Absorption and Reconstruction

Meaning of Absorption 

Absorption means an existing company taking over one or more companies. At that time, one or more companies must close their business and existing company will operate one or more company who are being  absorbed by it. 

For example : There are three companies in the market A,B and C. C company wants to become powerful in the market. So, C company offers A and B companies to sell their business to it. A and B companies accepts and close their business after getting purchase price from C company. This is the simple case of absorption. 

Meaning of Reconstruction

If any company is suffering loss and it close its business and join with or without other company, it create new company. That is called reconstruction. There are two types of reconstruction.

Amalgamation Vs Absorption Vs External Reconstruction - Comparison through Chart

Ist - External Reconstruction

When a company has no power to operate his own business due to heavy loss and it sells his all business to a new company. It will be external reconstruction.

2nd - Internal Reconstruction 

Internal Reconstruction means to do every action for bringing the company out of losses. If a company is suffering heavy losses, company can use the provision 94 of Indian Company law 1956 and reduce its capital.

{*} Simplified the meaning of Capital Reduction

You know Capital will increase with profits and decrease with losses.

Suppose, company has $ 100,000 share capital and Debt is $ 50,000. Company has losses in business 
$ 60000. Now, if company will use debt for losses, it means the end of company but if company reduce $ 60000 from share capital. It can relive after this. 

Capital reduction can be done with simple journal entry

1. Sacrifice which has been given by shareholders

Suppose, company has the share capital with $ 10 each share. Company wants to reduce by $ 2. It can do with following way

Old Share capital Account Debit $ 10

New Share Capital Account Credit $ 8
Capital Reduction or Reconstruction Account Credit $ 2

2. Sacrifice which has been given by Creditors and debentureholders

Creditors Account Dr. XXX
Debentureholders Account Dr. XXX

Capital reduction or reconstruction account Cr. XXX

3. Now this reconstruction account or capital reduction account can be used for written off any losses of business

Capital Reduction or Reconstruction Account Dr. XXX

Profit and loss account ( Losses ) Cr XXX

Any other losses Cr. XXX

One Important Question : Why are we passing above journal entries in the Process of internal reconstruction?

Answer is very simple. If you make the balance sheet of loss making company. You will see losses in the debit side. These shows zero assets, it is clear indication to all creditors that company has no resources and all past resources are utilized in bad project. So, either shareholders and creditor can do above or take the action to liquidate the company.