A corporation is a type of business wherein, typically, anyone can become an owner.
One only needs to have the means to purchase/acquire stocks of the corporation.
Even owning just a single share of stocks of the corporation already makes one a part-owner of the corporation.
That’s to say if you own even one share of Microsoft’s stocks, then you’re technically a part-owner of Microsoft.
There are multiple ways to purchase/acquire stocks of a corporation.
One way is to purchase them through the stock exchange.
Another way is to purchase them when the corporation itself does an IPO (initial public offering) or issues new shares.
The first method doesn’t affect the corporation’s financial standing as it’s essentially a sale through a secondary market.
In the second method though, it’s the corporation itself that is selling the stocks. Essentially, the corporation is raising funds by selling its stocks.
Any amount that the corporation receives from its sales of stocks directly affects its financial standing.
As such, any sales should appear in its financial statements. And they are reflected via the corporation’s paid-in capital.
Essentially, paid-in capital reflects the amount that the corporation has received from the sales of its stocks over the years.
In this article, we will be discussing what paid-in capital is.
What is its significance to a corporation’s financial standing?
How does one account for paid-in capital?
What are its components?
How does a corporation raise or lower its paid-in capital?
We’ll try to answer these questions as we go along with the article.
What is Paid-In Capital?
Paid-in capital refers to the amount of capital raised by a corporation from the issuance of its stocks.
From another perspective, it’s the amount of capital that investors pay to acquire stocks of the corporation, but only those that were direct purchases from the corporation.
Sales of stocks through the secondary market such as the stock exchange does not contribute to a corporation’s paid-in capital. Only the direct sales of stocks by the corporation itself count.
We can also refer to paid-in capital as contributed capital.
Paid-in capital typically consists of the stock’s par value and the amount that is in excess of the par value (a.k.a. additional paid-in capital or APIC).
On a typical balance sheet, a corporation will record common stocks and preferred stocks (if the corporation has any) at par value.
Corporations usually assign a nominal amount (e.g. $0.01/share) as a stock’s par value.
However, investors usually purchase stocks at a price that is higher than the par value.
Any amount that is in excess of the par value is recorded as additional paid-in capital or APIC.
You can usually find these accounts on the equity section of the corporation’s balance sheet.
Keep in mind the paid-in capital only includes the amount of capital that a corporation raises from the issuance or direct sales of its stocks.
Any amount raised from the sales of stocks through the secondary market does not affect a corporation’s paid-in capital.
Also, the capital that a corporation raises from its operations does not count towards its paid-in capital.
Rather, they go towards another equity account, which is the retained earnings.
The primary way to raise a corporation’s paid-in capital is to issue new stocks or directly sell stocks.
Components of Paid-In Capital
A corporation’s paid-in capital will usually consist of two items: common shares and additional paid-in capital.
Additional potential components include preferred shares, treasury shares, and paid-in capital from treasury stock.
Common shares (a.k.a. Ordinary Shares, Common Stock)
Common shares represent the value of the total outstanding common shares of the corporation.
They are the primary type of stock that a corporation will issue.
Holders of common shares gain voting rights and a right to receive dividends whenever the corporation declares and distributes them.
Common shares will mainly determine a shareholder’s percentage of ownership. For example, if a shareholder owns 70% of the total outstanding common shares, that shareholder essentially 70% of the corporation.
On a typical balance sheet, common shares are recorded at par value.
Preferred Shares (a.k.a. Preferred Stock)
A preferred share is similar to a common share in that it’s an equity instrument.
Holders of preferred shares have a right to receive dividends, usually at a predetermined rate.
In this way, preferred shares are also similar to fixed-income instruments such as bonds.
Whenever a corporation declares and issues dividends, preferred shareholders have priority over common shareholders.
Additionally, in the event of liquidation, preferred shareholders get paid first before common shareholders.
The trade-off for the preferential treatment of preferred shares is that they usually don’t grant voting rights.
That means that shareholders who only own preferred shares of a corporation don’t have any say in its business decisions.
Like common shares, preferred shares are recorded at par value on the balance sheet.
Additional Paid-In Capital (a.k.a. APIC, Capital Surplus)
Any amount that a corporation receives from the sale of stocks that is in excess of the par value goes towards the additional paid-in capital.
For example, if a stock has a par value of $1, then the corporation receives $5 for every sale of this stock, then it records the excess $4 as additional paid-in capital.
Additional paid-in capital can provide the corporation a layer of defense against losses.
This is especially useful when the corporation is only starting to build up its capital or retained earnings.
Treasury Shares (a.k.a. Treasury Stock)
When a corporation reacquires its outstanding shares, the shares become treasury shares.
On the balance sheet, the treasury shares account is a contra-equity account that reduces the paid-in capital balance of the corporation.
For example, if the corporation has total common shares and additional paid-in capital of $150,000 and treasury shares of $50,000, the net paid-in capital will be $100,000.
There are a variety of reasons why a corporation would want to reacquire its outstanding shares.
It could simply be because the corporation wants to reduce the number of shares circulating within the market, or the corporation plans to retire such shares eventually, etc.
Paid-in Capital From Treasury Stock
When a corporation resells its treasury shares, one among three scenarios may happen:
- The corporation makes a gain on sale
- The corporation incurs a loss; or
- The sale essentially breaks even
If the corporation is able to sell its treasury shares at a price higher than the repurchases price, the gain from the sale goes to the “paid-in capital from treasury stock” account.
It is an equity account that increases the paid-in capital balance of the corporation.
On the other hand, if the sale of treasury shares results in a loss, the loss reduces the retained earnings balance of the corporation.
If the sale neither results in a gain nor loss, then the sale simply returns the shareholder’s equity balance to its state before the corporation reacquired the shares.
Paid-in Capital From Retirement of Treasury Stock
Instead of reselling its treasury shares, a corporation may opt to retire them instead.
The retirement of treasury shares reduces the balances of treasury shares, common shares (or preferred shares if treasury stock is previously preferred shares), and additional paid-in capital.
If the repurchase price of the treasury shares is lower than the paid-in capital of the shares to be retired, then the difference is recorded as “paid-in capital from the retirement of treasury stock”.
This equity account reduces the effect of the retirement of treasury shares on the corporation’s paid-in capital.
If the repurchase price of the treasury shares is higher than the paid-in capital of the shares to be retired, the retirement will result in a loss.
This loss reduces the retained earnings of the corporation.
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