Internal vs external reconstruction

Companies are generally incorporated with the core objective of earning profits. In certain circumstances, however, companies begin to face obstacles which hamper their ability to continue operating successfully and earn profits. These may be in the form of management breakdowns, deteriorating financial condition and failed business model etc. In severe cases of such situations, companies may look to tide over these obstacles by opting for restructuring which involves reorganization of one or more critical structures of the company so as to make it functional and profitable.

The article “internal vs external reconstruction” looks at meaning of and differences between two forms of financial reconstruction – internal reconstruction and external reconstruction.

Definitions and meanings

Internal reconstruction

It is the form of company restructuring which focuses on the internal reorganization of the company’s financial position, without dissolving the company itself. In internal reconstruction the company’s legal existence remains and no new company is formed.

Internal reconstruction is generally warranted when:

1. Financial statements misrepresent the financial position; for example, assets are overvalued or fictitious assets exist on the balance sheet
2. The company is overcapitalized with a complex capital structure.

Internal reconstruction basically involves an overhaul of how its financial assets and liabilities are valued and reported. It looks to reach compromises with creditors for reduction in their payables. It also seeks to alter the heavy capital structure. This can take several forms such as alteration of share capital, change in dividend rates and other rights of shareholders, reduction of share capital and surrender of shares etc.

The ultimate intention of internal reconstruction is to generate surplus through reductions in liabilities such as settlement of creditors and alteration in share capital etc. Such surplus can be utilized to write off accumulated losses and overvalued or fictitious assets. This can improve the overall financial health of the company and keep it from a complete financial breakdown.

External reconstruction

External reconstruction is a form of company reorganization that involves the liquidation of the existing company followed by its takeover by a new company. The existing company that gets liquidated is termed as transferor company and the new company formed is termed as transferee company.

External reconstruction involves several activities which generally include:

1. Liquidation of the existing company
2. Formation of a new company to takeover the business (all assets and liabilities) of the existing company at agreed values.
3. Issue of shares in new company to shareholders of the existing company.
4. Financial arrangement can be made for settlement of liabilities of the existing company by the new company. For example, debenture holders or creditors can be discharged by way of issue of equity or preference shares.
5. The new company may take over assets at reduced values which more accurately represent the true value.

As external reconstruction generally involves modification of the claims of creditors, debenture holders and lenders, the existing company needs to obtain their approval.

Difference between internal and external reconstruction

The nine key points of difference between internal and external reconstruction are detailed below:

1. Meaning

• Internal reconstruction is the reorganization of the financial affairs of the company internally without undergoing liquidation.
• External reconstruction is the form of restructuring which involves liquidation of the existing company and formation of a new company to take over the running of its business as well as to take over its assets and liabilities at some decided values.

2. Existence of reconstructed company

• In the case of internal reconstruction, the existing company continues as a going concern. Only its assets and liabilities are revalued with the intent to improve its financial structure.
• In the case of external reconstruction, the existing company ceases to exist and is liquidated.

3. Creation of new company

• In internal reconstruction, no new company is formed.
• In external reconstruction, a new company is formed to take over the assets and liabilities as well as business of the existing company.

4. Transfer of assets and liabilities

• In internal reconstruction, no transfer of assets and liabilities takes place. They only undergo a revaluation.
• In external reconstruction, assets and liabilities of the existing company are transferred to the new company.

5. Purchase consideration

• Since there is no takeover by any company in the case of internal reconstruction, there is no calculation of purchase consideration.
• As the business and all of its assets and liabilities are taken over in case of external reconstruction, a purchase consideration is calculated. This purchase consideration is paid by the new company to the existing company.

6. Accounting

• In internal reconstruction, the surplus generated from settlement of liabilities is transferred to a reconstruction account and the balance in this account is utilized to write off and revalue fictitious and other overvalued assets.
• In external reconstruction, a realization account is created for receipt of purchase consideration. Assets and liabilities are settled and their accounts are closed, the surplus or shortfall also being transferred to realization account.

7. Impact on shareholders

• Internal reconstruction often involves reduction of capital, alternation of capital and surrender of shares. It, thus, reduces the shareholding of the shareholders.
• In external reconstruction, shareholders of the existing company get commensurate shares in the new company. It, thus, may or may not result in a reduction in their shareholding.

8. Impact on creditors

• In internal reconstruction, dues of creditors are compromised and they are settled at less than book values. It necessarily involves sacrifice on the part of the creditors.
• In external reconstruction, the creditors are taken over by and become liabilities of the new company. It, thus, does not necessarily involve sacrifice on their part. In several cases of external reconstruction, however, it may involve a modification or settlement of their dues. This is because their dues may be discharged by issue of shares in the new company instead of outright settlement.

9. Loss set off

• As the existing company continues as a going concern and the same shareholders continue to own the company in internal reconstruction, its accumulated losses can continue to be set off against its future profits.
• In external reconstruction, the existing company ceases to exist. Thus, the same loss set off may not be available to the new company against its future profits. This would depend on fulfilling of conditions laid out by the jurisdictional law on external reconstruction.

Conclusion

The purpose of both internal and external reconstruction is to improve the financial structure of the company. They focus on rationalizing the amount of liabilities of the company as well as revisiting the valuation of its assets.

If reconstruction is not undertaken in a timely manner for companies that are in severe financial trouble, they may end up becoming bankrupt under the burden of discharging high liabilities that they cannot afford. The purpose of both internal and external reconstruction is thus to protect the company from bankruptcy and rationalize its financial structure, giving it a better chance to perform better in the years to come.