Thus, if a company pays 1,25,000 on account of goodwill, which if valued correctly is worth Rs. 50,000 only, the capital is watered to the extent of Rs. 75,000. ‘Watered capital’ must be distinguished from over capitalization. Water enters the capital usually in the initial period-at the time of promotion.

Consequently, the working efficiency of the company will be decreased, and the prices of its shares will fall. Over capitalization in a company occurs when the total capital (debt & equity of the stockholders) of a company surpasses the actual value of its assets. Corporations must produce more in earnings than the money invested in increasing the capital invested by stockholders and other funding sources. Under-capitalisation generally occurs in a firm which is incorporated during a depression.

Capital sources

Over capitalization can, however, be found out only after the company has worked for some time. Although watered capital can be a cause of over capitalization, yet it is not exactly the same thing. If the earnings are up to the general causes of over capitalisation expectation, a concern will not be over capitalized even though a part of its capital is watered. It is a financial situation where a company has more than enough total capital as compared to the needs of its business operations.

By its nature, inflationary conditions are an important factor in over capitalisation of business enterprises, and equally affect both the newly promoted as well as the established companies. During boom period, companies have to pay high prices for purchases of fixed assets, and the amount of capitalisation is kept high. Higher capitalisation is justifiable until inflationary conditions prevail. But when the boom conditions subside and recessionary conditions set in, the real value of the company’s assets fall whereas the book value of its assets remain at a,  higher level.

Remedies of Over Capitalization

Earning capacity should be improved and care must be taken to spend every single rupee in the most profitable and economic manner. (ii) Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources. (v) In case of reorganisation, the face value of the equity share might be brought down.

Such a company may resort to tactics like increase in product price or lowering of product quality. (iii) Reduced earnings may force the management to follow unfair practices. Inefficient management and extravagant organisation may also lead to over-capitalisation of the company. In the same way, an overcapitalized company suffers from various adverse effects. It will face dissolution unless corrective measures are adopted. The result of idle funds, therefore, is a lower rate of return.

Earnings Management: Needs, Methods, Objectives

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However, as decided in Walkovszky v. Carlton, the parent corporation is not responsible for settling claims in excess
of remaining assets when an undercapitalized subsidiary fails. Undercapitalization may result from failure of a business to take advantage of these capital sources, or from inability to raise capital using any of these sources. There may be an underestimation of the capital requirements of the company by the promoters. This may lead to capitalization which is insufficient to conduct its operations. Undercapitalization is just the reverse of over-capitalization. The state of under-capitalization is where the value of assets is much more than it appears in the books of the company.

Acquisition of Goodwill at Excessive Price

If a company doesn’t have the capital to invest in additional manufacturing equipment or hire staff in order to capture increasing demand, undercapitalization can create missed opportunities. Similarly, undercapitalization can limit a company’s ability to expand into new markets or develop new products, creating additional opportunity cost. The evil effects of over-capitalisation are so grave that the management must take remedial measures to rectify the situation as soon as the first symptoms of over-capitalisation are observed by the firm.

• The first step for a company to correct the situation is by carrying out adequate internal investigations.
• (iii) There may be no certainty of income to the shareholders in the future.
• Because profit prediction will be challenging, there will be solutions to overcome the disparities.
• When the bank becomes critically undercapitalized the FDIC declares the bank insolvent and can take over management of the bank.