For any company, the shareholder’s equity portion of its Statement of Financial Position will consist of different equity instruments and reserves. Among these, the most common are paid-in capital, additional paid-in capital, and retained earnings.
Each of these balances represents a different aspect of the equity of a company. While these are all a part of the equity of a company, there is still some difference between them.
To better understand the similarities and differences between these balances, it is crucial to understand what each of these balances represents. Below is a general description of these balances.
What is Paid-in Capital?
Paid-in capital is a balance is the equity of a company that represents the par value of its issued shares. Every share issued by a company has a par value, which denotes the value of the share set in the corporate charter. That means the par value of a share does not change from one issue to another.
Therefore, the paid-in capital balance only consists of the total par value of all the issued shares of a company. The more share a company issues, the higher its paid-in capital balance is going to be.
Paid-in capital can also exist for the preferred shares of a company. Preferred shares are shares that give the shareholder a preference when it comes to dividends, and in case the company liquidates.
Preferred shares, like ordinary shares, also have a par value or face value, which the company defines beforehand. For all the preferred shares a company issues, it must record the total amount of their par value in the paid-in capital account.
For most companies, issuing shares will also give rise to another balance known as the additional paid-in capital balance. While this balance is closely related to the paid-in capital balance, and often depends on it, it represents a different aspect of equity.
What is Additional Paid-in Capital?
Additional paid-in capital consists of any additional amount above the par value of a share that a company receives for new share issues. The actual price a company charges for newly issued shares will almost always be different from its par value.
The actual price depends on various factors such as market conditions, company performance, environmental factors, etc. The company must split the paid-in capital amount from the total receipt for new shares and record the remaining amount in the additional paid-in capital account.
While additional paid-in capital balance represents a different amount and balance than the paid-in capital balance of a company, both of them are very closely related.
They make up the total equity a company received from its shareholders in exchange for issued shares, also known as contributed capital. There are also some rules and regulations that companies must follow when it comes to paid-in and additional paid-in capital balances.
What is Retained Earnings?
Retained earnings are also a part of the shareholders’ equity of a company. However, retained earnings do not relate to the finance a company generates from its shareholders. Instead, retained earnings represent the internally generated finance of a company that it makes through its operations.
The retained earnings of a company usually comprise of its accumulated profits less any dividends it pays to its shareholders.
A company generates profits through its operations. Sometimes, it may also make a loss instead of a profit. Either way, the retained earnings of a company reflects its performance over its lifetime. Retained earnings is also a type of finance that a company can use in its operations.
It is the lowest cost finance that a company can use since the company generates it internally. However, retained earnings may be finite depending on the resources and performance of the company.
Unlike with paid-in and additional paid-in capital, a company can distribute its retained earnings. Therefore, retained earnings represent the distributable profits of a company. These distributions come in the form of dividends. Every time the company pays dividends to its shareholders, it must deduct them from its retained earnings.
When companies initially start, their paid-in capital and additional paid-in capital balance will exceed their retained earnings balance. However, as they establish themselves and make profits, their retained earnings balance can exceed their paid-in and additional paid-in capital balances.
However, if they make a lot of losses instead of profits, the retained earnings balance may also become negative or go into a deficit. Paid-in and additional paid-in capital balances will never become negative for companies.
Three main balances will exist in the shareholders’ equity of companies including paid-in capital, additional paid-in capital, and retained earnings. Paid-in capital represents the total par value of the issued shares of a company, and additional paid-in capital represents the amount in excess of the par value of shares a company receives.
Lastly, retained earnings represent the total profits minus the total dividends paid by a company. Paid-in and additional paid-in capital are similar and often related to each other. However, they are different from retained earnings.
Dividends consist of compensation, usually in the form of cash, a company pays to its shareholders from its profits. Dividends represent the returns that shareholders get for the risk they take by investing in a company.
Usually, the higher these risks are, the more returns they will receive in exchange. Companies pay dividends after regular interval of times, such as annually, semi-annually, quarterly or even monthly in some cases.
As mentioned above, companies usually pay dividends from their cash reserves. It means the shareholders receive cash as a reward. In some other cases, companies may also pay dividends in the form of stock. In those cases, shareholders receive further shares of the company.
Shareholders can then sell the shares in the market and receive cash in exchange. Alternatively, they can keep the new shares and receive even higher dividends in the future. Usually, a company pays dividends from its profits. However, sometimes, it may also use its additional paid-in capital account to do so.
Additional Paid-in Capital
The additional paid-in capital account of a company represents the total amount of compensation it receives for issuing shares above their par value. For companies to use the additional paid-in capital account, they must issue shares above their par value. If they issue shares below or at the same price as their par value, the additional paid-in capital account balance will not increase.
To better understand the concept of additional paid-in capital, it is vital to understand the par value of a share and what it represents. The par value of a share represents its value stated in the corporate charter. While it denotes the worth of the particular instrument, companies don’t need to charge investors the same amount.
Usually, the value companies charge for issuing new shares is different from their par value. Due to the price difference, companies need the additional paid-in capital account.
For example, a company issues 1,000 shares, with a par value of $10, at $15 per share. The company receives a total of $15,000 (1,000 shares x $15 per share) for the shares. However, the company can only recognize the par value of the stock in the paid-in capital account.
Therefore, it must transfer only $10,000 (1,000 shares x $10 par value) to the paid-in capital account. It must take the difference of $5,000 ($15,000 – $10,000) to the additional paid-in capital account.
Finally, it is also crucial to understand that the additional paid-in capital account of a company does not depend on the market value of its shares. The market value of shares represents the value that market participants are willing to pay for already issued shares.
Since the company does not receive any benefits when its shares get traded in the stock market, the company cannot recognize those transactions. Therefore, the additional paid-in capital account remains unaffected.
How do dividend distributions affect additional paid-in capital?
As previously mentioned, dividend distributions can affect additional paid-in capital. It usually happens when a company issues a stock dividend to its shareholders. There are several reasons why a company may issue stock dividends. For example, it may issue stock dividends when facing a cash shortage or may issue a stock dividend for tax-planning purposes.
Stock dividends can increase the total number of shares that shareholders of a company hold. The stock dividends also depend on the percentage of the existing number of shares of shareholders. For example, a company issues a stock dividend, giving shareholders two shares for every five shares they hold.
If a shareholder already holds 1,000 shares in the company, they will receive an additional 400 (1,000 / 5 x 2) shares. In some cases, stock dividends may also increase the percentage of shareholding of the shareholders.
When a company issues a stock dividend, it must deduct its value from retained earnings balance. For the other side of the transaction, the company must also increase its paid-in and additional paid-in capital balance with the same amount. The transaction will have the same effect as if the company issued new shares.
However, instead of increasing the cash balance of the company, this transaction will decrease its retained earnings account balance. In other words, the company funds new stock issues from its retained earnings balance.
Companies pay a dividend to their shareholders regularly from their profits. Shareholders bear many risks when they invest in a company. Therefore, companies reward them for those risks in the form of dividends. Dividends may affect the additional paid-in capital account of a business as well.
The additional paid-in capital account of a company consists of the compensation it receives for new share issues in excess of the par value of the shares. Usually, stock dividends, dividends paid in the form of stock rather than cash, impact the paid-in and additional paid-in capital account balances of a company.
Companies generate finance through many different sources. The main source of finance for them is equity. Equity consists of the equity instruments of a company, usually ordinary shares, issued to shareholders.
A company issues these shares to its shareholders in exchange for compensation. Once shareholders buy shares, they can exchange them on the stock market.
Similarly, even investors that don’t buy shares directly issued by a company can purchase its shares and become a shareholder. Apart from the initial issue of shares, any subsequent transactions do not affect the accounts of a company.
They do affect other aspects such as ownership of the company, though. Under some laws, companies must also keep track of their shareholders, especially majority shareholders. However, the process does not have any financial impact.
The price of a stock in the stock market depends on several factors, which may be different from its issue price. However, the price of a stock in the market also affects its issue price. All stocks have a par value, which is its original price. However, a company may choose to charge more for its shares above its par value.
In that case, the company must split the amount it receives for the stock into par value and excess of par value. It must take the par value to the paid-in capital account and any amount received in excess of par to the additional paid-in capital account.
For example, if the par value of the stock of a company is $100 and it receives $150 for it, it must split it into its par value, $100, and excess of par value, $50. The company must take the $100 into its paid-in capital account and the $50 to its additional paid-in capital account. Some companies may also refer to the paid-in capital account as share capital and the additional paid-in capital account as share premium.
What causes changes in additional paid-in capital?
There are different reasons for changes in the additional paid-in capital account. The account balance can either increase or decrease. However, usually, it does not decrease unless in some specific cases, which require a company to reduce the additional paid-in capital account before reducing the paid-in capital account.
New share issues
An increase in the additional paid-in capital balance of a company usually occurs during new share issues. As mentioned above, if the company receives compensation above the par value of the shares, it will affect the additional paid-in capital of the company. It is because accounting standards require the paid-in capital balance of a company to reflect only the par value of its issued shares.
However, since the company receives a higher compensation, it must record the excess amount as well. Therefore, it uses the additional paid-in capital account as a reserve account to reflect the excess above par amount it receives for issuing new shares.
Preferred shares issues
Apart from ordinary shares, companies can also issue preferred shares. Preferred shares give the holder a preference over ordinary shareholders when a company pays dividends or during liquidation.
Similar to ordinary shares, preferred shares also have a par value. If the company receives compensation over the par value of the preferred stock, it must record the excess amount in the additional paid-in capital account. Therefore, it can also cause an increase in the account.
Stock buybacks can also cause a change in the additional paid-in capital balance of a company. However, instead of increasing it, stock buybacks result in a decrease in it. Stock buybacks are when a company decides to buy back its already issued shares from its existing shareholders. Stock buybacks have the opposite effect of a new share issue for a company.
However, a company must first net off the compensation it pays for stock buybacks against the additional paid-in capital balance and then the paid-in capital balance.
When a company wants to pay dividends but does not have enough cash reserves to do so, it can use the additional paid-in capital account for it. That is known as liquidating dividends. Liquidating dividends, like stock buybacks, negatively impact the additional paid-in capital account of a company, instead of increasing it.
A company, when using liquidating dividends, must net off any excess dividends against its additional paid-in capital balance before setting it off against the paid-in capital balance.
The additional paid-in capital account of a company includes payments it receives more than the par value of its shares for newly issued shares. Additional paid-in capital can change due to several factors.
Usually, a new issue of shares or preferred shares above their par value will increase the additional paid-in capital account of a business. On the other hand, stock buyouts and liquidating dividends may cause a decrease in the account balance.
When it comes to the amount of capital a company has, two main accounts show the total amount, paid-in capital and additional paid-in capital. While both of these represent the total capital of a company obtained from its shareholders, they are still different. To understand the difference, however, it is vital to understand what each of these accounts represents.
What is Paid-in Capital?
Understanding the paid-in capital of a company is straightforward. Paid-in capital, also known as share capital, is the account that represents the total capital of a company in the par value of shares issued. Par value of a share is its original price.
Companies must issue shares to their shareholders and other potential investors to obtain finance for their activities. All these shares have a predetermined par value.
The par value of a share is different from its market value. That is because the par value represents the value of the shares defined in the corporate charter.
The market value of a share, on the other hand, represents the value that market participants would be willing to pay for it. Its market value depends on several factors, such as the performance of the company in recent years and other external factors outside the control of the company.
Therefore, the paid-in capital balance in the accounts of a company represents only the par value of shares that it has issued. Paid-in capital does not take into account the market price of the share or how much the shareholder has paid for it, which is usually higher than the par value. Accounting standards require companies not to record any excess amount received for the issuance of shares in the paid-in capital account.
What is Additional Paid-in Capital?
As mentioned above, companies usually receive a higher amount for issuing new shares above the par value. Since they cannot record the amount in excess of par value in the paid-in capital account, they must record in another account, known as the additional paid-in capital account.
The additional paid-in capital account represents the equity of a company in excess of the par value of its issued shares. The amount of the capital in the account depends on the actual amount the company receives in exchange for issued shares.
Unlike the par value of a share, the actual price that the company will receive is not a part of the corporate charter. The price depends on its market price. However, the market price of the share isn’t the only deciding factor for its issue price, though.
The company issuing the shares has control over how much it charges. The higher the price, the more capital it will generate. However, higher prices may also attract lesser investors. Therefore, companies must decide on a price that investors will be willing to pay.
A company, ABC Co., issues 10,000 new shares. The shares have a par value of $1 per share. However, ABC Co. issues them for $5. It means that the total amount of capital that the company will receive for the issued shares is $50,000 (10,000 shares x $5 per share). However, the par value of the issued shares is only $10,000 (10,000 shares x $1 par value per share). The company must differentiate between how much to record in the paid-in and additional paid-in capital accounts.
Since the par value of the issued shares is $10,000, ABC Co. can record it in the paid-in capital account. In the additional paid-in capital account, ABC Co. must record $40,000. That is because it records $10,000 in the paid-in capital account, which represents the par value of the shares. Since ABC Co. received $50,000 for the total shares, the excess amount above par, $40,000, will be the additional paid-in capital.
The main difference between paid-in capital and additional paid-in capital is the amount recorded in each account. As mentioned above, paid-in capital only includes the par value of the issued shares of a company. Therefore, regardless of what its actual issue price is, a company must only record the par value in the paid-in capital account.
On the other hand, additional paid-in capital consists of capital that the company generates above the par value of the shares. As demonstrated in the example above, the additional paid-in capital account depends on the actual issue price of the shares.
The paid-in and additional paid-in capital accounts of a company represent its total equity generated through the issue of shares. While both the accounts are very similar and closely related to each other, there is a difference between the two.
Paid-in capital account represents the par value of the total issued shares of a company. On the other hand, additional paid-in capital account represents the excess amount above the par value of the shares that a company receives.
The main source of finance for a company is the equity investment it receives from its shareholders. The shareholders receive shares of the company in exchange for the shares of the company. The price of the share is usually the price that market participants are willing to pay for it.
Therefore, the price usually depends on the stock market. A company only receives compensation for its shares when it issues the shares initially. Any subsequent transactions related to those shares do not affect the accounts or finance of the company.
When a company issues its shares, it will receive compensation from the shareholders who buy the share. Every share has a par value, which is the predetermined value of that share. However, due to several factors, the actual price that shareholders pay for it might be different from its par value.
For example, the par value of a share may be $100, but shareholders may be willing to pay $150 for it. For the company, while $150 is capital, it must split it into two portions.
When a company receives compensation for shares above their par value, the excess amount is known as additional paid-in capital. In the example above, since the par value of the share is $100, and the actual price the company receives is $150.
Therefore, $50 ($150 – $100) is the additional paid-in capital. It is also known as share premium. The additional paid-in capital is an account that only increase due to the issuance of new shares above their par value. However, there are some ways in which companies can also reduce it.
Reducing Additional Paid-in Capital:
A reduction in the additional paid-in capital account is very rare. It is because it is a reserve account. Therefore, a company cannot use the account unless needed in specific conditions.
Usually, any reduction in the paid-in capital account will first affect the additional paid-in capital account. The conditions that result in a reduction in the additional paid-in capital balance of a company are the following.
1) Stock Buybacks
A stock buyback is a process used by a company to buy back shares from the market. It is also a way for companies to return wealth to their shareholders without paying them dividends or through stock appreciation. In a stock buyback, a company pays its shareholders cash in exchange for their shares.
On the other hand, the company also decreases its reserves for the value of the shares it repurchased. Stock buybacks work in many different ways. For example, a company can use tender offers to buy back shares or buy its shares from the stock market directly.
As mentioned above, the additional paid-in capital balance will reduce due to stock buybacks. However, if the value of the shares rebought is above the balance in the additional paid-in capital balance, then the company can also utilize its paid-in capital balance. However, the company won’t usually buy enough shares to affect its paid-in capital account as well.
2) Liquidating Dividends
During a partial or full liquidation, companies must make payments to their shareholders. Sometimes, companies may also not have enough cash to cover the issue of a dividend-paying stock. In both these cases, the company must pay its shareholders from its reserves. These are known as liquidating dividends.
In both scenarios, the company must liquidate its funds in its reserves to pay its shareholders. Usually, liquidating dividends are rare in companies but can still decrease the additional paid-in and the paid-in capital balances of a company.
Like stock buybacks, liquidating dividends also affect the paid-in capital balance. However, a company must first adjust it against any balance in the additional paid-in capital balance and then take the remainder to the paid-in capital account.
For example, if a company has a total cash dividend of $20,000 but only has cash reserves of $15,000, it will cover the remaining $5,000 from the additional paid-in capital balance.
3) Vertical Merger
In business terms, a merger is when two companies combine to group their resources to increase their market shares. A vertical merger is a merger between two participants of the same supply chain. In other words, a vertical merger is when a supplier and customer merge.
There are many advantages of disadvantages of vertical mergers for companies. Companies can reduce their additional paid-in and paid-in capital balances to nil through a vertical merger.
A vertical merger is a great way for a company to reduce its additional paid-in capital balance significantly. It can also use it to reduce its paid-in capital balance. However, for that to happen, the subsidiary must be created, funded and owned by only the parent company.
Companies issue shares to receive finance. The shares have a par value, which is their original value. However, shareholders may pay higher than par value for the share. A company issuing shares for a price over its par value must take the excess amount to the additional paid-in capital account, also known as share premium account.
There are different ways to reduce the additional paid-in capital of a business, including stock buybacks, liquidating dividends and vertical mergers.
A company has no legal obligation to return Shareholders’ initial paid-in or contributed capital. Contributed capital comprising paid-in capital and share premium is utilized to fund business operations. When a business performs well and generates profits its equity rises.
However, several factors cause the Shareholders’ equity to go in the negative column. As the total Shareholders’ equity comprises different components, either component alone or a combined effect of all can result in negative equity.
Let’s understand Shareholders’ equity components and the calculation for net Equity.
Shareholders’ Equity = Total Assets – Total Liabilities
In simpler terms, if total liabilities like long-term debts outweigh the total assets, shareholders’ equity will be negative. A highly leveraged company that has borrowed more than its underlying assets, represents negative equity.
Another reason can be the cost of debt may rise significantly due to a change in the interest rate. There are several factors in liabilities that can yield negative total equity.
1) Negative Equity Due to Excessive Debt Financing:
A company looking for cash needs can borrow money through debt financing. Excessive borrowings or net losses arising through financing activities can make liabilities outweigh the assets.
A highly leveraged company can represent negative equity on its balance sheet as equity is valued at book values.
High borrowings are a common reason for large companies showing negative total Equity. The main factor behind the costly debt financing is unsecured loans and high-interest rates.
Once a company’s leverage ratio is higher than normal, its borrowing abilities shrink and lenders charge even higher interest rates.
2) Negative Equity Due to low Retained Earnings:
Retained Earnings represent a significant portion of total equity. A company may decide to fund a project with retained earnings or pay a large dividend to its shareholders. Specifically, the dividend decision can affect retained earnings.
As the company may announce dividends in advance and at a pay-out date the total value of retained earnings or cash surplus may not be large enough.
A company performing badly for consecutive years accumulates net losses in retained earnings as a negative balance. A significant amount of negative retained earnings or losses can outweigh the assets and show negative equity as well.
3) Negative Equity Due to Share Buyback:
Large companies with multiple IPOs may have a substantial figure of outstanding shares in the market. A Large number of shares affect the EPS, DPS, and P/E ratios that are vital in company net worth evaluations. A company can buy back shares through treasury stocks or a share repurchase.
These shares are accounted for in a separate accounting entry under the total Equity section. A large buyback transaction can also result in negative total equity for shareholders.
A real-world example of a large treasury stock amount and negative shareholders’ equity is McDonald’s incorporation.
Although the company has reported significant profits of $6,025 million and a large EPS of $ 7.88, still it reports negative equity of ($ 8,210) million. The negative equity is mainly due to a large treasury stock accumulation of ($ 66,238) million. Data Source:
4) Negative Equity due to Negative Asset Valuations:
By definition, even if the assets are valued at zero value the liabilities will results in negative net equity for shareholders. That scenario represents in an insolvent or bankrupt situation. Another possible scenario can be the negative Goodwill or a large intangible asset’s amortization value.
Both Goodwill and intangible assets make up for a significant total asset’s portion of modern tech-based giant firms like Facebook and Google. Any market risk or a large transaction in amortization brought under the retained earnings (or other reserves) can also result in negative equity.
5) Consolidated Negative Shareholder’s Equity:
Mergers and Acquisitions happen mainly to gain the advantage of synergy effects. Some companies also acquire another for access to valuable assets such as cash, patents, and intangible assets like software.
However, many mergers fail due to the overvaluation of intangible assets and goodwill. Some companies may also offer a considerable overvalued share price offer to secure the deal. Any resulting negative Goodwill or carried over accumulated losses can result in total negative equity for consolidated statements.
Key Points on Negative Shareholder’s Equity:
Shareholders’ total equity comprises of several components like contributed capital, share premium, retained earnings, and Reserves. Negative equity does not imply that a company is unsuccessful.
A thorough investigation into the reasons for negative equity can reveal the true financial position for the Shareholders.
A large borrowing or excessively leverages firm may represent default risk. However, lower retained earnings can be due to a one-off transaction of dividends or any other investment.
Similarly, the large negative treasury stocks can be reissued to the shareholders at any time and do not reflect any negative consequences for shareholders.