What is Contributed capital - Definition, Importance and Need | LKP Securities
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LKP Securirities Limited | March 02
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What is Contributed capital - Definition, Importance and Need

Every company needs capital to operate and grow their business. While financial assets and help start a company, contributed capital helps in its expansion. It is the form of capital acquired by the company through stock sales to shareholders. In other words, it includes the assets or cash given by stakeholders to the company in exchange for a stake in it. 

Contributed capital is also known as ‘paid-in-capital’. It is a credit to the business. Companies issue their equity shares on a price perceived that they believe shareholders would pay to acquire them and when the purchase takes place, the transaction creates what is called contributed capital. However, the term may also be used about a component of the balance sheet in the company usually found under the stockholder’s equity. It is usually divided into two accounts in the stakeholder’s equity section, namely common stock and additional contributed capital.

When investors pay companies for their stocks, the usual entry in journals involves debiting cash accounts for the total cash received and crediting to the contributed capital account. The term refers only to the shares directly purchased from the company weather through Initial Public Offerings (IPOs) or a secondary stock issue. Stocks exchanged between investors on their own, in the open market are not taken into account.

Definition of contributed capital

Contributed capital is the total value of the stock that a shareholder gives the company in exchange for the stock. It includes the money from initial public offerings (IPOs) as well as direct listings and direct public offerings. The secondary offerings under contributed capital include issues of preferred stock. Furthermore, the receipt of fixed assets in exchange for stock along with any liability reduction falls under contributed capital.

Importance of contributed capital

The significance of contributed capital is a key marker in economics and business for several reasons.

  • Accountants, economists and agencies are generally attentive towards companies with significant contributed capital amounts because it is a good indicator of growth.

  • Investors, shareholders and stock traders view it as an indicator for the potential of the company. The amount signifies people’s trust in the firm’s operations and, hence, could prove profitable in the long run.

  • When the stocks trade higher than the prices set by the company, it reflects a surge in demand of the stock pushed by the investors’ sentiment of paying more than the par value to acquire a stake in the company. This is seen as an indicator of the company’s future performance. 

The need for contributed capital 

If the company plans not to go public, i.e., issue stocks to raise capital, it does not have to worry about collecting contributed capital and hence, tracking it. In the other case where it has or will need to go public, this form of capital plays a vital role in the overall profile of the company. However, if the company chooses never to go public, it greatly limits its chances of growth because there would be no money coming in from stock sales.

  • When stocks are issues and people buy them, the capital thus collected by the company has to be tracked and accounted for, by the responsible authorities. 

  • This data is stored for record-keeping and reporting to the management, so they can make investment and other decisions.

  • Government authorities and tax agencies perform random and yearly audits for companies upon requirement where this data comes in handy.

  • Accountants in the company need this data for preparing balance sheets and updating financial information quarterly and yearly.

  • Company authorities also need to report this data to the investors, so they are aware of the proceedings with their investments.

Myth vs reality

As with other terms in business and economics, some folks confuse contributed capital with different terms. Let us clear out the most commonly found ones here.

  • One of the most common misunderstandings associated with paid-in capital is that it comes from donations. This could not be farther from the truth. Donations or non-profits have nothing in common with paid-in capital because donations have nothing to do with the company being public or not.

  • Paid-in capital calculation comes into assessment when the company goes public or the stock is issued. When the stock gets traded between different parties, contributed capital of the company has no role to play and it does not receive any additional capital.

  • Contrary to popular belief, the terms contributed capital and capital contributed do not mean the same thing! While contributed capital may include loans inserted into the company by the business owner and even non-cash assets like machinery and buildings, contributed capital usually refers to the cash gathered by the sale of equity shares.

  • Contributed capital is not the net income earned by the company (also called the earned capital) and it does not include dividends. 

Calculation of contributed capital involves adding the par value of common stock found in the balance sheet’s equity section and the amount that stakeholders are ready to pay on top of the par value of a stock, mentioned in the additional paid-in capital accounts. If the company trades assets or liabilities for stocks, the positive or negative values of these items are also regarded in the total contributed capital.

If a company issued 1000 shares with a par value of INR 1 per share, while the shareholders pay INR 10 for each. The overall amount they would be paying turns out to be INR 10,000 that goes towards the contributed capital of the company. However, the company would list INR 1000 under a common stock account while the remaining amount is over and access to the par value. 

Overall, contributed capital is one of the most important indicators of the prospects of a company’s long-term growth and hence, it requires close attention from both the business owners and investors. While a consistent rise in it signifies strong chances of progress for the company, a downfall suggests people’s negative sentiments towards it. Issuance of new shares and preferred shares generally contributes towards an increase in contributed capital.
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