge. Purchase consideration is 484 less 50, that is 434 lakh. The two habitual errors this question tests are including fictitious assets and including liabilities the scheme leaves behind.

Question 6

In one scheme the purchase consideration is ₹380 lakh and net assets acquired at agreed values are ₹412 lakh; in another the consideration is ₹500 lakh and net assets are ₹455 lakh. State the treatment in each, the presentation, and the amortisation position.

Accepted Answer

In the first scheme the purchase consideration of 380 falls short of the net assets acquired of 412, so the difference of 32 lakh is credited to Capital Reserve. It arises because the transferee has acquired net assets worth more than it paid, which typically reflects a negotiated bargain or an acquisition of a business in difficulty, and it is a capital profit rather than an operating gain, so it is not available for distribution and does not pass through the profit and loss account. In the second scheme the consideration of 500 exceeds the net assets of 455, so the excess of 45 lakh is debited to Goodwill and presented as an intangible asset in the transferee's balance sheet. AS 14 requires goodwill arising on amalgamation to be amortised over a period not exceeding five years unless a somewhat longer period can be justified, which is a shorter and more prescriptive rule than AS 26 applies to intangibles generally. The direction of this comparison is reversed by candidates more often than any other single step in the chapter, and the safeguard is to say the rule in words before applying it: paying more than the assets are worth creates goodwill, paying less creates a capital reserve.

Question 7

Set out the sequence of closing entries in the transferor company's books on an amalgamation, and state what is transferred to the Equity Shareholders' Account and why the Realisation Account balance goes there.

Accepted Answer

The sequence is fixed and should be written the same way every time. First, open the Realisation Account by debiting it with all assets taken over at their book values, excluding fictitious assets and excluding cash where cash is not taken over, and crediting the individual asset accounts. Second, transfer the liabilities taken over by debiting the individual liability accounts at book value and crediting the Realisation Account. Third, record the purchase consideration due by debiting the Transferee Company's Account and crediting the Realisation Account. Fourth, record receipt of the consideration by debiting the shares, securities or cash received and crediting the Transferee Company's Account. Fifth, record realisation expenses by debiting the Realisation Account and crediting Bank, where the transferor bears them. Sixth, discharge any liabilities not taken over, debiting the liability and crediting Bank, with any difference to the Realisation Account. Seventh, transfer accumulated reserves and undistributed profits to the credit of the Equity Shareholders' Account, and accumulated losses and fictitious assets to its debit. Eighth, close the Realisation Account, its balance being the profit or loss on realisation. Ninth, settle the preference shareholders and distribute the balance to the equity shareholders, closing every account. The Realisation balance goes to the Equity Shareholders' Account because equity holders bear the residual: they take whatever remains after every liability and every preferential claim has been met, whether that is a gain or a loss.

Question 8

State the acquisition entry in the transferee's books under the pooling of interests method and under the purchase method, identifying what differs and why.

Accepted Answer

Under the pooling of interests method, the transferee debits the assets taken over at the transferor's existing book values, credits the liabilities at book value, credits the reserves of the transferor at book value so that they appear in its own statements retaining their identity, and credits the purchase consideration; any difference between the consideration and the share capital of the transferor is adjusted against reserves, so nothing is recognised as goodwill or capital reserve. Under the purchase method, the transferee debits the assets at the agreed values, credits the liabilities at agreed values, credits the purchase consideration, and takes the balancing figure to Goodwill if it is a debit or to Capital Reserve if it is a credit; the transferor's reserves are not brought in at all except for statutory reserves, which are carried forward with an Amalgamation Adjustment Account as the balancing debit. What differs, and why, follows entirely from the classification. A merger is not treated as an acquisition of one business by another but as a uniting of interests, so the combined entity simply carries forward what both entities had, values and reserves alike; a purchase is an acquisition, so the acquirer records what it bought at what it agreed to pay, and the difference between price and value is goodwill or a bargain.

Question 9

Explain the commercial problem internal reconstruction solves, and why liquidation is not the answer for the companies that use it.

Accepted Answer

A company that has traded at a loss for years carries a large debit balance of profit and loss, assets whose carrying amounts exceed what they are worth, and share capital that no longer represents anything real. Two consequences follow that a return to profitability does not cure. It cannot declare a dividend, because dividend may be declared only out of profits and the accumulated deficit must be made good first, so shareholders face an indefinite wait even if the business is now earning. And it cannot raise fresh capital, because no investor will subscribe alongside a deficit that their money would in effect be used to absorb. The company is therefore solvent in cash terms and paralysed in capital terms. Liquidation is not the answer because it would destroy a viable business: the trading operations may be sound, the workforce and customer relationships have value that a break-up realises nothing for, and creditors would ordinarily recover less in a winding up than from a company allowed to continue. Internal reconstruction rewrites the capital structure so that the balance sheet reflects reality — losses eliminated, assets at their true values, capital reduced to what it actually represents — while the company remains in existence. Nobody necessarily puts in new money; the parties give up parts of claims that were not going to be met in full in any event.

Question 10

Name the statutory routes available for internal reconstruction under the Companies Act, 2013 and state the approvals each requires. Which is the operative mechanism in most reconstruction problems?

Accepted Answer

There are four. Alteration of share capital under section 61 permits a company, if authorised by its articles, to consolidate and divide its share capital into shares of larger amount, to convert fully paid shares into stock and reconvert, to subdivide shares into shares of smaller amount, and to cancel shares not taken or agreed to be taken by any person; it requires an ordinary resolution in general meeting and no Tribunal involvement, and cancelling unissued shares in this way is expressly not a reduction of capital. Variation of shareholders' rights under section 48 permits the rights attaching to a class of shares to be varied with the consent of the prescribed proportion of that class. Reduction of share capital under section 66 requires a special resolution and confirmation by the National Company Law Tribunal, and may take three forms: extinguishing or reducing liability on shares not fully paid up; cancelling paid-up share capital which is lost or unrepresented by available assets; and paying off paid-up share capital in excess of the wants of the company. A scheme of compromise or arrangement under sections 230 to 232 is used where creditors and debenture holders also give something up, and requires the approval of the classes concerned and the sanction of the Tribunal. Section 66, generally within a scheme under section 230, is the operative mechanism in most reconstruction problems, because it is the one that cancels capital lost or unrepresented by assets.

Question 11

A scheme provides: equity shares of ₹10 reduced to ₹4 on 25 lakh shares; preference shares of ₹100 reduced to ₹70 on 2 lakh shares; debenture holders forgo ₹25 lakh; creditors of ₹120 lakh forgo 15%; fixed assets written down by ₹80 lakh; goodwill of ₹35 lakh, preliminary expenses of ₹6 lakh and a debit balance of profit and loss of ₹190 lakh written off; reconstruction expenses ₹4 lakh. Prepare the Capital Reduction Account and state the treatment of the balance.

Accepted Answer

Classify every clause as a sacrifice, which is a credit, or a write-off, which is a debit, and then build the account. Credits: equity capital reduced by 6 per share on 25 lakh shares, that is 150 lakh; preference capital reduced by 30 per share on 2 lakh shares, that is 60 lakh; debenture holders forgoing 25 lakh; creditors forgoing 15 per cent of 120 lakh, that is 18 lakh. Total credits are 253 lakh. Debits: fixed assets written down by 80 lakh; goodwill 35 lakh; preliminary expenses 6 lakh; debit balance of profit and loss 190 lakh; reconstruction expenses 4 lakh. Total debits are 315 lakh. The debits exceed the credits by 62 lakh, which means the scheme as stated does not cover the write-offs it proposes, and in an examination that is a signal to re-read the question for a sacrifice not yet taken into account or a figure misread, since a properly drafted scheme is designed to leave a credit balance or nil. Where the credits do exceed the debits, the balance is transferred to Capital Reserve, because it is a capital profit arising from a reorganisation of capital rather than a trading profit, and it is therefore not available for distribution as dividend. It is never transferred to the profit and loss account.

Question 12

Under a scheme, three years' arrears of preference dividend are cancelled. A candidate credits the arrears to the Capital Reduction Account. Comment, and explain why the cancellation nonetheless matters.

Accepted Answer

The credit is wrong. Arrears of cumulative preference dividend are not a liability recorded in the books: a dividend becomes a liability only when it is declared, and undeclared arrears on cumulative preference shares are a claim that must be satisfied before any equity dividend can be paid, disclosed by way of note as a contingent liability rather than recognised. Since nothing was recorded, cancelling them releases nothing that could be credited to the Capital Reduction Account, and crediting them would create a credit out of nothing and distort the account. The cancellation nonetheless matters a great deal commercially, which is why schemes routinely provide for it. Until the arrears are cleared, no equity dividend can be paid, so equity shareholders have no prospect of return however well the company trades, and the shares are correspondingly unattractive. Cancelling the arrears removes that overhang and is part of what the preference shareholders give up in exchange for a company that can continue rather than be wound up. The correct treatment is therefore disclosure of the cancellation in the scheme and in the notes, with no entry in the Capital Reduction Account, and a candidate who explains why no entry arises will score better than one who simply omits it.

Question 13

Describe an efficient method for working an internal reconstruction question in which the scheme is given in prose with clauses in no particular order, and state the check that catches most errors.

Accepted Answer

Read the scheme once and mark each clause as C or D in the margin: every clause is either a sacrifice by a shareholder, debenture holder or creditor, which is a credit to the Capital Reduction Account, or a write-off of a loss, a fictitious asset or an asset value, which is a debit. Do not attempt to work the clauses in the order given, and do not revise the balance sheet as you go, which is what makes these questions take three times as long as they should and introduces errors at every revision. Having marked the scheme, build the Capital Reduction Account in full from the marks, credits first then debits. Then draw the revised balance sheet once, in the Schedule III format, taking each figure from the original balance sheet as adjusted by the account you have just built. The check that catches most errors is twofold. The revised balance sheet must balance, and the Capital Reduction Account must close to Capital Reserve without leaving a residual debit. A debit balance on the Capital Reduction Account is a diagnostic rather than a result: it means either that a sacrifice in the scheme has been missed, most often a creditor or debenture holder concession buried in a later clause, or that a write-off has been overstated, most often by writing an asset down to its revised value rather than by the amount of the reduction.

Question 14

Distinguish an alteration of share capital under section 61 from a reduction of share capital under section 66, and explain why the approvals differ.

Accepted Answer

An alteration of share capital under section 61 changes the denomination or arrangement of the capital without changing its total: consolidating shares into larger units, subdividing them into smaller ones, converting shares into stock, or cancelling shares that have never been taken or agreed to be taken by any person. It requires only an ordinary resolution, must be authorised by the articles, and involves no Tribunal. A reduction of share capital under section 66 reduces the total capital itself, whether by extinguishing or reducing liability on shares not fully paid up, cancelling paid-up capital lost or unrepresented by available assets, or paying off capital in excess of the company's wants. It requires a special resolution and confirmation by the National Company Law Tribunal. The approvals differ because the interests affected differ. An alteration rearranges what the shareholders hold among themselves and leaves the fund available to creditors untouched, so the shareholders alone need be consulted. A reduction diminishes that fund, which is the security creditors relied on when they extended credit, so the law requires a higher shareholder majority and independent scrutiny by the Tribunal, which will consider creditors' objections before confirming. The cancellation of unissued shares under section 61 is expressly stated not to be a reduction, precisely because no capital was ever contributed against them.

Question 15

T Ltd has 20 lakh equity shares of ₹10, general reserve ₹40 lakh and a debit balance of profit and loss ₹15 lakh. P Ltd takes over all assets except cash of ₹5 lakh, and all liabilities except ₹60 lakh debentures. Agreed values: fixed assets ₹240 lakh (book ₹210 lakh), inventories ₹72 lakh (book ₹80 lakh), receivables ₹42 lakh (book ₹45 lakh); trade payables ₹35 lakh. P Ltd issues 3 shares of ₹10 valued at ₹18 for every 4 held, plus ₹20 lakh cash to shareholders. Classify, compute purchase consideration and identify goodwill or capital reserve.

Accepted Answer

Classify first. The consideration is not discharged wholly by the issue of equity shares, since 20 lakh is paid in cash and not merely for fractional shares, so condition three of AS 14 fails; the assets are also being revalued, so condition five fails as well. This is an amalgamation in the nature of purchase and the purchase method applies. Purchase consideration by net payments: T Ltd has 20 lakh shares, three for four gives 15 lakh shares in P Ltd valued at 18, that is 270 lakh, plus cash of 20 lakh paid to shareholders, giving 290 lakh. The debentures are excluded because purchase consideration is what is paid to shareholders, and P Ltd is not taking them over in any event. Net assets acquired at agreed values: fixed assets 240, inventories 72, receivables 42, cash not taken over, giving 354 lakh of assets, less trade payables taken over of 35 lakh, giving 319 lakh. Comparing the two, the purchase consideration of 290 is less than the net assets of 319, so the difference of 29 lakh is credited to Capital Reserve. In T Ltd's books the general reserve of 40 and the debit balance of profit and loss of 15 are transferred to the Equity Shareholders' Account, and the debentures are discharged out of the retained cash.

Practice — Amalgamation and Internal Reconstruction

Sign in to save attempts to your dashboard and track your accuracy over time

Find a verified tutor

Join a live course

Browse coaching centres

About

Categories

Support

Documentation

Get Study Tips & Updates

Download Our App

Download for iOS

Download for Android

Popular Cities