Why Is it Important to Separate Paid-In Capital From Earned Capital?

Paid-in capital and earned capital are two forms of equity capital shown in the shareholders' equity section of the balance sheet. Paid-in capital is also referred to as contributed capital that investors provide when they purchase a company's initially issued shares. Earned capital is retained earnings, the accumulated income a company has earned since its inception. The separation of paid-in capital from earned capital concerns the issue of legal capital and any additional capital in excess of share face value, as well as tracking earnings made and dividends distributed.

Maintaining Legal Capital

Legal capital is defined as the par value capital, the base amount of the paid-in capital. A stock's par value, or face value, is the stated value on each share of the stock. Companies usually set their stock's par value at $1 per share. Thus, the total par value capital is the par value multiplied by the number of shares issued. The amount of par value capital is separated from the rest of the equity capital as legal capital. Legal capital helps limit dividend distributions to stay within the total amount of retained earnings and any additional paid-in capital.

Additional Paid-in Capital

Companies often sell shares at a price higher than their stock's stated face value. The is commonly is referred to as additional paid-in capital. While par value capital is listed in the first line of the shareholders' equity section under common stock, any excess capital from share issuance is listed below par value capital in additional-paid-in-capital account. Additional paid-in capital provides a level of buffer to absorb dividend distributions or any operation losses before they can reach legal capital.

Measuring Accumulated Income

Earned capital, or retained earnings, must be reported separately from contributed capital so companies can track and measure their accumulated income over time. The earned capital account is essential for both providing an internal financing source and absorbing any asset losses. Moreover, retained earnings may become negative if a company has sustained losses over time in excess of accumulated earnings. With the separation of its earned capital from other equity capital accounts, a company can adjust its financing and operation activities to accommodate the level of retained earnings.

Measuring Dividend Distributions

Dividend distributions reduce the amount of retained earnings, and companies may distribute dividends over time in excess of retained earnings. As an equity account rather than an asset account, retained earnings are different from a company's cash position. A company may hold more cash than the amount of retained earnings, for example, as a result of borrowing. A company can overpay dividends beyond retained earnings; therefore, keeping the retained earnings account separate from other capital accounts enables a company to check on the sustainability of its dividend payments.