Owner’s Equity: Paid-in and Earned Capitals

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Preferred and common stockholders have some interests in organizations which are referred to as owner’s equity. Investors contribute to the capital of a corporation through the purchase of stocks sold by the corporation without the use of a secondary market (Pratt, 2010). This type of capital is referred to as paid-in capital.

The total paid-in capital is a combination of share capital and additional paid-in capital that is normally added to the nominal value of a stock. On the other hand, earned capital is the type of capital that comes from a company’s profitable operations (Pratt, 2010). The two types of capital are normally reflected on the balance sheet as part of the owner’s equity.

Earned capital is calculated by subtracting dividends from the total sum of the company’s beginning capital and the net income. The net income of a company is the major source of earned capital (Porter, 2010). Companies reinvest earned capital to generate more profits and at the same time retain their original capital.

Paid-in capital and earned capital should be kept separate because they are completely different and distinctive when it comes to capital sources (Porter, 2010). The sale of capital stock to investors brings new capital to the company. This paid-in capital is supposed to help the company in its quest to increase earned capital.

It s therefore very important to keep paid-in capital separate from earned capital for a firm to be in a better position to evaluate the impact of pain-in capital and the extent at which it helps in increasing the company’s earned capital (Porter, 2010). Combining the two may lead to an overestimation of profits on the balance sheet which may not be for stockholders.

There is always a high probability that the potential earnings from a company’s profitable operations may be misrepresented if paid-in capital is not separated from earned capital (Kimmel, 2010). The management of an organization may find it difficult to account for the company’s earnings if the two sources of capital are not separated.

Earned capital is more important than paid-in capital because of a number of reasons (Kimmel, 2010). To begin with, earned capital is very important when observed from the point of view of an investor. It important for a company to earn its money from profitable operations compared to overdependence on the sale of stocks to raise capital.

A company that has earned capital as its major source of capital is likely to earn investor confidence than the one that relies on paid-in capital (Kimmel, 2010). Stakeholders are able to see the value of their investment from the earned capital as opposed to paid-in capital. Investors can be encouraged to invest more in company depending on the earned capital which is normally reported on financial statements prepared by the company.

In a case where paid-in capital exceeds earned capital, an organization is likely to lose present and potential investors because this may not be a good sign for a profitable investment opportunity (Porter, 2010). From this argument, it is clear that earned capital is very important for an organization compared to paid-in capital.

Diluted earnings per share is more important than basic earnings per in the sense that diluted earnings take into account all the available shares after all the available stock options have been exercised (Pratt, 2010). Diluted earnings per share are more comprehensive compared to basic earnings per share that only estimates current outstanding shares.

The fact that diluted earnings per share estimates all the available shares after trading activities have been exhausted makes it more important than basic earnings per share (Pratt, 2010). Diluted earnings per share takes into account all the preferred stocks and warrants some of which may be theoretical. Diluted earnings per share provide actual figures that are useful when determining the value of a company (Pratt, 2010).

The valuation of a company using diluted earnings per share helps a company to determine its actual investment returns. Present and potential dilutive common shares within a particular period of time can only be shown using diluted earnings per share (Porter, 2010).

In conclusion, the owner’s equity is represented by the type and amount of interests that investors have in a particular organization. Paid-in capital and earned capital are the two major sources of capital which are used by companies to fund their operations (Pratt, 2010).

It is important to separate paid-in capital from earned capital because the two sources of capital are very distinct from each other and may end up misrepresenting the actual earnings of a company. Earned capital is very important for a company because of its tendency to attract investors to the company (Porter, 2010). The stability of a company is represented by the amount of its earned capital and therefore portrays the company as worth investing in.

The origin of operational funding can be determined if paid-in capital is completely separated from earned capital (Porter, 2010). Dilutive securities have an impact on the overall earnings of an organization and can also be used to determine the value of a company based on diluted earnings per share (Kimmel, 2010).

References

Kimmel, P. (2010). Accounting: Tools for business decision makers. New York, NY: John Wiley & Sons.

Porter, G. (2010). Financial accounting: The impact on decision makers. New York, NY: Cengage Learning.

Pratt, J. (2010). Financial accounting in an economic context. New York, NY: John Wiley & Sons.

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Owner’s Equity: Paid-in and Earned Capitals

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