Legal Capital

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Explanation

Par value or face value does not depict the stock's actual value; on the contrary, it is decided as an arbitrary or nominal amount. Face value is often set at a minimal price to protect investors by preventing firms from issuing stocks at a price lower than the par value.

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 share price reduces so much that it comes below par value, the firm's 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 dividends.

Nowadays, companies set very low par values because legal capital is so low 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 capital more than 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 shares are issued, the amount that exceeds the issued value is also recorded in Journal entries as an additional paid-in capital account, as mentioned in the above example.

In the above example, ABC Inc cannot announce a dividend over $10,00,000 with legal capital determined by the shares' par value.

Importance

  1. This concept was first implemented to protect the Firm's creditors in default or any financial crisis by maintaining a cash reserve, especially for such events.
  2. The concept of this capital can only be applied to issued stocks. It cannot be applied for such stocks that have been approved already for issuance but are yet to be issued.
  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 legal capital is so low that it could provide very low protection.

Advantages

  • This concept protects in case of any financial crisis.
  • It cannot be distributed to the Firm'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 and 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.

This capital concept only applies to stocks that have been issued. It cannot be applied to any stock approved for issuance but has not been issued yet to investors.

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