Chapter 7.7® - Conversion of Shares & Accounting for Treasury Stocks - Buying & Selling Treasury Stocks & Its Effects on Shareholder's Equity - Contributed Capital
Shares of any class may include the provision that they may be converted, at particular times and / or in particular quantities, into shares of another class.
Preferred shares may be convertible into common shares. Conversions are accounted for at book value, with an equal decrease to one share class and increase to another.
If 20,000 preferred shares, issued for an average of $36.70 per share, were to convert per the terms of their share certificates to 60,000 common shares (that is, 3-for-1):
A firm may also buy its own shares and hold them for eventual resale. These shares are called ‘treasury stocks’.
Accounting for the Treasury Stocks:
When a company buys treasury stocks, the cost of the shares acquired is debited to a treasury stock account which appears a deduction at the end of the shareholders’ equity section. When the shares are resold, the treasury stock account is credited for the cost, and the difference, which is the “gain or loss”, affects various equity accounts. The gain or loss is not reported on the income statements. A firm cannot improve reported earnings by engaging in capital transactions with their own shareholders. The balance in the treasury stock account is logically shown as a deduction from the total of shareholders’ equity.
This method of accounting for treasury stock is called the single-transaction method. The treatment is the same as that used for share retirement. An example will illustrate the sequence of entries.
a) Record initial sale and Issuance of 10,000 Common Shares at $26 per share
b) Record the acquisition of 2,000 common treasury shares at $28 per share
Note: The cash price paid is always the amount debited to the treasury stock account.
c) Record sale of 500 treasury shares at $30 per share (above cost)
Note: Had this sale been at cost ($28 per share), no amount would have been entered in the contributed capital account. If treasury shares are bought in a series of acquisitions at different prices, weighted average cost is used on disposition.
d) Record the sale of another 500 treasury shares at $19 per share (below cost)
Assuming entries (1) through (4) above, and a beginning balance in retained earnings of $40,000, the balance sheet would reflect the following: