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Accounting meets strategy: share repurchase programs.

If you've been a devoted reader of The New York Times or The Wall Street Journal over the last few years, you've undoubtedly read many articles about companies buying back their own stock. According to a recent WSJ article, aggressive share repurchases have been a significant factor in allowing organizations to manage their capital structure--the desired balance between debt and equity.

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Although the recession has slowed the rate of share repurchases, most experts think that repurchase programs will continue to be popular. As recently as October 2009, for example, IBM's board of directors expanded the company's share repurchase program, earmarking an additional $5 billion on top of the $2.6 billion IBM spent on its own stock in its second and third quarters. Also, the 2008 edition of Accounting Trends & Techniques reported that 65% of firms disclosed treasury stock--shares that are issued but are not outstanding--on their 2007 balance sheets, down only slightly from 68% in 2006.

The recession, therefore, has only slowed share repurchases. Even though, in the third quarter of 2009, stock buybacks were down 61% from a year earlier, the improvement over the second quarter--when expenditures on buybacks hit their lowest level since 1998-was an impressive 44%, according to The Wall Street Journal. While in an economic downturn firms are concerned with liquidity and often keep large cash balances, some may have taken this too far and may start to reconsider any decreases in share repurchases.

Over the past decade, treasury stock has become--and continues to be--an increasingly important way of managing the balance sheet. Integrating the underlying business objectives with the accounting mechanics of buybacks provides an excellent example of strategic accounting. As we've seen since the fall of Enron in 2001, finance and accounting managers can't have a myopic focus on the rules and mechanics of accounting; they must understand the firm's objectives in engaging in specific transactions if they're to communicate any confidence in the company's financial statements.

Accounting for Treasury Stock

There are two acceptable ways to account for treasury stock under Generally Accepted Accounting Principles (GAAP): the cost method and the par value method. Let's take a closer look at each one.

The Cost Method. When a company uses the cost method, the purchase of treasury shares is recorded at cost in a contra-equity account called Treasury Stock. It's shown on the balance sheet at the end of the stockholders' equity section as a deduction. Based on our research, the cost method is the most prevalent method of accounting for treasury stock.We examined companies in both the S&P 500 (large-cap firms) and S&P 600 (small-cap firms) to see how they account for share repurchases. We found that 387 firms in the S&P 500 engaged in share repurchases in each of three consecutive years (2005 through 2007). Of those firms, 78% used the cost method. Among small-cap firms, 334 engaged in share repurchases over the same time span, and, of those, 76% used the cost method. Confirming the widespread use of the cost method, the 2008 edition of Accounting Trends & Techniques reported that 96% of the firms in its sample that had treasury stock used the cost method to account for it.

The Par Value Method. Of the firms that had treasury stock transactions from 2005 through 2007, only 22% of the S&P 500 firms and 24% of the small-cap companies we examined used the par value method. In contrast to the cost method, when a company uses the par value method there's no Treasury Stock account on the balance sheet. The cost of the repurchased shares is deducted from paid-in capital accounts, and the shares are treated as if they were retired. If the company pays more than the original issue price for the shares, the excess cost is deducted from retained earnings. Even when a firm's balance sheet shows no sign of treasury stock, it's still advisable to check the statement of shareholders' equity and the statement of cash flows to see if a company is buying its own stock.

Rationale Behind Stock Buybacks

Historically, the most common reason for a firm to buy its own stock is to maintain or achieve a certain level of earnings per share (EPS). Although this may be the most widely accepted reason, there are several more important ones.

TRADITIONAL REASONS:

Distribution of Shares for Compensation Plans.

In their annual reports, most firms say they repurchase shares to have them available for bonus and stock option plans. But many companies repurchase more shares than they issue. This trend is reflected in Tables 1 and 2, which track stock issue and repurchase activity for companies in the S&P 500 and S&P 600 indexes, respectively, from 2004 through 2008. If we accept the common explanation that stock issuance was mostly driven by stock-based compensation plans, the data shows a remarkable number of these companies repurchased much more stock than they needed to cover current or future employee stock options.
Table 1: S&P 500 Companies: Stock Sales and Repurchases

The figures in the top two rows of the table show that the majority of
firms in the S&P 500 repurchased their own stock at a rate that
increased between 2004 and 2008. The bottom three rows of the table show
that most of the firms repurchasing stock buy back much more than they
issue, a tendency that generally increased over the years studied.

Year                                2004  2005  2006  2007  2008

Number of firms repurchasing stock  285   330   364   377   386

% of total                           57%   66%   73%   75%   77%

Repurchases > Sales                  76%   84%   88%   89%   88%

Repurchases 2x > Sales               49%   61%   72%   75%   72%

Repurchases 4x > Sales               28%   44%   48%   54%   62%

Table 2: S&P 600 Companies: Stock Sales and Repurchases

Compared to large companies, a smaller percentage of small-cap companies
repurchased their stock, although the practice is still widespread. The
figures in the top two rows of the table show that the number of firms
in the S&P 600 repurchasing their own stock increased between 2004 and
2008. The bottom three rows of the table show that a substantial number
of the firms repurchasing stock buy back much more than they issue, a
tendency that increased consistently over the years studied. Our
conclusion--for large-cap companies and small caps--is that these stock
repurchases must have been motivated by something other than the need to
cover current or future employee stock options.

Year                                2004  2005  2006  2007  2008

Number of firms repurchasing stock  208   233   250   288   346

% of total                           35%   39%   42%   48%   58%

Repurchases > Sales                  56%   63%   67%   73%   75%

Repurchases 2x > Sales               31%   38%   44%   51%   54%

Repurchases 4x > Sales               22%   25%   32%   38%   46%


Earnings per Share. Some companies use share repurchases to increase earnings per share or to at least prevent the dilution of EPS by shares issued under equity compensation plans. They hope that by decreasing the number of shares outstanding--which in turn increases EPS--the stock price will increase unrelated to any change in earnings. Nevertheless, we believe that companies should buy back shares (or distribute dividends) only when they can't find better growth opportunities or rates of return for their idle cash, not merely to boost the stock price.While EPS will rise when there are fewer shares outstanding, stock prices may not necessarily follow if shareholders perceive the company to be sacrificing cash that could instead be used to grow the business.

A Signal to Investors. Managers often believe that their shares are undervalued, perhaps because their inside information is more positive than the public perception of the company's relative strength. This problem is exacerbated by the difficulty of distinguishing between truthful and overly optimistic management. Empirical studies suggest that share repurchases occur about as often among value stocks (presumed more likely to be undervalued) as growth stocks. While none of the evidence sheds much light on what motivates managers to repurchase shares, the debate over fair value will probably continue, and the question of whether share repurchases can send a strong enough signal about underpriced stocks is unlikely to be resolved anytime soon.

STRATEGIC REASONS:

Excess Cash. Dividends have been the traditional way to return cash to shareholders. Companies are hesitant to reduce dividends because of the negative signal it sends financial markets. But share repurchase programs are much less visible and offer the company a valuable timing option. For instance, if a company decides to change the rate at which it repurchases stock, shareholders won't know about it until the next 10-K or 10-Q disclosure. Even then, the company isn't required to disclose changes in the rate of implementation on an existing buyback program.

Although companies may pay a dividend to get their shares on institutional buy lists that screen for dividends, they may well prefer share repurchases. The fact that many companies have both suggests they value flexibility. Research by Gustavo Grullon and Roni Michaely showed that firms that repurchased their own stock didn't see a significant market reaction to dividend reductions, whereas firms that cut their dividend without a repurchase program experienced a significant negative reaction. These researchers concluded: "When investors perceive that dividends are being replaced by repurchases, they view the reduction in dividends as much less negative." (For more on this topic, see "Dividends, Share Repurchases, and the Substitution Hypothesis" in the August 2002 issue of The Journal of Finance.)

During the past year or two, companies have kept higher cash reserves in response to the recession and an uncertain economy. As the economy recovers, however, there's an ongoing discussion about what companies will do with their extra cash. According to a recent article in The Wall Street Journal, tech companies in particular need to figure out "a better use for their expanding mountains of cash." For some industries, generating large amounts of cash can create problems for the firm--takeover bids from cash-hungry companies, for example. Keeping the cash balance from getting too large helps protect a firm from these types of takeover bids.

Capital Structure Maintenance. Another reason for purchasing treasury stock involves a firm's desire to maintain a target capital structure. Finance experts often debate whether or not there's an optimal structure. Is there a mix of debt and equity financing that's just right for a particular company? Some organizations believe there is, and they use treasury stock purchases to maintain the desired balance between debt and equity.

Suppose a company's debt remains constant. Two common events change the level of the firm's equity: net income and distributing stock to executives or employees. First, consider what happens to the debt-to-equity position of the firm when significant net income is earned. The retained earnings account is increased by the amount not paid out as dividends. To keep its relationship between the book value of debt and equity stable, the firm could buy treasury shares, which reduces equity under both the par value method and the cost method of accounting. Although paying dividends would accomplish the same thing, purchasing treasury stock is much more flexible and controllable.

In contrast, when dividends are declared, payment must follow.When a share repurchase plan is announced, the repurchase is still optional. Paying dividends may also create the expectation that they'll continue.

Second, when shares of stock are issued to executives and employees, paid-in capital is increased. But a purchase of treasury shares can offset this increase in equity. The flexibility inherent in this strategy is particularly valuable because management can't predict when employees will exercise their options.

In addition to changing the amount of equity with the purchase and sale of treasury stock, managers are also changing the number of shares of stock outstanding. This accomplishes several goals, including: (1) maintaining a desired EPS, (2) avoiding a dilution of EPS when stock options are exercised, (3) managing the amount of cash needed to pay a dividend, and (4) managing float.

Required Disclosures

In the United States, share repurchases are subject to a number of regulations, especially those specified under Securities & Exchange Commission (SEC) Rule 10b-18. Because a firm may be accused of insider trading, this rule provides a safe harbor for companies to avoid liability for manipulation when purchasing their own stock. (As a practical matter, most firms elect to have a broker manage the repurchase program so that purchase decisions aren't perceived to be influenced by the company.)

Effective December 2003, Rule 10b-18 requires that companies disclose in their 10-K and 10-Q a table listing:

* All repurchases for the last fiscal quarter,

* Total number of shares purchased,

* Average price paid per share,

* Total number of shares purchased as a part of their specific repurchase plan, and

* The maximum number (or approximate dollar value) of shares that may yet be purchased under their plan.

Companies must also include a footnote describing the terms of all publicly announced repurchase plans, including the date each was announced, the share or dollar amount approved, and the expiration date (if any). Share repurchase plans can be completed before the expiration date, or the date can be extended. For example, Costco authorized a share repurchase program in 2001 to buy back up to $500 million of its common stock through November 2004 (renewed through 2007), but the company didn't purchase any shares until after August 2005.

Some Recent Repurchase Programs

Dividend Equivalent of a Share Repurchase. Darden Restaurants, parent company to popular chains like Olive Garden and Red Lobster, actively repurchases its own shares and also pays dividends to its shareholders. We can calculate the dividend equivalent of the firm's share repurchases with information provided in the company's annual report. In fiscal 2008, Darden repurchased five million shares at a cost of $159.4 million.With 140.4 million common shares outstanding at the beginning of the fiscal year, the share repurchase amounted to a dividend of $1.135 per share (159.4/140.4). Compared to a cash dividend declared of $0.72 per share, the buyback program was definitely significant.

Merck provides another example of how impactful share repurchases can be. In fiscal 2008, Merck bought back 69.5 million shares for $2.725 billion. The company had approximately 2.172 billion shares outstanding during the year, which paid cash dividends of $1.52 per share. The share repurchase, on the other hand, provided an additional dividend equivalent to $1.25 per share (2,725/2,172). Although the cash dividend was greater than the stock repurchase equivalent, another $1.25 per share was a very significant increase in the per-share dividend.

Share Repurchases and the Increase in EPS. As mentioned earlier, in its 2008 annual report Darden Restaurants reported an average of 140.4 million common shares outstanding for the year ended May 25, 2008. Net earnings for the 2008 fiscal year were $377.2 million. During the year, Darden purchased five million shares of treasury stock. Suppose, though, that the firm hadn't repurchased any of its own shares during the year.With no change to earnings, what would the reported EPS look like?

* Reported earnings of $377.2 million divided by 140.4 million shares = $2.69 per share, as actually reported.

* Reported earnings of $377.2 million divided by 140.4 (+ 5) million shares = $2.59 per share if the shares had not been repurchased, making the denominator larger. EPS would have been smaller by $0.10 per share.

Another example of an increase in EPS because of share repurchases comes from Books-A-Million. For the fiscal year ended January 31, 2009, Books-A-Million reported net income of approximately $10.6 million and had an average of 15.2 million shares of common stock outstanding. During the year, the firm purchased 239,000 shares of treasury stock. Suppose Books-A-Million hadn't repurchased any of its own stock.With no change to earnings, the reported EPS for the fiscal year would have been $0.01 smaller. Anyone who watches earnings announcements knows that even a penny can make a difference in whether the company's earnings meet analysts' expectations.

* Reported earnings of $10.6 million divided by 15.2 million shares = $0.69 per share.

* Reported earnings of $10.6 million divided by 15.2 (+ 0.239) million shares = $0.68 per share.

The Bottom Line

Share repurchases have become increasingly popular as companies decide how best to use their cash surpluses. Although not often discussed in terms of a company's strategy, treasury stock transactions are important and have implications for the value of the firm. When the accounting and economic issues are understood, share repurchases convey valuable information to shareholders, securities analysts, and corporate treasurers. Moreover, buybacks provide management accountants with a flexible tool for managing leverage and distributions to shareholders. Both securities analysts and shareholders should recognize treasury stock transactions as an important component of shareholder value.

FURTHER READING

For more information about stock repurchases, here's a list of the articles we mentioned in the text.

Accounting Trends & Techniques, 2008 edition, published by the American Institute of Certified Public Accountants (AICPA), www.cpa2biz.com.

Kerry Grace and Rob Curran, "Stock Buybacks Plummet," The Wall Street Journal, March 27, 2009, p. C9.

Gustavo Grullon and David Ikenberry, "What Do We Know about Stock Repurchases?" Journal of Applied Corporate Finance, Spring 2000, pp. 31-51.

Gustavo Grullon and Roni Michaely, "Dividends, Share Repurchases, and the Substitution Hypothesis," Journal of Finance, August 2002, pp. 1649-1684.

Martin Peers, "Tech Companies Need a Cash Plan," The Wall Street Journal, March 21, 2009, p. B10.

Karen Richardson and Gregory Zuckerman, "Where Have Buybacks Gone?" The Wall Street Journal, January 24, 2008, p. C1.

Jason Zweig, "Corporate-Cash Umbrellas: Too Big for This Storm?" The Wall Street Journal, March 14, 2009, p. B1.

Jane L. Reimers, Ph.D., is a professor of accounting in the Crummer Graduate School of Business at Rollins College in Winter Park, Fla., and a member of IMA. Before joining the Crummer faculty in 2003, she was the KPMG Professor at Florida State University. You can reach her at (407) 646-2499 or jreimers@rollins.edu.

J. Clay Singleton, Ph.D., is a professor of finance in the Crummer Graduate School of Business at Rollins College. Before joining the Crummer faculty in 2001, he was vice president of Ibbotson Associates, where he was responsible for the firm's consulting, training, and research activities. You can contact him at (407) 691-1229 or jcsingleton@rollins.edu.
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Title Annotation:FINANCIAL MANAGEMENT
Author:Reimers, Jane L.; Singleton, J. Clay
Publication:Strategic Finance
Geographic Code:1USA
Date:Feb 1, 2010
Words:3058
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