Importance of paid-in capital separated from earned capital

Equity Paper

Contents

TOC o “1-3” h z u HYPERLINK l “_Toc377198043” Introduction PAGEREF _Toc377198043 h 1

HYPERLINK l “_Toc377198044” Importance of paid-in capital separated from earned capital PAGEREF _Toc377198044 h 1

HYPERLINK l “_Toc377198045” Paid-in capital or earned capital PAGEREF _Toc377198045 h 2

HYPERLINK l “_Toc377198046” Basic earnings per share or Diluted earnings per share PAGEREF _Toc377198046 h 3

HYPERLINK l “_Toc377198047” Conclusion PAGEREF _Toc377198047 h 4

IntroductionStockholders’ Equity has two sources of capital which include paid-in capital and earned capital. Paid-in capital must be kept alienated from earned capital to avoid misinterpretation of the sources which facilitate a clear distinction from operational capital acquired from profit making operation. Most of the investors are majorly concerned with the earned capital compared to the paid in capital. The reason behind this preference is the facts that earned capital represent the earning potential of a firm. Another major aspect is the dilution earning which is more detailed unlike the basic earnings per share earnings.

Importance of paid-in capital separated from earned capitalPaid-in capital is the capital that is raised from the sale of capital stock in the stock markets in form of shares while on the other hand, earned capital is the funds that a company or firm is able to acquire in form of profit accrued by the sale of services and goods. Both capitals are very significant to the growth and expansion of the firm’s operations. However, investors find it necessary to separate the two capitals because of several reasons.

Kimmel, et al (2010, P.577) observe that one reason for separating the two source of capital are very distinct funding source and that paid-in capital signifies the funds to be used in the enhancement of the earned capital. On the other hand, earned capital symbolises the funds accrued from the profitability of the operation of the firm and combining the two sources would lead to confusion. That is, the paid in capital accelerates and boost the earned capital. The intension of combining the two source of capital will lead to a misinterpretation and misrepresentation of the overall earning of the firm. Not only that, but can also cause complexity in calculations in regards to profits margins. The two sources of capital must be separated so that the shareholders and investors information can be clearly distinguished from one another.

The two capitals must be distinguishable in such a way that it provides a form of protection to companies offering capital in excess thus protect creditors and investors in case of liquidation. This is because the two values of capital depict the strength of the firm financially. Investors must be aware of the manipulation of earning which will be rendered difficult if the two capitals are combined making it very difficult to convince them on the method used to compute the earning.

Paid-in capital or earned capitalMajority of the investors in most case are concerned with the firm’s earned capital other than the paid-in capital. The reason behind this is that earned capital is a representation of the potential earnings that a firm can generate through it day to day operations. Therefore investors would like to venture into a business that yield dividend as per their expectation. While on the other hand, paid-in capital is the capital raised from the subscription of the shareholders through the sale of capital shares thus represent the capital that is invested by the shareholders and does not in any way represent the profitability of the firm. Despite the importance of the two forms of capital, paid-in capital is more significant that earned capital. Paid–in capital represents the amount the investors have raised above the par values of the firm’s stock. The par value is very important in calculating the stability of the firms in terms of financial status (Kimmel, et al, 2010, P.577).

As per the investor’s opinions, firms could rather earn money via operations other than selling capital stock. This is because the firm reporting their financial status using earned capital reveals their financial value to the stakeholders while on the other hand the firm that report using their paid-in capital in excess of the already earned capital does not necessarily imply that the firm is experiencing good investment opportunities. Brigham and Houston (2009, p.197) noted that earnings capital is also generally well thought-out as single and the most significant variable that is used in determining the share price in the market. Other issue that make an investor preference is that it is used in the computation of price to earnings valuation ration.

Basic earnings per share or Diluted earnings per shareThe diluted earnings per share is very important to all the venturing investors because of its detailed nature bearing a lot of information regarding the firms operation. This gives full details to the investors regarding the firm’s financial status for several duration of time unlike the basic earnings per share which is less detailed and lack vital and relevant information that allow an investor to make decisions. The diluted earnings as per each share reveals to the investors all the dilutive shares that are outstanding in a given financial period. As for the investor, it is important to inspect the diluted earnings per share because of it ideal computational techniques which shows the general and basic earning of the firm per share or dividends. Another reason for preference of diluted earnings per share is because of the fact that basic EPS does not take into account the potential dilutive impacts of the companies’ securities. Lacks of dilutive securities scare away potential investor due to lack of protection from the securities which can easily be converted into stock. The suitability of the diluted earnings per share is the calculation that is associates with it which is simple in the calculation of per share capital and dividends raised.

The reason why most investor opt for diluted earnings per share is because of it inclusion of the issues of security analysis. This therefore dictates that most investors do analyse the company presentation in terms of prospective investments. That is, majority of investors would opt to evaluate companies as a potential ventures by the use of the diluted earnings per share scheme (Stickney, et al, 2009, p.27).

ConclusionIt is wise to keep the earned capital alienated from the paid-in capital so as to avoid major issues that may lead to misinterpretation of the source in the final account balancing and also avoid the confusion that result from the unknown source of capital. Majorly, investors prefer to use earned capital instead of paid in capital because of its inclusions of security component. On the other hand dilution of earnings per share is embraced by the investors because of its detailed nature.

References

Brigham, E.F., & Houston, J.F. (2009). Fundamentals of Financial Management. Chicago:Cengage Learning. p.191-201.

Kimmel, P.D., Donald, Jerry, E.K., & Weygandt, J.(2010). Financial Accounting: Tools for Business Decision Making. New York, NY:John Wiley and Sons. p.570-597.

Stickney, C.P., Weil, R.L., Schipper, K., & Francis, J. (2009). Financial accounting: an introduction to concepts, methods, and uses. Chicago:Cengage Learning. P.25-31.