Treasury stock and share buyback accounting.
How does it work, and how does it affect the financial statements?
In this video we show how purchases of treasury stock (or "share buybacks") affect the cash
flow statement and the balance sheet, we walk through the accounting for both share buybacks
as well as re-issuing shares, and discuss the effect of share buybacks on earnings per share.
All of this in the context of a real-life example, so this goes beyond just the textbook explanation!
While analyzing annual reports, I often start with the cash flow statement, as this provides
great insights to a company's strategic decisions as well as its performance.
One example of a company that I follow is Adobe, a computer software company.
They started off their fiscal year 2017 with $1 billion in cash, and ended the year with $2.3 billion.
Cash from operating activities was a major inflow of $2.9 billion,
cash from investing activities an outflow of $400 million,
and cash from financing activities an outflow of $1.2 billion.
In the discussion of the financial results, Adobe explains that the CFFA movements were
mostly related to treasury stock: buybacks as well as issuance.
Adobe's stock repurchase program is designed to return value to shareholders and minimize
dilution from stock issuances.
The company gives an overview of the stock repurchases by fiscal year
and by board-approved repurchase plan.
8.2 million shares were bought back in fiscal 2017, at an average of $134 per share, for
a total amount of nearly $1.1 billion.
How does Adobe account for share buybacks?
Under the cost method, simply debit treasury stock, and credit cash.
Both of these are balance sheet accounts, there is no gain or loss in the income statement.
Treasury Stock is not an asset account, but a contra-equity account, meaning that it reduces
the amount of equity, which we will see next.
The journal entry reduces cash and equity by the same amount.
There is no automatic retirement of the bought-back shares, they are still considered issued but
not outstanding.
This is the line item overview of the equity balance for Adobe per the year-end of fiscal
2016 on the right and fiscal 2017 on the left.
The treasury stock balance within the equity section is $5.1 billion at year-end 2016,
and $6.1 billion at year-end 2017.
As you can see, treasury stock is a contra-equity account, it reduces the overall balance.
This more detailed overview shows the same $5.1 billion at the top, and $6.1 billion
at the bottom, as well as the number of shares that this represents.
Our $1.1 billion for the purchase of treasury stock is in the overview as a line item, and
so is the $150 million partial offset in the same treasury stock account from the proceeds
of re-issuing treasury stock under stock compensation plans.
Accounting for re-issuing treasury stock has three variations.
In all three of these, only balance sheet accounts are used, there is no gain or loss
in the income statement.
When treasury stock is re-issued at a price higher than its cost, the difference (or surplus)
is recorded as a component of additional paid-in-capital.
Debit cash (for the cash receipt), credit treasury stock (at the amount per share that
they were purchased for in the share buyback), and credit additional paid-in capital (for
the "surplus" between re-issue price and repurchase cost, times the number of shares).
When treasury stock is re-issued at a price lower than its cost, the difference is recorded
as a component of additional paid-in-capital to the extent that there are previously recorded
gains to offset the losses.
Basically the same journal entry as above, but now with a debit in
additional paid-in capital rather than a credit.
The stock is re-issued at a price lower than its cost.
A debit in paid-in capital lowers the overall equity balance (a partial offset to the credit
in treasury stock).
If there are no treasury stock gains in additional paid-in-capital, the losses upon re-issuance
of treasury stock are recorded as a reduction of retained earnings.
Similar journal entry as the second option above.
A debit in retained earnings lowers the overall equity balance (a partial offset to the credit
in treasury stock).
How do share repurchases affect earnings per share?
Adobe explains that shares physically delivered by December 1st, 2017 were excluded from the
computation of earnings per share.
Here's the financial performance summary that includes the earnings per share calculation,
with at the bottom the number of shares used to compute EPS.
This number of shares is lower than the year before, under both ways (basic and diluted)
of calculating.
As Earnings Per Share is net income divided by number of shares, a decrease in the denominator
of the equation will help make this financial indicator go up.
That's a quick and practical explanation of how purchases of treasury stock (or "share
buybacks") affect the cash flow statement and the balance sheet, an overview of the
accounting for both share buybacks as well as re-issuing shares, and a look at the effect
of share buybacks on earnings per share.
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