August 2000


By Joseph R. Oliver and Katherine S. Moffeit

In an era of abundant IPOs and stock placements, corporations also are announcing record buybacks of their outstanding shares. Repurchases serve a variety of purposes, from increasing earnings per share to providing stock for employee benefit plans.

Although buybacks can be a sound part of a publicly held corporation’s financial strategy, they are complex endeavors that involve SEC rules, proper accounting and disclosure under GAAP, and certain federal income tax implications.

Reasons for Buybacks

A recent poll by the Financial Executives Institute (FEI) identified the following top reasons for repurchases of stock by publicly held corporations:

Earnings and capital markets. Although many fast-growing companies in the headlines do not currently report profits, traditional investment analysis still examines elements such as earnings per share, price-earnings ratios, and dividends per share. These measurements benefit when fewer shares are outstanding. Often, by expressing confidence in the company’s future and its share values, a buyback announcement from the board of directors boosts share prices, which increases the stock’s price-earnings ratio.

Announcing its intent to reacquire stock signals to the capital markets that the corporation has excess cash and is willing to use it for the direct benefit of shareholders, many of whom prefer increased share values to dividends. Cash dividends are subject to federal income tax rates up to 39.6%, but long-term capital gain on the sale of stock is taxed at no more than 20% for federal purposes. A shareholder may sell as many or as few shares as desired, depending on the need for cash or the preference to remain invested.

Dividend policy. If a company pays cash dividends, it generally must aim for stable dividends. Shareholders that rely on dividend income will not invest in a corporation with fluctuating dividends. Swings in dividends per share also send mixed signals to the financial markets and may themselves influence share values.

In years of high cash inflow, a company can use excess cash for new projects or acquisitions, but opportunities offering a return exceeding the cost of capital vary from year to year. A corporation may retain unused cash for later and invest it temporarily in interest-bearing securities. However, if the company shifts a significant part of business resources into low-yield investments, the overall return on assets and the market value of outstanding shares decreases. Repurchasing stock may be a better use for excess cash.

Debt-to-equity ratio. For many companies, an important objective is the fine-tuning of the ratio of debt financing to equity financing in order to maintain a high credit rating, borrow at low interest rates, and minimize the weighted average cost of financial resources. While creditors require a cushion of shareholder equity, repayments of maturing debt sometimes increase the percentage of financing from equity and the average cost of capital. Adjustments to capital via share repurchases adjust the ratio and minimize the cost of capital.

Employee compensation. Companies often use reacquired shares for employee stock benefit plans, performance-based compensation arrangements that avoid the $1 million cap of IRC section 162(m), and other incentive and retirement plans. Increasing the percentage of stock held by employees sometimes decreases the possibility of a hostile takeover. Reselling unneeded stock may increase paid-in capital. If a repurchase program coincides with a period of rising stock prices, the corporation can hold shares in the treasury to appreciate during the interim. Buying stock when prices dip or across a period of time reduces the likelihood that a company will need to purchase shares at high prices to satisfy peak employee demand.

SEC Rules

The company itself is covered by the SEC rules that prohibit insider trading in a public corporation’s stock. A corporation may not repurchase its own stock before any material inside information is reported to the public; a company should announce the decision to buy back stock before commencing actual purchases.

The SEC’s complex section 240.10b-18, referred to as Rule 10b-18, is generally regarded as the safe harbor for stock buybacks, although it does not provide absolute protection from litigation. Highlights of Rule 10b-18, which also provides various exceptions and traps, include the following:

Time. A corporation generally may not perform the opening trade on any day and may not trade during the 30 minutes before the market closes. The same restrictions apply to any affiliated purchasers, such as advisors involved in the decision to buy back stock.

Volume. During any one day, a corporation generally may not buy more stock than the larger of one round lot (generally 100 shares) or the number of round lots nearest to equaling 25% of the stock’s average daily trading volume for the four calendar weeks preceding the start of the buyback program.

Block purchases, which may be privately negotiated outside of the market, typically are not subject to the volume restriction if each block--

Price. A corporation generally may not reacquire its stock with a purchase price or bid that exceeds the greater of the highest current independent bid quotation or the last independent sale price. Affiliated purchasers are bound to the same ceiling.

Broker or dealer. Only one broker or dealer may be employed on any one day to buy stock or make bids for the corporation and any affiliated purchasers.

Assume, for example, that X Corporation plans to repurchase shares of stock for employee benefit plans and that after the board of directors’ decision is announced, there is no material inside information. Before the buyback begins, X informs officers, employees, and directors of their responsibilities under insider trading rules. No individuals involved in X’s decision purchase any shares during the buyback period unless they coordinate their purchases with X. On Monday, X begins reacquiring shares through one broker, avoiding the opening trade and the last 30 minutes before the market closes. The top independent bid quote on Monday is $30. The last independent sales price is $29.50. None of the bid or settlement prices for shares that X buys exceed $30. X’s average daily trading volume for the last four weeks has been 120,000 shares. Monday’s market repurchases are limited to 300 round lots (25% of 120,000 shares), but one block purchase of 5,000 shares from a large shareholder is negotiated for a total cost of $147,500. On the basis of the facts, X’s buyback appears to comply with Rule 10b-18.

A smaller publicly held company’s legal department may lack the familiarity, time, or confidence to oversee occasional buybacks. Large brokerage firms have departments specializing in corporate stock repurchases. A corporation considering repurchases might interview several brokers and inquire about—

A corporation that regularly repurchases stock might rotate and monitor brokers to make sure that shares are consistently bought at good prices, a high level of service is delivered, and the CFO or other officers and directors have access to a depth of talent and expertise.

Financial Accounting and Reporting

The most obvious issue that stock buybacks raise for financial accounting and reporting purposes is the proper treatment of treasury stock. Both the cost method and the par value method are acceptable for GAAP purposes. Whichever method a corporation uses, the company generally presents treasury stock in its financial statements as a reduction in the stockholders’ equity section. The company records each repurchase at cost and maintains separate records to document the date of purchase, share price, and number of shares bought.

The company may use FIFO, average cost, or some other acceptable inventory method to track shares. If the corporation resells its treasury stock, perhaps because part of the stock buyback strategy involves holding shares for appreciation, the treasury stock account is credited for the cost of shares sold. Any difference is treated as paid-in capital in excess of par or stated value.

Under the par value method, a corporation increases its treasury stock account by the par or stated value of each reacquired share. The company removes from its books all of the original capital balances for the stock repurchased. Thus, when the amount paid exceeds par or stated value, the excess is debited to paid-in capital in excess of par or stated value up to the amount per share credited to the account when the stock was originally sold. Any additional amount that the corporation must pay in order to reacquire stock is debited to retained earnings. If the repurchase price is less than the proceeds at original issuance, the par value method credits the difference to paid-in capital from treasury stock transactions. Upon resale, any “gain” is credited to paid-in capital from sale of treasury stock. Any “loss” is debited to paid-in capital to the extent that it offsets gains from previous sales of the same class of stock; the excess is debited to retained earnings.

In some instances, the amount paid per share for a block purchase or other reacquisition could significantly exceed the current market price. Analysis may indicate that the company should allocate part of the amount paid to certain rights or privileges not apparent on the face of the transaction.

Accounting and reporting for treasury stock may differ in certain circumstances. Also, previous transactions or choices of accounting methods can affect the financial treatment of stock buyback programs or even eliminate them altogether. For example, according to Staff Accounting Bulletin No. 96 (SAB 96), the SEC may disallow use of the pooling method to account for a merger if a company buys back stock as part of the transaction or if the combined company later repurchases stock outside of certain safe harbors. Financial measures would suffer and the entire market capitalization of the combined entity could plummet if the purchase method of accounting were then required. As a result, some companies have avoided buybacks and even rescinded repurchase programs already announced. One factor that increases a corporation’s vulnerability to SAB 96 is that the SEC staff views the “formulation of an intention” to repurchase stock, not the buyback announcement, as the action that eliminates pooling of interests.

Certain uses of reacquired stock may themselves call for specific financial accounting methods. For example, stock issued to employees may lead the practitioner to APB 25, ARB 43, FAS 123, or perhaps to FASB interpretations or other sources of GAAP. Furthermore, the year’s compensation expense reported for book and tax purposes may differ, raising deferred tax issues.

Rather than straightforward purchases of stock, a company could reacquire shares by means of option contracts, equity forward contracts, or other instruments. ABC Corporation might arrange for a bank to buy ABC shares for future delivery at a particular (e.g., current) price plus interest. Some variations of these methods could result in off-balance sheet financing in the interim. Accounting and reporting for these transactions is beyond the scope of this article.

Federal Tax Considerations

Under IRC section 1032, a corporation generally recognizes no gain or loss on the initial issuance of its stock or on the purchase and sale of treasury stock. Similarly, a company recognizes no gain or loss on the lapse or acquisition of an option to buy or sell its stock. Thus, any gain realized is tax free and any loss is nondeductible, and neither is reported on Form 1120, U.S. Corporation Income Tax Return. During a rising stock market, a company’s after-tax benefit from investing in its own stock may exceed the return from investments in securities of other corporations.

Assume, for example, that Y Corporation invests $100,000 in its own stock and $100,000 in the stock of Z Corporation. Any gain on Z shares is taxed as ordinary income because corporations receive no preferential treatment on Form 1120 for long-term capital gains. If each investment appreciates 20%, or $20,000, Y owes perhaps $6,800 of tax (in the 34% federal corporate income tax bracket) on the Z stock, reducing the after-tax return to 13.2%. This falls far short of the 20% after-tax benefit on Y’s own stock and illustrates a strong secondary reason for stock buybacks, regardless of the corporation’s primary motive.

However, any difference in after-tax return might be reduced during a long holding period if dividends are received on the stock of the other corporation. In general, 70% or 80% of dividends that Y receives on Z stock would escape federal tax because of the dividends-received deduction of IRC section 243.

A corporation recognizes taxable gain if it buys back its own shares (perhaps in a block purchase) with appreciated noncash property such as real estate, equipment, or the securities of other companies. The amount reported on Form 1120 is the difference between the fair market value and adjusted basis of the property given up, under IRC section 311(b). A corporation generally recognizes no loss, however, if the property exchanged has a fair market value lower than its adjusted basis.

Suppose Y Corporation reacquires a block of stock from a shareholder by giving real estate to ABC that has a fair market value of $250,000 and an adjusted basis of $160,000. The corporation recognizes a $90,000 gain on the purchase, taxable at regular corporate rates, but any later gain on disposal of the stock escapes federal income taxes under IRC section 1032.

Other Tax Issues

Although often ignored in stock buyback discussions because of the 75-shareholder limit, S corporations also report a gain when exchanging appreciated property for stock under IRC section 1366. An S corporation’s gain is passed through to shareholders, however, and the corporation itself does not pay tax except on built-in gains described in IRC section 1374.

Additional federal income tax rules involved in stock buybacks include the following:

Joseph R. Oliver, PhD, CMA, CFM, CPA, is a professor, and Katherine S. Moffeit, PhD, CPA (inactive), is an associate professor of accounting, both at Southwest Texas State University in San Marcos.

Joseph R. Oliver, PhD, CMA, CFM, CPA, is a professor

Katherine S. Moffeit, PhD, CPA (inactive)
is an associate professor of accounting,
both at Southwest Texas State University in San Marcos.

James L. Craig, Jr., CPA

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