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.