Capital stock consists of claims held by owners arising from investments in the firm. A corporation is authorized by the state government to come into existence and to issue shares. Once authorized, the corporation’s shares fall into one of these four categories:
- Unissued, unsubscribed shares which have not been committed for issuance to anyone.
- Unissued, subscribed shares which can be issued only to persons who have agreed to buy them.
- Issued, outstanding shares which are held by stockholders who possess the rights outlined in the charter.
- Issued, not outstanding shares which have been issued and subsequently acquired by the corporation (also known as treasury stock).
Classes of Stock
The charters of many corporations allow them to issue more than one class of stock. Holders of the various classes possess different rights. Preferred stock carries one or more special privileges that distinguish it from common stock and often carries one or more negative characteristics that compensate the
common stockholders for their inferior position. Possible positive features of preferred stock include:
- Preference for dividend distributions.
- Preference for liquidation distributions.
- Redeemability: the holder can choose to receive cash in full settlement for returning the stock to the corporation.
- Convertibility: the holder can choose to become a common stockholder.
Possible negative features include:
- Callability: the corporation can choose to retire the stock by paying cash.
- Nonvoting status.
- Limits on dividends.
In many cases, preferred stockholders’ rights more closely resemble those held by creditors rather than owners.
Common stockholders own the residual interest in the firm; that is, they fall last in the order of precedence with respect to receiving cash upon the corporation’s dissolution. The claims of the common stockholders are the ones increased by profits or decreased by losses (after considering preferred stock dividends). Occasionally, different classes of common stock are issued by a corporation, of which at least one must have voting rights.
The term legal capital is frequently used in statutes related to incorporation to identify the minimum amount of owners’ claims that cannot be satisfied through the distribution of assets. The concept of legal capital was originally established in order to protect creditors against the actions of an unscrupulous management that might siphon off the liquid assets and leave a corporate “shell” that would be unable to pay its debts.
The quantity of legal capital is either stated in the statute as a given amount (such as $1,000 in Washington, D.C.) or as an amount based on the number of shares of stock issued. The slight protection of legal capital has been substantially replaced by stronger doctrines created and enforced by courts. In general, they are based on the fiduciary responsibilities of managers. Consequently, the amount of legal capital is not a key item for financial accounting disclosure.
The amount recorded in the capital stock account for a particular class of stock depends on whether the shares have a par value. Par value stock has an assigned value per share that is fixed in the corporate charter. In some states, legal capital may be defined as the aggregate par value of the issued shares. This amount is used in financial accounting to determine the amount recorded in the account for the capital stock claims. Par value is also meaningful when dividends are expressed as a percentage of par value, as usually occurs for preferred shares.
A very low par value is often established in order to minimize legal capital
and to reduce state fees related to chartering and operating the corporation that is proportional to aggregate par value. For example, Delaware, a state in which many large companies are incorporated, assesses fees on this basis.
As an alternative to issuing par value stock, many firms issue no-par-value shares. Legal capital for these corporations may be established by the use of a stated value per share that substitutes for par value or by using the total value received
upon issuance. The balance of the capital stock account equals the stated value of the outstanding shares or the total proceeds if there is no stated value. The choice among issuing par value, stated value, or true no-par-value shares may be determined by state laws. For example, if a Delaware corporation issues no-par-value stock, fees are computed as if the stock has a $100 per share par value.
In addition to the dollar amount recorded in the capital stock account, the balance sheet or notes should provide these facts:
- Special privileges or penalties of the class, such as dividend rate, limits, and voting rights.
- Number of shares authorized, issued, subscribed, outstanding, and reacquired.
Below Example shows excerpts from Capitol Food Industries, Inc. and General Motors that illustrate these disclosures.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.