Reacquiring shares of stock

Companies sometimes acquire their own shares of stock. Such shares may be used for employee incentive programs, future mergers with other companies, or for other reasons. In general, when a company acquires its own stock, its resources (assets) decrease and its sources of resources (stockholders' equity) decrease. The specific accounts affected depend upon the type of stock purchased and what management intends to do with the shares.

Reacquiring common stock When a company acquires its own common stock, it may either retire the shares or hold them for future use. To understand the effects of both options, it may be helpful to review three aspects of common stock. First, the total number of shares a company may issue, based on its articles of incorporation, is called its authorized shares. Second, the total number of shares sold to owners is called issued shares. Third, the total number of shares in the hands of owners is called outstanding shares. As you will see in the following discussion of treasury stock, it is possible for a company's issued shares to differ from its outstanding shares. At this point, however, assuming treasury stock does not exist, a company's issued shares will equal its outstanding shares and both will be less than its authorized shares.

For example, assume a company's articles of incorporation provide for the possibility of 40,000 common shares to be sold. In such a case, the company's authorized common shares are 40,000. If 10,000 common shares are sold to owners, the company's issued shares become 10,000. If all 10,000 issued shares remain in the hands of owners, the company's outstanding shares are also 10,000. As a result, the company's authorized shares (40,000) are more than its issued shares (10,000) and outstanding shares (10,000). Note also that the number of issued shares (10,000) equals the number of outstanding shares (10,000).

Retiring common stock When a company retires some of its common stock, it purchases them from owners and reduces the number of shares issued and the number of shares outstanding. Such shares continue to be authorized shares and may be issued by the company again at a later date. Continuing the above example, it the company retires 500 common shares, its authorized shares remain at 40,000, its issued shares fall to 9,500 (10,000 500), and its outstanding shares fall to 9,500 (10,000 500).

The financial effects of a company retiring its own common stock, are a decrease in resources (assets) and an equal decrease in sources of resources (stockholders' equity). Assets and stockholders' equity both decrease by the dollar amount the company pays to acquire the stock.

For example on October 11, if the company acquired the 500 common shares at a price of $5 per share, show the effects on the company's resources and sources of resources.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

- $2,500
cash

=

 

 

- $1,000
common stock

- $1,500 additional paid-in capital, common stock

 

 

The cash payment for the 500 shares reduces the company's resources (assets) as the $2,500 cash flows out to owners (500 shares x $5 per share = $2,500). The company's sources of resources (stockholders' equity) decrease by $2,500 because the owners' rights to the company have been reduced. The common stock account was reduced by the $1,000 par value of the number of shares retired (500 shares x $2 par = $1,000). The $1,500 reduction of the additional paid-in capital, common stock account represents the elimination of the amount of additional paid-in capital, common stock originally recorded when the stock was issued to owners. Remember, the 10,000 shares were originally sold to owners at $5 per share. Thus, each common share had been issued at $3 above par ($5 per share sales price - $2 per share par = $3 additional paid-in capital). If the company had paid $4 per share to acquire the 500 shares, additional paid-in capital would have been reduced by only $1,000 [500 shares x ($4 purchase price - $2 par) = $1,000]. If the company had paid $9 per share to acquire the 500 shares, additional paid-in capital would have been reduced by $1,500 and retained earnings would have been reduced by $2,000 [500 shares x ($9 purchase price - $2 par - $3 additional paid-in capital) = $2,000]. Regardless of the specific accounts affected, the most important point of retiring common stock is the decrease in the company's resources and sources of resources. Managers are concerned about retiring stock because the process reduces the amount of resources they have to work with in the future. From an accounting standpoint, it is important to note that gains or losses are not recorded on the retiring of common stock. Since such transactions do not involve customers, but are strictly transactions between the company and its owners, any "gains or losses" affect contributed capital or retained earnings and do not appear on the income statement.

Remembering that assets increase with debits and that debits must equal credits, prepare the journal entry to record the $2,500 cash payment to retire 500 shares of the company's common stock.
 

  Date

Description

Post.
Ref.

Debits

Credits

Oct. 11

Common Stock

 

1,000

 

 

Additional Paid-in Capital, Common Stock

 

1,500

 

 

    Cash

 

 

2,500

 

Common stock retired

 

 

 


 

** You now have the background to do text exercise 12.13.
 

Treasury stock When a company acquires some of its own stock and holds it rather than retiring it, such shares are called treasury stock. The shares continue to be authorized shares and may be used by the company again at a later date but they are not currently in the hands of owners. Although the treasury shares were authorized (in the articles of incorporation) and had been issued to owners, they are not outstanding because they are not being held by owners. Continuing the above example, if the company acquires 500 common shares and does not retire them, its authorized shares remain at 40,000, its issued shares also remain at 10,000, while its outstanding shares fall to 9,500 (10,000 500). Thus, when a company has treasury stock, its issued shares differ from its outstanding shares. Since treasury stock shares are not in the hands of owners, such shares are not eligible to vote on any stockholders' issues, nor are such shares eligible to receive cash dividends. Many companies use treasury stock for employee stock purchase plans to provide incentives to employees. The companies acquire their own shares, hold them until employees achieve certain goals, and then distribute the shares to employees. More advanced accounting courses will discuss the accounting for treasury stock and employee benefits.

The financial effects of a company acquiring its own common stock and holding it, are a decrease in resources (assets) and an equal decrease in sources of resources (stockholders' equity). Assets and stockholders' equity both decrease by the dollar amount the company pays to acquire the stock.

For example on October 11, if the company acquired the 500 common shares at a price of $5 per share, show the effects on the company's resources and sources of resources.
 

Total
Resources

=

Sources of
Borrowed
Resources

+

Sources of
Owner Invested
Resources

+

Sources of
Management Generated
Resources

Assets

=

Liabilities

+

Stockholders' Equity

- $2,500
cash

=

 

 

- $2,500

treasury stock

The cash payment for the 500 shares reduces the company's resources (assets) as the cash flows out to owners. The company's sources of resources (stockholders' equity) decrease by $2,500 because the owners' rights to the company have been reduced. The $2,500 reduction in stockholders' equity was recorded in the treasury stock account. Notice the common stock account and additional paid-in capital, common stock account were not affected by the purchase of treasury stock. This is because the common stock has not been retired. It was issued to owners, purchased by the company, and is still being held by the company.  Notice, also, that the decrease in stockholders' equity was not shown in either the sources of owner invested resouces column or the sources of management generated resources column.  The actual stockholders' equity accounts ultimately affected by treasury stock depend upon the par value of the shares, the price at which the shares were originally issued to owners, the price paid by the company when it reacquired the shares, and the final use of the treasury stock by the corporation.  As long as the treasury stock is held by the corporation, the dollar amount of the treasury stock appears in the treasury stock account, which is reported as a separate account in stockholders' equity.

Remembering that assets increase with debits and that debits must equal credits, prepare the journal entry to record the $2,500 cash payment to acquire 500 shares of the company's own common stock to be held by the company.
 

  Date

Description

Post.
Ref.

Debits

Credits

Oct. 11

Treasury Stock

 

2,500

 

 

    Cash

 

 

2,500

 

Treasury stock purchased

 

 

 

The treasury stock account is a contra stockholders' equity account: it is a stockholders' equity account with a debit balance. It is usually the last stockholders' equity account on a company's balance sheet, as can be seen below.
 

Stockholders' Equity

 

Contributed Capital

 

  8% Preferred Stock, $10 par, 5,000 shares authorized, 1,000 shares issued

$10,000

  Common Stock, $2 par, 40,000 shares authorized, 10,000 shares issued

$20,000

  Additional Paid-in Capital, Preferred Stock

$2,000

  Additional Paid-in Capital, Common Stock

$30,000

Total Contributed Capital

$62,000

Retained Earnings

$136,000

Less: Treasury Stock, 500 shares

$2,500

Total Stockholders' Equity

$195,500

Based on the above stockholders' equity section, the company has 40,000 common shares authorized, 10,000 shares issued, and 9,500 shares outstanding (10,000 shares issued 500 treasury shares). This means the company has 30,000 more shares it can issue (40,000 shares authorized 10,000 shares issued) and 500 shares it can use for such things as employee incentive programs ( 500 treasury shares).
 

Practice Exercise

The Christopher Corporation's articles of incorporation provided for the sale of 10,000,000 shares of $.05 par common stock.  As of November 30, 6,000,000 shares had been sold, 10,000 shares had been acquired by the company and retired, and 8,000 shares had been acquired by the company and were still being held.

1.  Calculate the Christopher Corporation's number of issued shares as of November 30.

Issued shares are the number of shares sold but not retired.  Issued shares include any shares being held as treasury stock.  On November 30, the Christopher Corporation's issued shares are 5,990,000 (6,000,000 shares sold - 10,000 shares retired).

2.  Calculate the Christopher Corporation's number of outstanding shares as of November 30.

Outstanding shares are shares sold to owners and still owned by them.  Treasury shares are not included in outstanding shares because they are not owned by stockholders.  On November 30, the Christopher Corporation's outstanding shares are 5,982,000 (5,990,000 shares issued - 8,000 treasury shares).

3.  Calculate the number of common shares eligible to vote for the Christopher Corporation's board of directors and receive cash dividends as of November 30.

5,982,000 common shares.  Only owners of outstanding shares are eligible to vote for the board of directors and receive cash dividends.  Retired shares and treasury shares do not have voting rights or rights to cash dividends.
 

** You now have the background to do text exercises 12.14 and 12.15.

 

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