Hello and welcome everyone. In today's lesson, we'll continue our discussion of the main transactions for contributed equity. More specifically, we'll focus on those transactions that result in the contraction of the contributed equity caused by the retirement of the shares or equivalently, the purchase back of treasury shares. Most medium and large-sized companies buy back their own shares. Many have formal share repurchase plans to buy back stock over a series of years. When a company's management feels that the market price of its stock is undervalued, it may attempt to support the price by decreasing the supply of the stock in the marketplace. You should note the contrast between the company's purchasing its own shares versus purchasing a share in another company, which is obviously an investment. Though not considered an investment, the repurchase of shares often depends on the firm's decision to use the available cash best way possible. By increasing per-share earnings and supporting the share price, shareholders obviously benefit. To the extent this strategy is effective, a share buyback can be viewed as a way to distribute company's profits without paying any dividends. Obviously, as you know, capital gains from any stock price increase are taxed at a lower capital gain tax rates than ordinary income tax rates on regular dividends. Another primary motivation for most stock repurchases is to offset the increase in shares that routinely are issued to employees under stock-based compensation plans or programs. Also, shares might be required to distribute in a stock dividend, a proposed merger, or as a defense against a hostile takeover. So various reasons why would a company go and buy back. Whatever the reason the shares are repurchased back for, a firm has one of two choices to account for those buybacks. First one is, the shares can be formally retired. The other one is that the shares can be called treasury stock, and that's obviously expecting to reissued again. Out of tradition and for practical reasons, companies usually re-acquire shares of previously issued stock without formally retiring them. Shares repurchased and not retired are referred to as I said, treasury stock. Because reacquired shares are essentially the same as shares that were never issued at all, treasury shares have no voting rights, nor do they receive any cash dividends. When shares are repurchased as treasury stock, we reduce the shareholders equity with a debit to a contra equity account, which is going to be leveled again in the name of the stock, treasury stock. That entry is reversed later through a credit to treasury stock when the treasury stock is re-issued or resold. The purchase of treasury stock and its subsequent resale are considered to be a single transaction. Meaning that the purchase of treasury stock is perceived as a temporary reduction of shareholders' equity to be reversed later when the treasury stock is resold. The company temporarily debits the treasury sock account when acquiring the shares, as I said. The common stock account is not affected at all when I buy back the stock. Later, when the shares are resold, the treasury stock account will be credited and any difference between the cash proceeds upon resale will be allocated to specific shareholders' equity accounts as we will discuss shortly in this lesson. That's when I buy back for the purpose of reissuing. What about retiring? When a corporation retires it's own shares, those shares assume the same status as authorized, but unissued shares, just the same as if they were never issued. We saw in the previous lesson that when the shares are sold, usually cash or any other, and shareholders equity are increased, the company becomes obviously larger. On the other side, when cash is paid to retire the stock, that fact is to decrease both the cash and the shareholders' equity, obviously the size of the company is reduced. When shares are formerly retired, we should reduce precisely the same accounts that were previously increased when the shares were originally issued. Meaning those common or preferred stock and the paid-in capital in excess of the par value in the name of each of those. How we treat the difference between the cash paid to buy the shares and the amount the shares originally were sold for, which is the debit to the common stock and additional paid-in-capital, depends on whether the cash paid is less than the original issue price, in this case, we'll have a credit difference, or if the cash paid is more than the original issue price, and in this case, we'll have a debit difference. Let's talk about briefly each difference more. If a credit difference is created; Case 1, we credit paid-in capital share repurchase. Second case, if a debit difference is created, which we refer to as Case 2, we debit paid-in capital share repurchase, but only if that account already has a credit balance. Otherwise, we debit retained earnings. Specific accounts paid-in capital, reducing that account beyond its previous balance would create a negative balance which can never happen. That's why we refrain from, in this case, debiting the paid-in capital and we debit the retained earnings. Formally, retiring shares restores the balances in both the common stock account and the paid-in capital in excess of par to what those balances would have been if the shares never had been issued at all. That's why when we reverse it, as if those were not issued at all. After shares are formerly retired, any subsequent sale of shares is simply the sale of new unissued shares and is accounted for accordingly. In summary, a corporation may acquire treasury stock for one or more reasons. Whatever the reason is that the company purchase those shares for, a firm has the choice of how to account for the buyback either as stock repurchase for the sake of being reissued or formally retiring those shares that were purchased back. Thank you.
