It takes money to make money, which is why contributed capital is important. Also known as paid-in capital, it's the money companies raise by selling shares. Say a corporation sells $300,000 in shares through an initial public offering. Now it has $300,000 in contributed capital to spend and to record on the balance sheet. Only shares bought from the company count as contributed capital. Investors buying and selling shares from each other doesn't affect the corporate bookkeeping.
Counting Contributed Capital
Unlike some accounting formulas, the capital stock calculation is simple. The company issues stock and investors buy the stock. The total amount they pay is the contributed capital. If the company issues more stock, that increases the capital amount of a company. Recording the capital accurately in the accounts and on the balance sheet can be more complicated.
Say an investor buys $3,000 in shares. Under double-entry bookkeeping you record the $3,000 as a debit to the Cash account and a credit to Contributed Capital. Some investors, however, strike different deals: they offer fixed assets such as equipment or buildings for stock, or reduce some of the company's debts for stock. In that case, the debit would go to the relevant asset account or to reducing the liability account containing the debt.
Contributed Capital on Balance Sheets
Your company's balance sheet takes the total assets, subtracts the corporate liabilities and labels whatever remains as owners' equity. The money generated by the stock sale goes on the asset side. It's balanced by a contributed capital account in the owner's equity section. Alternatively, you can report contributed capital in two accounts, common stock, and additional paid-in capital. The common stock account lists the par value or face value of the issued stock; additional paid-in capital records any money investors paid above that.
Suppose the initial public offering has a par value of $1.4 million but the IPO brings in $1.8 million. $1.4 million would go in the common stock account. You report the remaining $400,000 as additional paid-in capital. In a casual conversation, some people use "paid-in capital" to mean just the additional paid-in capital, which can become confusing if you don't use it the same way.
Paid-in capital and retained earnings are terms that can get confused, too. Retained earnings is another asset account in the balance sheet, consisting of the company's cumulative after-tax net income, less dividends. Suppose the corporation makes a total of $2.4 million over its first two years, but $1.4 million goes to either buying equipment or taxes. It also issues $400,000 in dividends over the same period. That leaves $600,000 of income in the corporate coffers at the end of the second year, which goes on the balance sheet as retained earnings. Retained earnings and contributed capital make up the bulk of owners' equity.
Importance of Contributed Capital
If your company is privately held, contributed capital won't show up on the balance sheet. It only applies when a corporation's stock trades publicly. Nonprofits don't have contributed capital, as they don't have stockholders. Charities do get contributions but legally donated money is completely different.
For companies that go public, contributed capital is important to be able to grow. If you have a healthy paid-in capital account on the balance sheet, that can attract further capital; it's a sign your stockholders considered you a good investment. Stock issues that generate additional paid-in capital are a particularly encouraging sign that investors have faith in you.
An alternative view, though, is that contributed capital only matters because you're legally required to report it. What really matters is the total owners' equity, which shows how much the company's net worth outweighs its debts.