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Chapter18: Shareholders’ Equity

Share Buybacks

In the previous section we examined various ways stock might be issued. In this section, we look at situations in which companies reacquire shares previously sold. Most medium- and large-size companies buy back their own shares. Many have formal share repurchase plans to buy back stock over a series of years.

 

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DECISION MAKER'S PERSPECTIVE

When a company's management feels the market price of its stock is undervalued, it may attempt to support the price by decreasing the supply of stock in the marketplace. A Johnson & Johnson announcement that it planned to buy back up to $5 billion of its outstanding shares triggered a buying spree that pushed the stock price up by more than 3 percent.

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Decreasing the supply of shares in the marketplace supports the price of remaining shares.

   When announcing plans to repurchase up to $1 billion of its shares, Bullion Monarch Mining chairman and chief executive officer Don Morris explained, “We believe the current share price … represents an excellent investment opportunity for the company.”10 Although clearly a company may attempt to increase net assets by buying its shares at a low price and selling them back later at a higher price, that investment is not viewed as an asset. Similarly, increases and decreases in net assets from that activity are not reported as gains and losses in the company's income statement. Instead, buying and selling its shares are transactions between the corporation and its owners, analogous to retiring shares and then selling previously unissued shares. You should note the contrast between a company's purchasing of its own shares and its purchasing of shares in another corporation as an investment.

FINANCIAL
Reporting Case

Q1, p.1007

   Though not considered an investment, the repurchase of shares often is a judicious use of a company's cash. By increasing per share earnings and supporting share price, shareholders benefit. When Walmart announced a $15 billion buyback of common stock in 2009, Neil Currie, an analyst with UBS Securities commented, “Walmart has taken a major step in attempting to improve returns on investment.”11

p. 1025

   To the extent this strategy is effective, a share buyback can be viewed as a way to “distribute” company profits without paying dividends. Capital gains from any stock price increase are taxed at lower capital gains tax rates than ordinary income tax rates on dividends.

 

Unlike an investment in another firm's shares, the acquisition of a company's own shares does not create an asset.

   Perhaps the primary motivation for most stock repurchases is to offset the increase in shares that routinely are issued to employees under stock award and stock option compensation programs. Microsoft reported its stock buyback program designed to offset the effect of its stock option and stock purchase plans as shown in Graphic 18-5.

 

Companies buy back shares to offset the increase in shares issued to employees.

GRAPHIC 18-5
Disclosure of Share Repurchase Program—Microsoft

Real World Financials

 

Note 11: Stockholders' Equity (in part)

Our board of directors has approved a program to repurchase shares of our common stock to reduce the dilutive effect of our stock option and stock purchase plans.

   Similarly, shares might be reacquired to distribute in a stock dividend, a proposed merger, or as a defense against a hostile takeover.12

   The usual pattern of stock buybacks was interrupted by the recent economic decline. With corporate profits down and cash in short supply, companies drastically reduced their share repurchases. Companies in the S&P 500 reduced their buybacks in the first quarter of 2009 a whopping 73% from the first quarter a year earlier.13 For some companies, the decision was a choice between cutting buybacks or cutting dividends, and dividend reductions are more obvious and less palatable than curtailing a buyback program.

   Whatever the reason shares are repurchased, a company has a choice of how to account for the buyback:

   

1.

 

The shares can be formally retired.

2.

 

The shares can be called treasury stock.

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Shares Formally Retired or Viewed as Treasury Stock

When a corporation retires its own shares, those shares assume the same status as authorized but unissued shares, just the same as if they never had been issued. We saw earlier in the chapter that when shares are sold, both cash (usually) and shareholders' equity are increased; the company becomes larger. Conversely, when cash is paid to retire stock shares repurchased and not designated as treasury stock., the effect is to decrease both cash and shareholders' equity; the size of the company literally is reduced.

   Out of tradition and for practical reasons, companies usually reacquire shares of previously issued stock without formally retiring them.14 Shares repurchased and not retired are referred to as treasury stock shares repurchased and not retired.. Because reacquired shares are essentially the same as shares that never were issued at all, treasury shares have no voting rights nor do they receive cash dividends. As demonstrated in Illustration 18-5 on the next page, when shares are repurchased as treasury stock, we reduce shareholders' equity with a debit to a negative (or contra) shareholders' equity account labeled treasury stock. That entry is reversed later through a credit to treasury stock when the treasury stock is resold. Like the concepts of par value and legal capital, the concept of treasury shares no longer is recognized in most state statutes.15 Some companies, in fact, are eliminating treasury shares from their financial statements as corporate statutes are modernized. Microsoft retires the shares it buys back rather than labeling them treasury stock. Still, you will see treasury shares reported in the balance sheets of many companies.

 

FINANCIAL
Reporting Case

Q2, p.1007


Reacquired shares are equivalent to authorized but unissued shares.

p. 1026

ILLUSTRATION 18-5
Comparison of Share Retirement and Treasury Stock Accounting—Share Buybacks

Formally retiring shares restores the balances in both the Common stock account and Paid-in capital—excess of par to what those balances would have been if the shares never had been issued.

When we view a buyback as treasury stock the cost of acquiring the shares is debited to the treasury stock account.

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*Because there is a $2 million credit balance.

Accounting for Retired Shares

When shares are formally retired, we should reduce precisely the same accounts that previously were increased when the shares were sold, namely, common (or preferred) stock and paid-in capital—excess of par. The first column of Illustration 18-5 demonstrates this. The paid-in capital—excess of par account for American Semiconductor shows a balance of $900 million while the common stock account shows a balance of $100 million. Thus the 100 million outstanding shares were originally sold for an average of $9 per share above par, or $10 per share. Consequently, when 1 million shares are retired (regardless of the retirement price), American Semiconductor should reduce its common stock account by $1 per share and its paid-in capital—excess of par by $9 per share. Another way to view the reduction is that because 1% of the shares are retired, both share account balances (common stock and paid-in capital—excess of par) are reduced by 1%.

   How we treat the difference between the cash paid to buy the shares and the amount the shares originally sold for (amounts debited to common stock and paid-in capital—excess of par) depends on whether the cash paid is less than the original issue price (credit difference) or the cash paid is more than the original issue price (debit difference):

   

1.

 

If a credit difference is created (as in Case 1 of Illustration 18-5), we credit paid-in capital—share repurchase.

2.

 

If a debit difference is created (as in Case 2 of Illustration 18-5), we debit paid-in capital—share repurchase, but only if that account already has a credit balance. Otherwise, we debit retained earnings. (Reducing the account beyond its previous balance would create a negative balance.)

   Why is paid-in capital credited in Case 1 and retained earnings debited in Case 2? The answer lies in the fact that the payments made by a corporation to repurchase its own shares are a distribution of corporate assets to shareholders.

   In Case 1, only $7 million is distributed to shareholders to retire shares that originally provided $10 million of paid-in capital. Thus, some of the original investment ($3 million in this case) remains and is labeled paid-in capitalshare repurchase.

p. 1027

   In Case 2, more cash ($13 million) is distributed to shareholders to retire shares than originally was paid in. The amount paid in comprises the original investment of $10 million for the shares being retired plus $2 million of paid-in capital created by previous repurchase transactions—$12 million total. Thirteen million is returned to shareholders. The additional $1 million paid is viewed as a dividend on the shareholders' investment, and thus a reduction of retained earnings.16

 

Paid-in capital—share repurchase is debited to the extent of its credit balance before debiting retained earnings.

Payments made by a corporation to retire its own shares are viewed as a distribution of corporate assets to shareholders.

Accounting for Treasury Stock

We view the purchase of treasury stock as a temporary reduction of shareholders' equity, to be reversed later when the treasury stock is resold. The cost of acquiring the shares is “temporarily” debited to the treasury stock account (second column of Illustration 18-5). At this point, the shares are considered to be issued, but not outstanding.

   Recording the effects on specific shareholders' equity accounts is delayed until later when the shares are reissued. In the meantime, the shares assume the fictional status we discussed earlier of being neither unissued nor outstanding. Effectively, we consider the purchase of treasury stock and its subsequent resale to be a “single transaction.”

 

When a share repurchase is viewed as treasury stock, recording the effects on specific shareholders’ equity accounts is delayed until the shares are reissued.

  
ADDITIONAL CONSIDERATION

The approach to accounting for treasury stock we discuss in this chapter is referred to as the “cost method.” Another permissible approach is the “par value method.” It is essentially identical to formally retiring shares, which is why it sometimes is referred to as the retirement method of accounting for treasury stock. In fact, if we substitute Treasury stock for Common stock in each of the journal entries we used to account for retirement of shares in Illustrations 18-5 and 18-6, we have the par value method. Because the method has virtually disappeared from practice, we do not discuss it further in this chapter.

  

BALANCE SHEET EFFECT.   Formally retiring shares restores the balances in both the Common stock account and Paid-in capital—excess of par to what those balances would have been if the shares never had been issued at all. As discussed above, any net increase in assets resulting from the sale and subsequent repurchase is reflected as Paid-in capital—share repurchase. On the other hand, any net decrease in assets resulting from the sale and subsequent repurchase is reflected as a reduction in retained earnings.

   In contrast, when a share repurchase is viewed as treasury stock, the cost of the treasury stock is simply reported as a reduction in total shareholders' equity. Reporting under the two approaches is compared in Graphic 18-6 using the situation described above for American Semiconductor after the purchase of treasury stock in Illustration 18-5 (Case 2) on page 1026. Notice that either way total shareholders' equity is the same.

GRAPHIC 18-6
Reporting Share Buyback in the Balance Sheet

Retirement reduces common stock and associated shareholders' equity accounts.

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p. 1028

Resale of Shares

After shares are formally retired, any subsequent sale of shares is simply the sale of new, unissued shares and is accounted for accordingly. This is demonstrated in the first column of Illustration 18-6.

 

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ILLUSTRATION 18-6

Comparison of Share Retirement and Treasury Stock Accounting—Subsequent Sale of Shares

After formally retiring shares, we record a subsequent sale of shares exactly like any sale of shares.

The resale of treasury shares is viewed as the consummation of the “single transaction” begun when the treasury shares were purchased.

   American Semiconductor sold 1 million shares after reacquiring shares at $13 per share (Case 2 in Illustration 18-5).

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    *Because there is a $2 million credit balance.

   The resale of treasury shares is viewed as the consummation of the single transaction begun when the treasury shares were repurchased. The effect of the single transaction of purchasing treasury stock and reselling it for more than cost (Case 2 of Illustration 18-5 and Case A of Illustration 18-6) is to increase both cash and shareholders' equity (by $1 million). The effect of the single transaction of purchasing treasury stock and reselling it for less than cost (Case 2 of Illustration 18-5 and Case B of Illustration 18-6) is to decrease both cash and shareholders' equity (by $3 million).

 

Allocating the cost of treasury shares occurs when the shares are resold.

   Note that retained earnings may be debited in a treasury stock transaction, but not credited. Also notice that transactions involving treasury stock have no impact on the income statement. This follows the reasoning discussed earlier that a corporation's buying and selling of its own shares are transactions between the corporation and its owners and not part of the earnings process.

 

Determining the cost of treasury stock sold is similar to determining the cost of goods sold.

  
ADDITIONAL CONSIDERATION

Treasury Shares Acquired at Different Costs

Notice that the treasury stock account always is credited for the cost of the reissued shares ($13 million in Illustration 18-6). When shares are reissued, if treasury stock on hand has been purchased at different per share prices, the cost of the shares sold must be determined using a cost flow assumption—FIFO, LIFO, or weighted average—similar to determining the cost of goods sold when inventory items are acquired at different unit costs.

  

CONCEPT REVIEW EXERCISE

TREASURY STOCK

Situation: The shareholders' equity section of the balance sheet of National Foods, Inc., included the following accounts at December 31, 2010.

p. 1029

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Required:

1.

 

National Foods reacquired common shares during 2011 and sold shares in two separate transactions later that year. Prepare the entries for both the purchase and subsequent sale of shares during 2011 assuming that the shares were (a) retired and (b) considered to be treasury stock.

a.

 

National Foods purchased 6 million shares at $10 per share.

b.

 

National Foods sold 2 million shares at $12 per share.

c.

 

National Foods sold 2 million shares at $7 per share.

2.

 

Prepare the shareholders' equity section of National Foods' balance sheet at December 31, 2011, assuming the shares were both (a) retired and (b) viewed as treasury stock. Net income for 2011 was $400 million, and preferred shareholders were paid $1 million cash dividends.


SOLUTION

1.

 

National Foods reacquired common shares during 2011 and sold shares in two separate transactions later that year. Prepare the entries for both the purchase and subsequent sale of shares during 2011 assuming that the shares were (a) retired and (b) considered to be treasury stock.

a.

 

National Foods purchased 6 million shares at $10 per share:

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b.

 

National Foods sold 2 million shares at $12 per share: ($ in millions)

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c.

 

National Foods sold 2 million shares at $7 per share: ($ in millions)

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2.

 

Prepare the shareholders' equity section of National Foods' balance sheet at December 31, 2011, assuming the shares were both (a) retired and (b) viewed as treasury stock.

p. 1030

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Note: This situation is continued in the next Concept Review Exercise on page 1038.

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The FASB and IASB are working together on a project, Financial Statement Presentation, to establish a common standard for presenting information in the financial statements, including classifying and displaying line items and aggregating line items into subtotals and totals. This standard will have a dramatic impact on the format of financial statements. An important part of the proposal involves the organization of elements of the balance sheet (statement of financial position), statement of comprehensive income (including the income statement), and statement of cash flows into a common set of classifications.

   A key feature of the new format is that each of the financial statements will include classifications by operating, investing, and financing activities (similar to the current statement of cash flows), providing a “cohesive” financial picture that stresses the relationships among the financial statements.

   For each statement, though, operating and investing activities will be included within a new category, “business” activities. Each statement also will include three additional groupings: discontinued operations, income taxes, and equity (if needed). The new look for the financials will be:

The FASB and IASB are working together on a standard that would have a dramatic impact on the format of financial statements.

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p. 1031

   Notice that we would have an equity section, not just in the balance sheet, but in the other statements as well. The proposal doesn't change the elements in the equity section of the balance sheet. Changes in equity items would be presented in the equity section of the statement of cash flows (for example cash dividends) and in the statement of changes in equity, which is essentially the same as the current statement of shareholders' equity described in this chapter. In a sense, the statement of comprehensive income also reports changes in equity because net income increases retained earnings and other comprehensive income changes accumulated OCI, both components of equity. The new format also standardizes the presentation of a separate statement of comprehensive income as opposed to the presentation choices available now.

Demonstrating the cohesiveness among the financial statements is a key objective of the Financial Statement Presentation project.

Each statement is slated to have an equity section.




10“Bullion Monarch Mining Announces Results of Stock Buyback Program for FY 2009,” Forbes.com, July 6, 2009.

11“Walmart Plans to Buy Back $15 Billion in Shares,” Bloomberg.com, June 1, 2009.

12A corporate takeover occurs when an individual or group of individuals acquires a majority of a company's outstanding common stock from present shareholders. Corporations that are the object of a hostile takeover attempt—a public bid for control of a company's stock against the company's wishes—often take evasive action involving the reacquisition of shares.

13Ben Steverman, “The Incredible Shrinking Stock Buyback,” BusinessWeek, June 19, 2009.

14The concept of treasury shares originated long ago when new companies found they could sell shares at an unrealistically low price equal to par value to incorporators, who then donated those shares back to the company. Since these shares already had been issued (though not outstanding), they could be sold at whatever the real market price was without adjusting stated capital.

Because treasury shares are already issued, different rules apply to their purchase and resale than to unissued shares. Companies can:

   

a.

 

Issue shares without regard to preemptive rights of shareholders.

b.

 

Distribute shares as a dividend to shareholders even without a balance in retained earnings.

15The Revised Model Business Corporation Act eliminated the concept of treasury shares in 1984 after 1980 revisions had eliminated the concepts of par value and legal capital. Most state laws have since followed suit.

16In the next section of this chapter, you will be reminded that dividends reduce retained earnings. (You first learned this in your introductory accounting course.)

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