What’s Behind Treasury Stock?
If a company buys back some of its own stock, then the market price of the company’s stock may go up, plans may be in the works for an expansion or the Board of Directors may anticipate a hostile takeover. If management is simultaneously converting stock options as part of a compensation plan, then there may be little impact on stock price at all. How can a user of financial statements be alerted to these potential activities so she can ask the right questions? The answer (in part): By understanding the accounting for treasury stock purchases and the presentation on financial statements in accordance with Generally Accepted Accounting Principles (GAAP).
When a company reacquires stock that was previously issued and holds it for a future use, the stock is identified as "Treasury Stock." The main reporting concern behind the accounting for treasury stock purchases and any subsequent resales is to reflect the transactions as changes to equity accounts. Revenue and expense accounts are never impacted by these transactions which might mislead a financial statement reader.
There are two different methods of accounting for the purchase of treasury stock: the cost method and the par method. The cost method is more widely used and is discussed below. See What is Treasury Stock and What Does It Mean for the Investor? for more background information on treasury stock.
The following example is used to illustrate the cost method of accounting for treasury stock purchases by a corporation and the subsequent resale. Click on the image below to see the Stockholders’ Equity accounts of My Computer Company.
Acquisition of Treasury Stock
My Computer Company has decided to repurchase 1,000 shares of the common stock that is currently outstanding at a price of $4 per share. The journal entry to record this transaction is as follows:
Dr. Treasury Stock $4,0000
……………………Cr. Cash $4,000
To record the purchase of 1,000 shares of treasury stock at $4 per share.
Click on the image below to view how the Stockholders’ Equity section will look.
The notable change is that Treasury Stock is a "contra" stockholders’ equity account (as opposed to an asset account) and reduces total stockholders’ equity. The paid-in-capital for common stock does not change because the amount authorized does not change. However, the shares outstanding in the description are reduced by 1,000 shares.
Subsequent Resale of Stock
My Computer Company can decide to resell or retire the treasury stock at any time. In our example, 1,000 shares of treasury stock are later sold at a price of $5 share. The journal entry to record this transaction is as follows:
Dr. Cash $5,0000
……………………Cr. Treasury Stock $4,000
……………………Cr. Paid-in Capital from Treasury Stock $1,000
To record the sale of 1,000 shares of treasury stock at $5 per share.
Click on the image below to view how the Stockholders’ Equity section will look after this transaction has been recorded.
The important point is that the sale did not result in income which might be misunderstood by the user of a financial statement. If the subsequent resale was at a lower price, for example $2 per share, the difference reduces Paid-in Capital from Treasury Stock.
Images are courtesy of Marjory Pilley