Treasury Stock Accounting | Cost Method and Constructive Retirement Method
/What is Treasury Stock?
A company may elect to buy back its own shares, which are then called treasury stock. There are many reasons for the repurchase of stock, which include the following:
A stock buyback program that is intended to reduce the overall number of shares and thereby increase the earnings per share. This action can also increase the price of the stock, especially if a company has a policy of buying its own shares whenever the price falls below a certain threshold level.
When a company is forced to buy back shares from someone who is attempting to gain control of the business.
When a company has the right of first refusal to reacquire shares. This is a common situation when the current owners want to keep additional parties from gaining ownership of the business.
When management wants to take a publicly-held company private, and needs to reduce the number of shareholders in order to do so. The Securities and Exchange Commission imposes a maximum number of shareholders that a business can have while still being privately held, so a stock repurchase plan is needed to buy out the excess number of shareholders.
A business has no alternative use for excess cash, and so elects to use it on a stock repurchase. This makes the most sense when the market price of the shares is low, so that the business is removing a large number of shares from circulation in exchange for its cash outlay.
Management may intend to permanently retire these shares, or it could intend to hold them for resale or reissuance at a later date. Stock that has been repurchased does not qualify for voting purposes, nor should it be included in the earnings per share calculation that is reported by publicly-held businesses.
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How to Account for Treasury Stock
The two aspects of accounting for treasury stock are the purchase of stock by a company, and its resale of those shares. We deal with these treasury stock transactions next.
The Cost Method
The simplest and most widely-used method for accounting for the repurchase of stock is the cost method. The accounting covers the topics noted below.
Cost Method Stock Repurchase
To record a repurchase, simply record the entire amount of the purchase in the treasury stock account.
Cost Method Stock Resale
If the treasury stock is resold at a later date, offset the sale price against the treasury stock account, and credit any sales exceeding the repurchase cost to the additional paid-in capital account. If the sale price is less than the repurchase cost, charge the differential to any additional paid-in capital remaining from prior treasury stock transactions, and any residual amount to retained earnings if there is no remaining balance in the additional paid-in capital account.
Cost Method Stock Retirement
If management decides to permanently retire stock that it has already accounted for under the cost method, it reverses the par value and additional paid-in capital associated with the original stock sale, with any remaining amount being charged to retained earnings.
Example of the Cost Method
The board of directors of Armadillo Industries authorizes the repurchase of 50,000 shares of its stock, which has a $1 par value. The company originally sold the sales for $12 each, or $600,000 in total. It repurchases the shares for the same amount. The controller records the transaction with this entry:
| Debit | Credit | |
| Treasury stock | 600,000 | |
| Cash | 600,000 |
Later, the company has a choice of either selling the shares to investors again, or of permanently retiring the shares. If the board were to resell the shares at a price of $13 per share, the entry would be:
| Debit | Credit | |
| Cash | 650,000 | |
| Additional paid-in capital | 50,000 | |
| Treasury stock | 600,000 |
Alternatively, the board may elect to retire the shares. If it were to do so, the entry would be:
| Debit | Credit | |
| Common stock, $1 par value | 50,000 | |
| Additional paid-in capital | 550,000 | |
| Treasury stock | 600,000 |
Constructive Retirement Method
An alternative method of accounting for treasury stock is the constructive retirement method, which is used under the assumption that repurchased stock will not be reissued in the future. Under this approach, you are essentially reversing the amount of the original price at which the stock was sold. The remainder of the purchase price is debited to the retained earnings account.
Example of the Constructive Retirement Method
The board of directors of Armadillo Industries authorizes the repurchase of 100,000 shares of its stock, which has a $1 par value. The company originally sold the shares for $12 each, or $1,200,000 in total. Armadillo pays $1,500,000 to repurchase the shares. The controller records the transaction with this journal entry:
| Debit | Credit | |
| Common stock, $1 par value | 100,000 | |
| Additional paid-in capital | 1,100,000 | |
| Retained earnings | 300,000 | |
| Cash | 1,500,000 |
In the journal entry, the controller is eliminating the $100,000 originally credited to the common stock account and associated with its par value. There is also an elimination from the additional paid-in capital account of the $1,100,000 originally paid into that account. The excess expenditure over the original proceeds is charged to the retained earnings account.
Presentation of Treasury Stock
None of the entries associated with treasury stock transactions appear on the income statement; instead, the entries are confined to the balance sheet. Treasury stock is presented within the equity section of the balance sheet, as a deduction from the other equity line items.