The Capitalization of Profits

by Alan Li; Updated September 26, 2017
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Capitalization is a term that refers to the process of turning something into capital, and capital is a term with multiple interrelated definitions that render it unclear without additional context. In this case, capital is used to refer to a corporation's shareholders' equity, in particular the resources invested into its operations by those shareholders. Capitalization of profits refers to the process of turning the corporation's retained earnings into additional shares in its capital stock to be distributed to existing shareholders.

Corporations

Corporations are a class of businesses that are unusual in that they are considered independent legal entities. As such, corporations are not the same legal person as their shareholders and cannot pass legal liabilities incurred through their activities onto those same shareholders. Shareholders are considered owners of the corporations by virtue of purchasing shares in the corporation's capital stock and thus investing resources into them.

Shareholders' Equity

A business's economic resources can be said to equal its economic obligations and the investments that its owners have put into it. Owner investment into the business is called equity and that of corporations is specifically called shareholders' equity. Shareholders' equity can have multiple sub-listings under it but will almost always include share capital and retained earnings. Share capital is the value that its shareholders have invested into the corporation.

Retained Earnings

Retained earnings can be defined as the accumulated portions of earnings that the corporation has chosen over time to reinvest into its operations rather than distribute to its shareholders as dividends. In each period, a business earns revenues but incurs expenses in doing so. The difference between revenues and expenses is either a net income or a net loss, depending on the business's performance, and this figure is added onto the retained earnings account at the end of each period.

Capitalization of Profits

Capitalization of profits refers to the corporation's decision to turn a portion of its retained earnings into share capital. In this case, retained earnings represents the corporation's profit while share capital is the capital that is referenced in the term. Corporations do this by distributing the newly created shares to their shareholders in proportion to the numbers of shares that these shareholders already owned.

About the Author

Alan Li started writing in 2008 and has seen his work published in newsletters written for the Cecil Street Community Centre in Toronto. He is a graduate of the finance program at the University of Toronto with a Bachelor of Commerce and has additional accreditation from the Canadian Securities Institute.

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