Contributed Surplus

These are the profits that the corporations make outside direct operations.

Corporations that profit outside direct operations are called "contributed surplus" (CS). Understanding what it means and its purpose can help us easily use it in financial statements

Contributed Surplus

It is an accounting phrase that refers to shares sold for more than their par value or the maximum value authorized under the company charter according to the stock certificate. 

Also known as additional paid-in capital, it is recorded in the shareholder's equity portion of a company's balance sheet. This page has two entries for surplus contributions. 

The first entry shows how much money sells at par value, and the second shows how much cash sells for more than the par value.

Compute the total quantity of assets minus the sum of total liabilities, par value of the stock, and retained earnings to calculate the surplus for a share. If a corporation sells a stake for more than it is worth, the excess money is included as contributed surplus. 

This surplus can pay off outstanding debts, liabilities, and loans. In addition, investors may become more interested in a company's actions if it uses contributed surplus to buy assets and pay penalties, which improves its financial well-being and reputation.

How does it work? 

It differs from share premium in several important ways, including 

  • its gratuitous nature; 
  • The fact that it does not count towards a company's assessable capital; and 
  • A company can make distributions from its contributed surplus account that do not violate the capital maintenance rules.

Furthermore, the surplus is not considered for calculating a company's assessable capital, which determines the annual government fee owed to the Bermuda Registrar of Companies.

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Therefore, unlike a statutory reduction of share premium that requires, among other things, a legal notice to be published and shareholder consent, a company does not need to be concerned that it will violate specific capital maintenance rules with a contributed surplus account.

It is typical for corporations to use their surplus account to erase debt owed to their shareholders or to offer loans to their subsidiaries in addition to making a distribution to their shareholders.

Whether they gave any portion or all of the assets in the account, a shareholder has no right to claim the money credited to the contributed surplus account.

Companies should approve a resolution approving distributions from their contributed surplus account and recognizing receipt of the money constituting contributed excess to verify the report is accurate.

companies

While there is no legal duty to do so, it is prudent to ensure that sums representing contributed surplus are correctly recorded and to state that the contribution is not for a stock subscription.

By law, companies must verify that the contributed excess account is correct, or they will face financial penalties.

Companies must seek legal guidance on the proper classification and any measures necessary to record, reduce, or disburse funds from the company's contributed surplus account if in doubt.

Types of contributed surplus

Some of the types are:

Type A

This contributed surplus account carries any excess on issuing shares with a par value. No sum is recorded in this account if shares are issued at par value.

Citigroup, for example, issues 10,000 ordinary shares with a par value of $1 each for $25 apiece. It obtains $25,000 in cash as a result of the transaction. 

$10,000 is allocated to the common stock equity account (10,000 shares * $1/share), and $15,000 (10000 shares * ($25 - $1)) is assigned to the Contributed Surplus account - Issuance of Common Shares.

Trading

Type B

Any earnings or losses on repurchasing its stock are recorded in these accounts. 

When a stock is purchased, it is removed from the books at the price at which it was issued, and any difference between the price and the price paid by the company (market value) is recorded in this account. 

Example: Citigroup decides to repurchase all 10,000 shares initially issued in the earlier model (from Type A). The market value of the shares has dropped to $20 since then. 

Mobile Trading

It means that on the repurchase, the corporation records $5 in value for each share for a total of $50,000 (10,000 shares x $5 / share). This additional $50,000 is applied to the Type B account Contributed Surplus - Repurchase and Cancellation of Common Shares.

Type C

Any other equity value on share transactions that do not type A or B is held in these accounts. In addition, any values resulting from selling sophisticated financial instruments are likewise recorded in these accounts.

Common type C accounts are as follows:

1. Warrants: Stock warrants can be used to pay for goods or services provided by a company. The issuer must account for the fair value of the equity instruments issued or the fair value of the consideration received, whichever can be measured more accurately. 

The asset or expense associated with the goods or services must be recognized simultaneously. 

Laptop and Mobile

It offers the company an extra source of money for the future. When a company's capital appears degrading but does not require rapid capital infusion, it may issue it. As a result, the concern is to ensure that future capital sources are enough.

Stock warrants generate more investors and demand for the company's shares. If the company's shares trade at $1000 per share and are issued at $500 per share, it may appeal to investors who lack the financial means to purchase the company's stock. 

They can buy stock warrants to keep the right to buy the company's equity in the future. It can maintain goodwill from the stockholders of the corporation.

The company's appeal will be enhanced by combining it with other financial products. It also lowers the company's financing costs.

If warrant holders exercise their entitlement to convert their warrants into shares, the company's stock will have more market liquidity.

Laptop

Reasons why companies issue stock warrants are:

  • If the market price of the company's shares is higher than the exercise price of the warrant, investors may choose to exercise it. As a result, investors will obtain shares at a discount to the market price. 

Because investors may opt to exercise their warrants, the diluting effect will have a more negligible impact on shareholders.

  • Warrants serve as an alternative investment for the company's stockholders. Investors who want to invest money into the company might purchase contracts. 

It has a lower investment cost than purchasing the company's stock. Warrants' market price is typically more volatile than the company's stock price.

Demerits of issuing stock warrants:

  • The total number of warrants, shares reserved for warrant exercise, and shares reserved for existing contracts shall not exceed 50% of the company's share capital.
  • The company is responsible for determining the exercise price and timing. Therefore, the company should plan for the time and amount of finances it will require. 

They must be given a better deal to attract investor interest because they are lightly traded and issued by a few corporations. 

  • Only publicly traded companies can issue warrants.

2. Stock Option Expensing: Within a publicly-traded company's profit and loss reporting, stock option expensing is a way of accounting for the value of share options issued as incentives to employees. 

Loss from the exercise is accounted for on the income statement, balance sheet, and cash flow statement by noting the difference between the market price (if one exists) of the shares and the cash received, the exercise price for issuing those shares through the option.

stock opening

Reasons why companies issue stock options are:

  • Purchasing shares necessitates a significant upfront investment, which requires a large cash outflow. However, with a smaller initial investment, an investor can gain substantial exposure to the underlying asset in an option.
  • Short-selling stocks carry a significant level of risk and legal ramifications. With options, however, a short position can be taken by paying a premium based on conjecture or possessing certain information.

Reasons why companies suffer from demerits when stock options are issued:

  • Losses for option buyers will be restricted to the premium amount paid. On the other hand, the writer of the options will be taking a tremendous risk. It could be limitless. 

As a result, stock options carry a much higher risk than a direct stock purchase.

  • Shares can be sold anytime after purchase, even if it has been a hundred years. However, an instrument must be squared off in options by specific, predetermined expiration date. 

As a result, even if the investor loses money, they will be forced to square off the instrument, even if it is at a loss.

  • In most cases, the investor pays the acquisition price as a share investment. After that, there is no need to pay anything. 

The option seller, on the other hand, will have to keep a continual eye on market prices to settle the market-to-market price of an instrument at the end of the day.

option seller

3. Conversion rights: The capacity of shareholders to convert preferred shares into common shares is referred to as conversion rights. Conversion rights are significant because they influence the calculation of other shareholder rights. 

The number of outstanding shares on an as-converted basis is used in most computations. It means that the total number of shares is calculated by incorporating the shares that would be converted into preferred shares. Optional and required conversion rights are available. 

Optional conversion rights: Optional conversion rights allow the holder to first convert their preferred stock shares into common stock shares on a one-to-one basis. These rights are linked to the investor's preference for liquidation. They are non-negotiable.

investment

For example, let's say that an investor has a $50 million non-participating liquidation preference (with a 2x multiple) that represents 30% of the business's outstanding shares, and the company is sold for $1000 million. 

As a result, the investor would be entitled to the first $100 million under its liquidation preference, with the remaining $900 million being divided among the common stockholders.

On the other hand, the investor would receive $300 million if it chose to convert its shares to common stock under its optional conversion rights (thus preceding the liquidation advantage).

Required Conversion Rights: The holder of mandatory conversion rights must convert their preferred stock into common stock. It is referred to as "automatic conversion" since it occurs automatically.

rights

  • Finally, founders should advocate for a majority threshold for an automatic conversion with Series A Preferred's written permission. 

If there are many series of preferred stock, holders should be required to vote as a class (otherwise, a single series could block the transaction).

Such rights are always negotiable. 

Issues with Conversion rights: 

  • Founders should advocate for a low multiple of the Original Purchase Price (for example, two or three times the Original Purchase Price) to increase their IPO flexibility.
  • Similarly, founders should strive for "gross" (rather than "net") proceeds and a valuation of $10-15 million – or, better yet, "for a total offering of not less than $10-15 million (before underwriters' fees and expenses)."
  • Qualified counsel can sometimes persuade investors to remove these thresholds entirely (to avoid the possibility of having to obtain last-minute waivers when pricing the IPO). 

If not, the corporation must verify that the thresholds for all preferred stock series are the same.

Key Takeaways

  • Contributed Surplus is the profit that arises due to indirect operations of a company, and while calculating a company's assessable capital, it is not considered.
  • It is recorded in the shareholder's equity portion of a company's balance sheet and is sometimes known as "additional paid-up capital."
  • Type A accounts include the issuance of shares over their par values. 
  • After stock purchase, it is removed from the books at the price it was issued, and any difference between that price and the price paid by the company (market value) is recorded in the Type B account.  
  • Share transactions that do not go into Type A or Type B go into Type C accounts. 
  • Type C includes stock warrants, stock options, and conversion rights as some of the most common types of accounts. 
  • Investors essentially like to obtain shares at a discount to the market price. Hence, if the shares' market price is higher than the exercise price of the warrant, investors choose to exercise it. These warrants also serve as an alternative to the company's stockholders. 
  • On the downside, only publicly listed companies can issue warrants. This issuance also requires much planning, which can be highly time-consuming. 
  • Another demerit associated with them is that the total number of warrants, shares reserved for warrant exercise, and shares reserved for existing contracts are not allowed to exceed 50% of the company's share capital.
  • Stock options only require smaller initial investments, allowing investors to gain exposure to the underlying asset in an opportunity. 
  • However, losses for stock options writers can be limitless, and at the end of the day, they would be required to keep an eye on the market at all times to settle the market-to-market price of an instrument. 
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