Treasury Stock: Cost Method
| There are mainly two methods of accounting for treasury stock: the cost method and the par value method. This section discusses the cost method. |
The Cost Method
The cost method of accounting for treasury shares is the most common method of accounting for treasury shares because of its simplicity, and is the only method allowed by the IFRS. The main difference between the two methods is when a gain or loss is recognized on treasury stock transactions.
When companies use the cost method, the purchase of treasury stock is viewed as a temporary reduction in shareholders’ equity. The reason for this is that the company expects to reissue the shares instead of retiring them. When the company reissues the treasury shares, the temporary account is eliminated. The cost of treasury stock reacquired is charged to a contra account, in this case a contra equity account that reduces the stockholder equity balance. The purchase of treasury shares leaves the common stock and contributed balances intact.
For example, consider the following balance sheet:
Sunny Sunglasses Shop Shareholders Equity
| Stockholders Equity | |
| Common Stock @ Par, $1 Authorized 100,000 Shares Issued 25,000 Shares |
$25,000 |
| Additional Paid-In Capital | $25,000 |
| Retained Earnings | $15,283 |
| Total Stockholders Equity | $65,283 |
If Sunny acquires 1,000 shares of common stock at $5 per share, he would make the following accounting journal entry:
| Account | Debits | Credits |
| Treasury Stock | $5,000 | – |
| Cash | – | $5,000 |
Both stockholders equity and net assets are reduced from the purchase of treasury share stock. Debiting the contra equity account, treasury stock, reduces stockholders equity, and net assets are reduced from the decrease in the cash balance.
The cost method of accounting for treasury stock affects the accounting balance sheet as follows:
Accounting for Treasury Stock Using the Cost Method
| Stockholders Equity | |
| Common Stock @ Par, $1 Authorized 100,000 Shares Issued 25,000 Shares, 1,000 Shares of which are Treasury Stock |
$25,000 |
| Additional Paid-In Capital | $25,000 |
| Retained Earnings ($5,000 restricted for cost of treasury stock held) | $15,283 |
| Less: Cost of 1,000 treasury shares | ($5,000) |
| Total Stockholders Equity | $60,283 |
The stockholders equity section has decreased by $5,000. The capital accounts remain intact as originally reported, since the cost method treats the purchase of treasury share stock as a temporary reduction in stockholders equity.
In this example, Sunny issued 25,000 shares. Treasury stock is stock taken off the market and not yet retired, thereby reducing the number of shares outstanding. The amount of stock issued does not change, since the portion of the stock issued is now treasury stock held by the company, reducing only the amount outstanding by the amount of the treasury share stock.
Most states restrict earnings distributions and dividends to the balance of retained earnings less the cost of treasury shares held. GAAP therefore requires a disclosure in the form of a footnote or parenthetically which would be included with the balance sheet to signify the reduction of retained earnings from the acquisition of treasury stock. This is important since a company can only pay dividends to the extent of its available retained earnings less any treasury stock held, in this case $10,283 ($15,283 – $5,000). The amount of shareholder equity that cannot be distributed to shareholders is often referred to as legal capital.
When the shares are reissued, treasury stock is credited for the cost of the reissued shares. If the treasury stock is reissued at a price greater than the original cost, the company credits a separate contributed capital from treasury stock account. If the company reissues the treasury shares at less than cost, the difference is first taken out of the contributed capital account for treasury shares. If the difference remains after reducing the contributed capital account to zero, retained earnings is then reduced.
Treasury Stock Transactions can only Decrease Retained Earnings
| Companies cannot create earnings through buying or selling their own capital stock. Treasury stock transactions generally increase and decrease contributed capital. Occasionally treasury stock transactions may decrease retained earnings, but a company cannot increase retained earnings through treasury stock transactions. |
Sunny reissues 200 shares of treasury shares at $7 per share.
| Account | Debits | Credits |
| Cash | $1,400 | – |
| Treasury Stock (200 x $5) | – | $1,000 |
| Contributed Capital from treasury stock transactions – common | – | $400 |
Sunny reissues 300 shares of treasury shares at $3 per share.
| Account | Debits | Credits |
| Cash | $900 | – |
| Contributed Capital from treasury stock transactions – common | $400 | – |
| Retained Earnings | $200 | – |
| Treasury Stock (300 x $5) | – | $1,500 |
After the above transactions, the equity section of the balance sheet for Sunny Sunglasses Shop now appears as follows:
Accounting for Treasury Stock Using the Cost Method
| Stockholders Equity | |
| Common Stock @ Par, $1 Authorized 100,000 Shares Issued 25,000 Shares, 500 Shares of which are Treasury Stock |
$25,000 |
| Additional Paid-In Capital | $25,000 |
| Retained Earnings ($2,500 restricted for cost of treasury stock held) | $15,083 |
| Less: Cost of 500 treasury shares | ($2,500) |
| Total Stockholders Equity | $62,583 |
Total treasury stock decreased by $2,500, the amount of the 500 treasury shares sold at the original cost of $5. The stockholders equity account increased by $2,300, the amount of the treasury shares sold ($2,500) less the loss to retained earnings of $200. The $200 loss occurred when Sunny reissued 300 treasury shares at $3. The loss not only absorbed the original gain recorded in the contributed capital from treasury stock transactions – common for $400, but then reduced retained earnings for the remaining loss of $200.
Since retained earnings cannot be increased in treasury share transactions, Sunny recorded the gain in the contributed capital account. However, when a loss occurred, the loss is first taken from the contributed capital account and then, if a loss remains, from retained earnings.
Sunny formally retires the remaining 500 shares of treasury shares.
| Account | Debits | Credits |
| Common Stock | $500 | – |
| Contributed Capital in excess of par – common | $500 | – |
| Retained Earnings | $1,500 | – |
| Treasury Stock (500 x $5) | – | $2,500 |
The common stock, contributed capital, and treasury shares are retired based on the original values in each account, with the difference going to retained earnings.
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Hi Michelle –
You can adopt a cost flow assumption like FIFO or specific identification for treasury shares purchased (and later sold). Since the cost method avoids identifying amounts and prices of original shares issued, you will only need to identify original shares purchased with a cost flow assumption if the shares are retired.
Kenneth
if for example i have issued 25,000 $1 par common stock for $2 per stock and issued 25,000 $1 par common stock for $3 per stock, then reacquired 500 of the common stocks for $5 per stock, what would be the entry to retire the treasury stocks??
Kenneth Meunier’s comments are certainly more than helpful! I look forward to checking out his personal website.
Yes, companies can purchase treasury shares to increase the market price of the stock because this can return capital to the existing shareholders. (This also avoids a capital gains tax since the tax is deferred until the stock is sold, unlike dividends where tax is owed immediately.)
There is no guarantee, however, that stock repurchases will result in more returns to shareholders. For more in depth discussion, please see treasury stock.
Can I give treasuary shares as bonus shares to shareholders?
Hi Nix –
Keep in mind that under the cost method the treasury shares were never taken out of the common stock account. Instead, the treasury shares account reduces the total common shares in the balance sheet as a separate temporary contra account, so when they are reissued they reduce the amount of treasury shares in the temporary contra account, but remain in the permanent equity account, common shares.
If the company does decide to actually retire the treasury shares, a separate entry must be made to eliminate the common stock and increase treasury share account.
The par value method, on the other hand, reduces the common stock account directly.
When treasury shares are sold, cash is increased and treasury shares decreased.. my dilemma is, what happens to the sold treasury shares?? do they become part of the outstanding shares again??
Razel –
The treasury shares account is maintained at the original purchase price ($5 per share), so any premium over $3 that it was sold for below cost in the example above is accounted for in T.S. as originally purchased, and written down to contributed capital and then R.E. if sold below that $5 price, and increasing contributed capital (not RE) if sold above that price.
Kenneth
is there still have share premium eventhough it was sold below cost ?
Thanks for informative post