Legal Capital

Legal capital is defined as an amount of a firm’s equity that is not allowed to leave the business; an amount that cannot be distributed to shareholders in the form of dividend or as anything else. It is referred as the par value of firm’s common or preferred stock issued to the investors.

Explanation

Par value or face value does not depict the actual value of the stock; on the contrary, it is decided as an arbitrary or nominal amount. Face value is often set at a minimal price in order to protect investors by preventing firms to not issue stocks at a price lower than the par valuePar ValuePar value of shares is the minimum share value determined by the company issuing such shares to the public. Companies will not sell such shares to the public for less than the decided value.read more.

The concept of legal capital was first introduced to produce a reserve for the company’s creditors in the event of default. However, the intent of this capital is effectively negated for those businesses issuing stock having extremely low par values.

When the Firm’s’s share price reduces so much that it comes below par value, the firm Board of Directors can determine the capital of the Firm by defining a stated value to the stock or the amount of owner’s equity that the Firm needs to maintain after buying back its stock and issuing dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company.read more.

Nowadays, companies set very low par values because of which legal capital is so less that it could provide very low protection.

Example

ABC Inc issues 1,00,000 common stock shares at $10 par value, the total value of common stock issued at par equals $10,00,000.

In this case, if there is any additional amount that ABC Inc receives on issuing the stock, the additional amount will be recorded as additional paid-in capitalAdditional Paid-in CapitalAdditional paid-in capital or capital surplus is the company's excess amount received over and above the par value of shares from the investors during an IPO. It is the profit a company gets when it issues the stock for the first time in the open market.read more in excess over par. Let’s assume ABC Inc. receives $15 per share on issuing. Hence, additional paid-in capital comes out to be $5 * 1,00,000, which is $5,00,000, which will be recorded in Journal Entries as follows:

Legal Capital Example

When the Firm’s’s shares are issued, the amount that exceeds the issued value is also recorded in Journal entries as additional paid-in capital accountCapital AccountThe capital account refers to the general ledger that records the transactions related to owners funds, i.e. their contributions earnings earned by the business till date after reduction of any distributions such as dividends. It is reported in the balance sheet under the equity side as “shareholders’ equity.”read more, as mentioned in the above example.

In the above example, ABC Inc cannot announce a dividend in excess of $10,00,000 legal capital determined by the par value of the issued sharesIssued SharesShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more.

Legal-Capital

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For eg:
Source: Legal Capital (wallstreetmojo.com)

The value of the legal capital of the Firm is the cumulative amount of the par value of all of its stocks.

Hence, if a firm has a par value of $10 with a total of 10,000 shares outstanding, its legal capital would be $100,000.

Legal Capital = $10000 * $10 = $100,000

Importance

  1. This concept was first implemented in order to protect the Firm’s creditors in the event of default or any financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more by maintaining a cash reserve, especially for such events.
  2. The concept of this capital can only be applied to issued stocks. For such stocks that have been approved already for issuance but yet to be issued, It cannot be applied.
  3. The value of assets of a firm should always exceed the sum of the value of liabilities it has and the amount of legal capital.i.e., Assets >= Liabilities + Legal Capital
  4. The par value of issuing security depicts some of the full parts of this capital.
  5. Nowadays, companies set very low par values because of which legal capital is so less that it could provide very low protection.

Advantages

  • This concept provides protection in case of any financial crisis.
  • It cannot be distributed to the Firm’s’s shareholders by any means.
  • A firm does not need to pay dividends to the shareholders if doing so would damage its Legal Capital.
  • A firm does not need to acquire capital shares if such activity could weaken this capital.
  • This capital ensures that the value of assets of a firm should always exceed the value of liabilities.

Conclusion

Legal capital is an amount of a firm’s equity that is not allowed to leave the business, an amount that cannot be distributed to shareholders in the form of dividends or as anything else. It is referred to as the par value of the Firm’s common or preferred stock issued to the investors.

The concept of this capital is only applicable to stocks that have been issued. It cannot be applied to any stock that is approved for issuance but has not been issued yet to investors.

Nowadays, companies set very low par values because of which legal capital is so less that it could provide very low protection.

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