Custom «Accounting» Essay Paper
Paid-in capital refers to the total amount of money that investors or company’s owners inject in the company as an investment. This mainly refers to the funds injected to start a business. If two people came together to start a company and each of them contributed $80,000, then the company would have $160,000 as paid in capital. It is important that companies establish and maintain separate ledger accounts for each investor since in some instances, investors do not contribute equal amounts. Thus, this will be a key consideration in the sharing of profits and revenues generated by the company.
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On the other hand, earned capital is the total amount of net profits that a company decides not to distribute as dividends to the investors. In most cases, companies choose not to distribute part of its earnings as dividends so that they can fund investments and expansion projects (Kimmel, Weygandt, & Kieso, 2009). This saves the company from the need for getting funds from financial institutions and paying interest. Earned capital can also be termed as the retained earnings.
When presenting share capital in the balance sheet, paid-in capital and earned capital appear as separate lines. It is important to separate the two types of capital for a number of reasons. One of the reasons is that separating them enables one to see whether the company is making profits or not. It is due to the fact that earned capital represents the profits made after investing the paid-in capital. Combining the two will make it difficult to ascertain the amounts of profits. The other reason for sparating them is for tax purpose. Earned capital forms the basis for tax calculations and not for paid-in capital. Combining them would result in increased tax liability. This would also be a misrepresentation of the revenues to the tax authorities. The third reason for separating the two is to enable the investor to evaluate whether the earned revenues are able to meet the companies’ obligations and leave the investors with some profits. Ideally, after launching a business, investors should not inject more money to pay for the daily running of the operations. The company should be able to generate enough funds to pay for its current obligations. Knowledge of whether the company is making enough money or not would enable investors to pull out in good time in the event that the company is unable to generate enough funds to meet all the obligations.
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To every investor in the market, earned capital is more important than the paid-in capital. The reason behind this assertion is that earned capital is a representation of a company’s ability to generate revenues from the amounts of money the investors injected into the company. All investors invest their money in starting a business with the hope that the operations of the company will generate enough funds to pay all the obligations and retain some funds for the investors (Pratt & Salimi, 2010). Additionally, when looking for additional funds to invest, new investors will look at the earned capital over a period the company has been in operations. New investors have interests in companies that have a high earned capital and shun investing in companies that have low or declining earned capital. If the company’s earned capital has been on the rise, then the new investors can be willing to inject funds in the company regardless of the initial paid-in capital. This is because they are certain that they will recover their investments. Additionally, when a company is seeking for financing from financial institutions, the latter will look at the earned capital to assess whether the company will be able to repay the loans plus the interest. Therefore, it is clear that earned capital is more important compared to paid-in capital.
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Basic earnings per share (EPS) amounts of profits or losses attributable to the outstanding common shares during the reporting period. Accompany arrives at the basic EPS by dividing the profits or losses available to the common shareholders by the average common shares during the reporting period. Diluted EPS provides a basis to estimate shares a company could have theoretically after exercising all stock options, preferred stocks, warrants, and convertible bonds. The theory assumes that since all the investments stated exercised, then the number of outstanding shares can rise anytime (Bens, Nagar, Skinner, & Wong, 2003). This lowers the amounts of earnings attributable to each share.
For an investor, diluted EPS is far much important than the basic EPS since it provides a detailed explanation of the real earning power of the company. This means that an investor needs to have concerns about a company that has a basic EPS same as the diluted EPS since it means that the company does not have any investments that it can convert when need arises.
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