Tuesday, February 16, 2010

Accounting for Treasury Stock

Hello Dear Reader,
Having addressed on "Earnings per Share", I would like to move on to another essential aspect of stockholder's equity, Accounting for Treasury Stock.

Recalling the definition of Treasury Stock, it is the stock reacquired or repurchased by the issuing entity,  reducing the quantity of outstanding stock on the open market. To explain differently, when an entity reacquires its own common or preferred stock in an open-market transaction, such stock is termed Treasury stock. Bear in mind, it is the stock which is authorized and issued but not outstanding. Also be acquainted that:-
  1. It is reported as a reduction (debit) in stockholder's equity;
  2. No gain or loss is recognized on a treasury stock transaction and
  3. Retained earnings may be decreased abut never increased by the treasury stock transaction.
There are two ways to account for treasury stock transactions:
  • Cost method
  • Par-value method
Either of the methods adopted will not affect the stockholder's equity. What sets them apart is their stance and use of different equity accounts.

Cost Method
It is a less complicated method than the par-value method where an entity considers purchase of treasury stock as a temporary reduction in stockholders equity and not as retirement of shares. Distinguishing features include:
  1. Debit the treasury stock account for the cost to acquire the shares.
  2. At the time of reissuance/sale of treasury stock, credit the treasury stock account for the cost of shares.
  3. The gain/loss on acquistion is recognized at the time reissuance/sale.
    • Gains are credited to paid-in-capital from treasury stock transactions.
    • Losses are first charged to paid-in-capital  from treasury stock transactions and the remainder, if any is charged to retained earnings.
  4. Retirement of treasury stock will require additional journal entries.

Par Value Method
This method holds the view point that a treasury stock transaction is "retirement" of shares and its reissuance/sale is a "new" issue. It is slightly more complex than cost method but when it comes to retirement of treasury stock the journal entries are fairly simple. 

Note: Under par value method we start with the assumption of retiring such shares, therefore, when the treasury shares are actually retired, the treatment is fairly simple. This does not hold true for cost method.

Key features of par value method:-
  1. On repurchase of own shares, debit the treasury stock account for the par value and not the cost of reacquisition.
  2. Treasury shares acquired for a price more than they were originally issuedDebit additional paid-in-capital (APIC - common stock) for the premium received when the shares were first issued to public. The excess, if any, goes to retained-earnings.
  3. Treasury stock acquired at a cost equal to or less than the original issue cost - Debit APIC - common stock for premium at the time of issuance and paid-in-capital from treasury stock is credited for the difference between the original issue price and the cost to acquire treasury stock.
  4. When treasury shares are resold, credit the treasury stock account at par value and credit or debit APIC - Treasury Stock for the remainder.
I have exemplified both the methods through simple transactions in powerpoint slides. Please use the link beneath to view the file.

This brings me to a finale of Treasury Stock Accounting. I trust you benefit from it.

Remain with me...more will come....


Friday, February 5, 2010

Earnings Per Share

Hello Friends!

It's been some time since I last wrote on "Pension Accounting". I apologize for not being able to keep up with the desired pace and will endeavour not to lose track of it. Laying my thoughts aside on how I feel about neglecting the job I volunteered for, I shift to an interesting topic “Earnings Per Share(EPS)” .

Simply put, EPS is the piece of an entity's income allocated to each outstanding share of common stock. It is the key indicator of a company's profitability and a major component of price-to-earnings ratio. FASB Statement 128 (Codification Topic 260) requires the computation, presentation and disclosure of EPS for publicly traded entities.

All entities with publicly held common stock start off by computing Basic EPS while ignoring any potentially dilutive securities. In addition to Basic EPS, Diluted EPS is determined where the capital structure of an entity includes potentially dilutive securities. The objective of Basic EPS is to assess performance of an entity over its reporting period and that of Diluted EPS is to provide similar results while giving effect to all dilutive potential common shares that were outstanding during that period.

Note: A security is considered potentially dilutive if any other contract/security allows its owner to acquire common stock during the reporting period or after the end of the reporting period. For example, stock options/warrants,  and convertible bonds/preferred stock.

Both Basic and Diluted EPS  must be presented for two elements:-

a) Income from Continuing Operations - It is the income (or loss) available to common stock holders after adjusting the preferred stock dividend.
Dividend on cumulative preferred stock is always backed out whether declared or not from the net income. However, in case of non-cumulative preferred stock, a deduction is made for the dividend that has been declared.

b) Net Income - Not only an adjustment is made for preferred stock dividend as discussed above but also for income from discontinued operations, extraordinary items and cumulative effect of a change in accounting principle.

Presentation - EPS is reported on the face of Income statement for both the elements mentioned above. Where an entity reports a discontinued operation, an extraordinary item or the cumulative effects of accounting changes, the EPS must either be presented on the face of income statement or in the notes to financial statements.
Computation of Basic EPS

Basic EPS = Income from Continuing operations or Net Income   
                 Weigheted-average no. of common shares outstanding

Weighted-average number of shares outstanding during the period include shares outstanding the entire period, shares issued during the period and shares where all of the conditions of the issuance have been met. 

In computing the weighted-average no. of shares following adjustments are required:-

1. Treasury shares are excluded as of the date of repurchase. Example - if on Jan 1, year 1 shares issued and outstanding were 20,000 and on Jul 1, year 1 the company reacquired its 4000 shares and held in treasury, the weighted average shares outstanding for year 1 would be 18,000 (20,000 * 6/12 + 16,000 * 6/12).

2. Stock Dividends and Stock Splits - If stock dividends and stock splits are given effect to during the year,  they are reflected in EPS retroactively for all periods presented i.e they should be considered outstanding for the entire period in which they were issued. Example - if 10,000 shares were outstanding on Jan 1 and on Jul 1stock dividend of 10% is issued, the no. shares outstanding on Jan 1 will be 11,000 (10,000 + 10% of 10,000).

If the events take place after the close of the period but before the completion of financial report, the per share contribution should be based on the new number of shares.
The retroactive treatment is given to stock dividends and stock splits for the reason that they change the total number of shares but not the proportionate shares outstanding.

Computation of Diluted EPS

a) If-converted method - It is identical to Basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding during the period, if dilutive common shares would have been issued from conversion of debt or preferred stock. The numerator  is adjusted to add back i) any dividends on convertible preferred stock and ii) the after tax amount of interest recognized in the period associated with any convertible debt.

Dilutive Effect: Convertible preferred stock is dilutive if Basic EPS is greater than preferred dividend per share of common stock obtainable. Similarly, convertible bonds are dilutive if Basic EPS is greater than interest net of tax per share of Common stock obtainable. Only when the dilutive effect is established, both numerator and denominator are adjusted for the items mentioned above.

In other words, the conversion, exercise or contingent issuance of securities should not have an anti-dilutive effect. Anti-dilutive ssecurities are excluded from diluted EPS. Thus, it is important to calculate the per share effect of each potentially dilutive security and include only those which have a dilutive effect.

Where a loss from continuing operations already exists, including potential shares in the denominator of a Diluted EPS will result in an anti-dilutive per-share amount. Thus, potential common shares are excluded in computation of diluted EPS when a loss from continuing operations exist, even if the entity reports net income.

b) Treasury Stock method applies to options and warrants. Under this method exercise of warrants is assumed at the beginning of the period or at the time of issuance, whichever, is later and proceeds from exercise are assumed to be used to purchase common stock at the average market price during the period.

This method is applied indivdually to each option and warrant to asssess if they are dilutive. If the average market price is less than the exercise price, the options and warrants are anti-dilutive.

The effect of options and warrants is only on the denominator i.e weighted average number of shares, for the net additional shares that are issued.

The difference between i) additional number of shares issuable under the warrant/option and ii) number of shares assumed to be purchased at the average market price is included in the denominator.

Example: Entity X has 1,000 warrants outstanding exercisable at $54 per share. The average market price of the share is $60. Assuming that the warrants are exercised, the incremental shares includible in the denominator would be 100 (1,000 - (1000*54/60)). Since options/warrants have only a denominator effect, its per share effect is $0.00. 

Remember, Diluted EPS should reflect the maximum dilution of all potentially dilutive securities. Thus, always begin with the security with the smallest individual per share effect or the most dilutive security and include all with a dilutive effect. Because options and warrants have $ 0.00 per share effect, they are always the most dilutive securities.

With this, I wrap up the topic on Earnings Per Share. Once again, before I close...a confession...somewhere in my thoughts I felt culpable and lost by not joining in any dialogue with you in the last two weeks but at this point in time I feel less remorseful.

Have a Nice Weekend!