Repurchase of Shares

Companies often repurchase their own shares, an action known as “share buybacks.” Share repurchase can be driven by various motivations, including tax benefits, enhancing financial ratios, and offering flexibility for future use of the shares. By reacquiring shares, companies alter their capital structure and manage stockholder equity efficiently.

Reasons for Share Repurchase

Tax-Efficient Distribution
- Companies may opt to distribute excess cash to shareholders in a tax-efficient manner through buybacks.
- Capital gains on share sales often incur lower tax rates than ordinary dividends, benefiting investors by nearly halving the tax implications.
- This approach is favorable, especially when the taxation environment discourages heavy dividend payouts.
Improving Earnings per Share (EPS)
- By reducing the number of shares outstanding, companies can boost their EPS, thus potentially increasing the market perception of their profitability.
- Enhanced EPS may drive share prices up, aligning with shareholder interests, though it’s not always a long-term strategy for value enhancement.
Stock for Employee Compensation
- Some companies retain repurchased shares for employee stock compensation programs or to fulfill stock option plans.
- By holding these shares, companies are prepared for stock grants without issuing new shares, which can dilute ownership percentages.
Thwarting Hostile Takeovers
- Repurchasing shares limits the shares available to potential hostile investors, helping existing management maintain control.
- In situations where external entities attempt to gain influence, buybacks serve as a defensive strategy to protect current ownership structures.
Stabilizing the Market Price
- Corporations sometimes repurchase shares to create a demand floor, preventing excessive price drops.
- This action can provide stability, particularly during periods of market volatility, offering reassurance to current investors.

Treasury Stock: Understanding the Concept

Definition: Treasury stock represents a corporation’s own shares that have been reacquired after issuance and are held in the treasury.
Not an Asset: Treasury stock is not considered a corporate asset and does not represent ownership or voting rights.
Impact on Equity: Treasury stock transactions reduce both assets and stockholders’ equity without adding new assets or resources to the company.

Accounting for Treasury Stock

Companies use two primary accounting methods for treasury stock:

Cost Method
- This method records treasury stock at the reacquisition cost.
- Each purchase of treasury stock debits the “Treasury Stock” account and credits cash.
- Upon resale, any difference between cost and resale price is recorded in equity accounts, not as gains or losses.
Par Value Method
- Under this approach, treasury stock is recorded at par or stated value.
- All transactions involving treasury shares are logged as deductions from capital stock, showing treasury stock as a reduction in contributed capital.

Practical Example of Treasury Stock Transactions

Let’s explore an example:

Example Scenario: Luna Corp. issues 50,000 shares at $8 per share, then repurchases 5,000 of those shares at $10 each.
Cost Method:
- Purchase of 5,000 shares: Debit Treasury Stock $50,000 (5,000 x $10), Credit Cash $50,000.
- Sale of 1,000 shares at $12 each: Debit Cash $12,000, Credit Treasury Stock $10,000, and record $2,000 in “Paid-in Capital from Treasury Stock” for the excess.
Par Value Method:
- Treasury stock is recorded based on par value, adjusting capital stock rather than adding equity from the sale.

Balance Sheet Presentation

When showing treasury stock on the balance sheet:

It is typically displayed as a deduction in the equity section, reducing overall stockholders’ equity.
The company does not recognize gains or losses from treasury stock transactions in income, as these transactions do not involve new income.

Situations of Repurchase Above Market Value (Greenmail)

In certain scenarios, a company may acquire treasury stock at a premium price, typically to deter unwanted takeover attempts. This premium is recorded in a specific account, often labeled as “greenmail,” representing an agreement to avoid additional stock acquisitions. The excess paid is not capitalized but expensed as part of the acquisition-related costs.

Donated Treasury Stock

Companies may receive donations of treasury stock from shareholders or government entities, especially in cases where additional cash flow is essential. According to GAAP, this donated stock is recorded as a gain at fair market value on the transaction date, strengthening stockholders’ equity.

Retirement of Treasury Stock

When a board decides to retire treasury stock:

It results in a permanent reduction in capital stock, effectively decreasing the number of shares issued and reducing stockholders’ equity.
Retirement entries offset treasury stock costs against contributed capital and retained earnings, removing shares from circulation.

Example: Assume Horizon Inc. retires 2,000 shares of $5 par value stock, initially acquired at $6 each. The retirement entry would:

Debit Common Stock at par ($5 x 2,000 = $10,000).
Credit Treasury Stock ($6 x 2,000 = $12,000).
Debit Retained Earnings or Paid-in Capital for the $2,000 excess.

Conclusion

Repurchasing shares offers flexibility for corporations to manage ownership structure, incentivize employees, and stabilize market prices. However, it impacts the company’s financial statements by adjusting equity without providing new assets. Proper accounting for treasury stock ensures transparent equity management, benefiting shareholders and adhering to legal requirements.