Accounting for Treasury Stock Using the Cost Method

There are mainly two methods of accounting for treasury stock shares: the cost method and the par value method. This section discusses the cost method.

The cost method of accounting for treasury stock shares is the most common method because of its simplicity. 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 shares 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:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares

If Sunny acquires 1,000 shares of common stock at $5 per share, he would make the following accounting journal entry:

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 shares affects the accounting balance sheet as follows:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares,
1,000 Shares of which are Treasury StockRetained Earnings ($5,000 restricted for cost of treasury stock held)Less: Cost of 1,000 treasury shares

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.

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.

Contributed Capital from treasury stock transactions – common

Sunny reissues 300 shares of treasury shares at $3 per share.

Contributed Capital from treasury stock transactions – common

After the above transactions, the equity section of the balance sheet for Sunny Sunglasses Shop now appears as follows:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares,
500 Shares of which are Treasury StockRetained Earnings ($2,500 restricted for cost of treasury stock held)Less: Cost of 500 treasury shares

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.

Contributed Capital in excess of par – common

The common stock, contributed capital, and treasury stock shares are retired based on the original values in each account, with the difference going to retained earnings.