financial management accounting meets strategy: share

FINANCIAL MANAGEMENT

Accounting Meets Strategy: Share Repurchase

Programs

Fe b r u a r y 2 0 1 0 I S T R AT E G IC F I N A N C E 47

ILLU

STR

AT

ION

: A

RT

DIS

C

: Share Repurchase Programs

By Jane L. Reimers and J. Clay Singleton

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.

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 com-

pany’s share repurchase program, earmarking an addi-

tional $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 repur-

chases. Even though, in the third quarter of 2009, stock

buybacks were down 61% from a year earlier, the

improvement over the second quarter—when expendi-

tures 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 man-

aging the balance sheet. Integrating the underlying busi-

ness objectives with the accounting mechanics of buy-

backs 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 spe-

cific transactions if they’re to communicate any confi-

dence in the company’s financial statements.

Accounting for Treasury StockThere 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 stockhold-

ers’ 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 trea-

sury 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 share-

holders’ equity and the statement of cash flows to see if a

company is buying its own stock.

Rationale Behind Stock BuybacksHistorically, 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 num-

ber of these companies repurchased much more stock

than they needed to cover current or future employee

stock options.

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 compa-

nies 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 fol-

low 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 exac-

erbated by the difficulty of distinguishing between truth-

ful and overly optimistic management. Empirical studies

suggest that share repurchases occur about as often

among value stocks (presumed more likely to be under-

valued) as growth stocks. While none of the evidence

sheds much light on what motivates managers to repur-

chase shares, the debate over fair value will probably con-

tinue, and the question of whether share repurchases can

send a strong enough signal about underpriced stocks is

unlikely to be resolved anytime soon.

48 S T R AT E G IC F I N A N C E I Fe b r u a r y 2 0 1 0


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 repur-

chase program experienced a significant negative reac-

tion. These researchers concluded: “When investors

perceive that dividends are being replaced by repurchases,

they view the reduction in dividends as much less nega-

tive.” (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


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%


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 wide-

spread. 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%



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 main-

tain the desired balance between debt and equity.

Suppose a company’s debt remains constant. Two com-

mon 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 posi-

tion 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 accom-

plish 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 pur-

chase 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 DisclosuresIn 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 lia-

bility 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 deci-

sions 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, includ-

ing 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 com-

pany didn’t purchase any shares until after August 2005.

Some Recent Repurchase ProgramsDividend Equivalent of a Share Repurchase. Dard-

en 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 com-

pany’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 begin-

ning 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 buy-

back 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 compa-

ny had approximately 2.172 billion shares outstanding

during the year, which paid cash dividends of $1.52 per

50 S T R AT E G IC F I N A N C E I Fe b r u a r y 2 0 1 0


share. The share repurchase, on the other hand, provid-

ed 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.


140.4 (+ 5) million shares = $2.59 per share if the

shares had not been repurchased, making the denomi-

nator 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 dif-

ference in whether the company’s earnings meet analysts’

expectations.


15.2 million shares = $0.69 per share.


15.2 (+ 0.239) million shares = $0.68 per share.

The Bottom LineShare 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 flexi-

ble tool for managing leverage and distributions to share-

holders. Both securities analysts and shareholders should

recognize treasury stock transactions as an important

component of shareholder value. SF

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 [email protected].

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

[email protected].


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, pub-

lished 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.

financial management accounting meets strategy: share

Documents