Companies usually raise finance through two sources, including debt and equity finance. Debt finance usually comes from third parties that provide a loan to the company.
On the other hand, equity finance generates from the company’s shareholders. These shareholders may include new investors or existing ones. Both of these provide finance to fund a company’s operations.
The primary source of equity finance is the issuance of shares. When companies issue shares, they receive finance through which they can fund their operations. Usually, these shares have a par value which also dictates their value on the balance sheet.
However, the par value only exists as a legal requirement for companies to satisfy. Sometimes, companies may also issue shares at a higher price.
The accounting for the issuance of shares isn’t straightforward. In essence, companies must account for this source as equity.
However, accounting standards require them to separate them into several accounts. Usually, companies record the par value of shares in one account. Any surplus on the transaction ends up on the capital surplus account.
What is a Capital Surplus?
A capital surplus refers to the additional amount resulting from companies issuing shares above the par value. Usually, the par value dictates the minimum value of the shares that companies can receive.
In some jurisdictions, this amount may be lower, allowing companies to issue their stock for discounts. However, some laws may prevent companies from allotting shares at a value lower than the par value.
When companies issue shares at a premium, they receive more funds. Fundamentally, these funds are a part of the finance that companies generate through equity.
Therefore, there is no difference in whether the amount is higher or lower than the par value. Accounting standards, however, require companies to separate the additional amount in a different account.
Therefore, capital surplus refers to the premium above the share’s par value that a company receives. Most companies use the share premium account to record the additional amount.
Other names for capital surplus also include share premium, paid-in surplus or paid-in capital in excess of par. With this account, companies can provide a better picture of their issuance process for the shares.
A capital surplus represents the additional paid-in capital above par value that investors pay for a company’s shares. For the investors, the premium paid on the stock forms their investing cost.
For companies, however, it creates equity reserves received above the shares’ par value. Most companies maintain this account as a part of the accounting requirements to separate the additional amounts.
Overall, a capital surplus is a part of a company’s stockholders’ equity. It represents the premium above the total value of a company’s shares and the amount received for those shares.
The concept of par value of shares is crucial to the capital surplus recognized by companies. However, capital surplus does not represent distributable capital to shareholders. In essence, it is the same as a company’s share capital.
How do companies create Capital Surplus?
Several sources contribute to a company’s capital surplus. As mentioned, the first difference between a company’s stock’s par value and the paid-in amount.
When companies issue their stocks at a premium to par or stated value, they generate a capital surplus. It is the most prominent source of creating a capital surplus. However, several other sources also exist.
Companies can also create a capital surplus from treasury stock. When companies buy back their shares and sell them later, they can charge more than their buyback value.
In essence, it is similar to the above source. However, it involves the issuance of shares to the general public after reacquiring them from existing shareholders.
Although companies do not indulge in this process specifically to generate a capital surplus, it is a side result.
Companies can also create a capital surplus from a reduction of par or stated value. As mentioned, this surplus represents the difference between a company’s share’s par value and its sale proceeds.
The higher the par value is, the lower the capital surplus will be. However, if companies decrease the par value of their shares, they can create a capital surplus. This process involves lowering the par value instead of higher sale proceeds.
In some cases, companies can also create a capital surplus through mergers and acquisitions. When a company acquires or merges with another company, they combine their resources.
Similarly, it will include accumulating both the companies’ capital surpluses. Lastly, companies can also make a capital surplus through donated stock. In practice, stock donations are the least common source of capital surplus since they are rare.
What is an example of a Capital Surplus?
A company, ABC Co., issues 1,000 common shares to the general public to raise finance for a new project. The par value of these shares in the company’s resolution is $100 per share. However, the market value of these shares is $260. ABC Co. issued these shares for $250. It means the company received a $150 premium for each share due to the difference with its par value.
Overall, ABC Co. received $250,000 (1,000 shares x $250 per share) for the shares it issued. However, the par value of these shares is $100,000 (1,000 shares x $100 per share). In this case, the market value of these shares is irrelevant since it does not dictate the funds ABC Co. will receive. Of the $250,000, ABC Co. will record $100,000 as share capital.
The residual amount of $150,000 ($250,000 funds received – $100,000 par value) will be ABC Co.’s capital surplus. This figure will go on the company’s share premium account.
As mentioned, the share premium account will include any surplus received over for shares issued above par value. The $100,000 for the par value will become a part of its share capital account.
What is the Difference Between Capital Surplus and Retained Earnings?
Both capital surplus and retained earnings form a part of a company’s stockholders’ equity. Therefore, they both contribute to its total equity.
It is a common characteristic that both these accounts share. In essence, however, capital surplus and retained earnings are different. These differences arise due to the nature of both accounts.
Firstly, capital surplus refers to the additional funds received for shares issued above par value. It is a source of external finance that companies receive.
Similarly, these funds do not rely on a company’s financial performance, although it may affect them. Retained earnings, in contrast, represent accumulated profits over the years after deducting dividends. They are a source of internal finance which depends on financial performance.
The calculation for capital surplus and retained earnings differ based on the above definitions. Capital surplus involves subtracting the par value of shares from the actual amount received for issuance.
In contrast, retained earnings include adding up a company’s profits over the years. However, it also involves subtracting dividends paid to shareholders and accounting for any losses.
Overall, capital surplus does not represent a company’s earnings or relate to its financial performance. Similarly, it is not a form of distributable capital that companies can pay out as dividends.
It falls under the additional paid-in capital category under equity in the balance sheet. However, companies can distribute retained earnings. These do not fall under share capital or any of its components.
Capital surplus represents the premium received for issuing shares above the par value. This surplus forms a part of a company’s stockholders’ equity. Similarly, several sources can result in a capital surplus for companies. Capital surplus differs from retained earnings, although both form a part of a company’s equity.