6.2 Accounting for Capital

CONTRIBUTED CAPITAL

Usually two accounts are used to record contributed capital or the issuance of stock to shareholders. The two accounts include Common Stock and Additional Paid-in Capital (APIC). Common Stock represents the number of shares issued to shareholders multiplied by the par value per share. APIC represents the amount invested by shareholders above the par value per share.

EARNED CAPITAL

Separate from shareholders’ contributed capital recorded in the Common Stock and APIC accounts are the profits a corporation has accumulated over time, or what is referred to as earned capital. Accountants capture this balance in the Retained Earnings account. Retained Earnings accumulates a corporation’s total net earnings since the company’s inception and then subtracts the total amount distributed to shareholders.

The Retained Earnings (Earned Surplus) Calculation is as follows:

Retained Earnings illustrates a basic financial choice available to corporations: they can either (1) distribute profits to shareholders subject to legal limitations discussed earlier in Chapter 6.1, or (2) reinvest profits into the business. The portion of earnings not distributed becomes part of Retained Earnings which may then be reinvested accordingly. A company may choose to reinvest profits into the business to fund growth, improve infrastructure, or expand capacity, with the objective of generating future income.

CLOSING ENTRIES

Review from LO 2.5 Closing Entries

At the end of each accounting cycle, Net Income is closed into Retained Earnings.

Based on the Retained Earnings calculation, dividends or distributions paid to shareholders will also impact the balance. When dividends or distributions are paid to shareholders, the Dividends  account is increased by a debit whereas Cash is credited for the balance paid.

CASH DIVIDENDS FROM THE SHAREHOLDER’S PERSPECTIVE

From the standpoint of a shareholder, income derived from owning common stock generally takes one of two forms.

First, shareholders may receive cash dividends, which constitute a taxable event under federal income tax law. When a corporation distributes a cash dividend, the shareholder is treated as having received ordinary income in the amount of the dividend at the time it is paid. This income is subject to taxation in the year of receipt regardless of whether the shareholder reinvests the funds.

Second, shareholders may recognize income upon selling their shares for a profit. If the sale price of the stock exceeds the shareholder’s basis, usually the original purchase price, the shareholder realizes a capital gain which may be subject to either short-term or long-term capital gains tax depending on the holding period.

It’s important to note that the basis is not always static. Although it begins as the amount the shareholder paid to acquire the stock, it can be adjusted over time due to various tax-related events such as stock splits, return-of-capital distributions, or certain corporate reorganizations which may increase or decrease the adjusted basis used to compute gain or loss upon sale.

Understanding these distinctions is critical not only for tax planning but also for evaluating shareholder rights and corporate governance decisions related to distributions and stock transactions.

SUMMARY

A corporation’s equity includes both contributed capital (i.e., what shareholders invest) and earned capital (i.e., profits the company keeps over time). These amounts are tracked through accounts like Common Stock, Additional Paid-in Capital, and Retained Earnings. Accurate records of stock issuances, profits, and dividends help the company make sounds financial decisions. For shareholders, it’s important to understand how dividends and stock sales are taxed and how their investment value may change over time. Overall, these basics are key to understanding how corporations manage money to benefit shareholders.