The pros and cons of using stock buybacks

As stock buybacks become the norm for public companies looking to distribute excess cash to shareholders, accounting experts are cautioning companies to be sure they understand the accounting consequences and structure contracts accordingly.

More than 300 of S&P 500 companies bought back more than $1 billion of their shares from March 2014 to March 2016, according to Institutional Investor, exemplifying an increasingly common alternative to dividend payments. While buybacks can be executed in a number of ways, the accelerated share repurchase approach started to pick up some popularity in the early 2000s. Companies like the way it reduces the number of shares outstanding to produce an attractive and immediate bump to the earnings-per-share calculation.

The approach tapered somewhat in the wake of the financial crisis, but has gained a healthy head of steam the past few years. “Every time companies become flush with cash, we see an uptick in accelerated share repurchase programs,” says Jonathan Howard, senior consultation partner at Deloitte. The recent wave even prompted at least one Big 4 firm to issue an alert to clients assuring companies understand how the accounting works.

An ASR is a two-part transaction that involves both a treasury stock purchase and a forward contract. Depending on how it is structured, it could qualify for equity treatment, but it could also be characterized at least in part as a debt arrangement.

That sends companies into the thicket of hedge accounting, where more than a few public companies have stumbled into restatement. In fact, data from Audit Analytics has shown classification of debt and equity as the most common cause of restatements for several consecutive years.

The ASR is a means of buying back shares with an upfront purchase through an investment bank so as to minimize disruption of the share price. The company strikes a deal with an investment bank to buy a specific number of shares at a stated price, which might be the current market price or an expected average over some future period of time.

“Under the accounting model we have today, the change in value flows through equity, so it doesn’t show up elsewhere in the balance sheet or income statement. There’s a bit of a policy implication there.”

Terry Warfield, Accounting Professor, University of Wisconsin Madison

The investment bank will borrow shares from existing shareholders to provide to the company immediately, then engage in smaller-lot purchases over the term of the agreement to minimize any rise in share price. The actual price to buy the shares probably won’t exactly match the upfront price the company pays to the investment bank, so the two parties will settle up any difference at the end of the term.

The treasury stock purchase aspect of an ASR is well understood under current GAAP. “That’s straightforward,” says Faye Miller, a partner with RSM. “You just credit cash and debit equity.” It’s the forward sale contract that commands caution. “From an accounting perspective, it can get very complex,” she says.

The forward sale contract might qualify for equity treatment, but it also might be a liability. The difference is deep in the details of the contract and the accounting rules, both of which require careful analysis.

From an accounting perspective, the distinction is enormously important. If it’s treated as a liability, that means it must be re-measured every accounting period, and changes must be recorded through net income. That introduces the potential for volatility in the income statement, which companies typically prefer to avoid.

To understand how to account for the forward contract within an ASR, companies need to refer to multiple different areas within the Accounting Standards Codification, says Vicki Dickinson, associate professor at the University of Mississippi who has studied ASRs. That’s part of the reason it gets tricky.

ACCOUNTING IMPLICATIONS OF ACCERLERATED SHARES

Below PwC discusses the comeback of accelerated share repurchases and what it means for the books.
When companies have excess cash, they may pay dividends to shareholders or engage in share buyback programs. There are various ways a company can buy back shares, including open market purchases or accelerated share repurchase (ASR) programs. Generally, companies use investment banks to structure and execute ASR programs, Repurchasing a large number of shares at a purchase price determined by an average market price over a period of time.
Among the perceived benefits of an ASR program are the company’s ability to remove shares delivered to it from the investment bank on Day 1from the EPS computation, and the avoidance of certain regulatory considerations (e.g., no blackout periods and no limit on the number of shares that can be purchased). In addition, the investment bank that’s involved often guarantees a discount from the average price of the company’s stock over the contract period.
Accounting implications
On Day 1, an ASR is accounted for as two transactions: a treasury stock purchase and a forward sale contract. The treasury stock purchase is straightforward, but the forward contract generally meets the definition of a derivative. As such, the company must consider whether the forward contract should be classified in equity or as a liability. Equity classification does not require subsequent remeasurement, while liability classification requires remeasurement at fair value, with changes in fair value reported through earnings.
In order to be classified in equity, the forward contact miust qualify for the derivative scope exception. Typically the scope exception is available only if the contract is indexed to the company’s own stock and the ASR contract is classified as equity. The analysis required to determine if the scope exception applies involves understanding the economics behind all adjustments that can be made to the settlement value.
Companies should also consider the impact of the ASR on basic and diluted EPS. For instance, a company should assess all dividend provisions in the contract in order to ensure that the contract is not considered a participating security, which would require the use of the two class method for purposes of computing EPS. In addition, the contract will likely require the use of the treasury stock method for purposes of computing diluted EPS.
Source: PwC

Three specific historical accounting pronouncements recommended by the Emerging Issues Task Force of the Financial Accounting Standards Board contain the key guidance necessary for the analysis of an ASR, says Howard. Those include EITF 99-7 on accounting for share repurchase programs, EITF 00-19, which covers how to account for a derivative indexed to a company’s own stock, and EITF 07-5, which helps with the determination of whether an instrument is indexed to a company’s own stock. They are contained in the ASC now under Topics 505 and 815.

The rules have not changed considerably, but changes are scattered in GAAP in guidance on EPS, derivatives, and liabilities versus equity, says Dickinson. “The codification evolves as practice evolves, and I would say changes are coming more through informal guidance channels with the help of the external audit function,” she says.

The forward contracts associated with ASRs can have literally pages and pages of terms and conditions, each of which must be evaluated carefully against the accounting guidance, says Howard. “The investment banks know the rules. The accountants know the rules. We just have to be cautious of new adjustments going into these,” he says. “You always have to know if there’s a new feature in there.”

Dickson and her colleagues have raised questions through their research about whether investors are getting a full view of the economic consequences of ASRs under current accounting guidance. When a company is allowed to treat the forward contract as equity, that means the company’s exposure to changes in its own stock price are not fully visible to investors. “The company is going to have an off-balance-sheet asset or liability, depending on which direction the stock price is moving, that has not been reflected in financial statements,” says Dickinson.

Terry Warfield, accounting professor at the University of Wisconsin Madison, who participated in the research, says the accounting challenge arises in how the derivative is indexed in the company’s own stock. “Under the accounting model we have today, the change in value flows through equity, so it doesn’t show up elsewhere in the balance sheet or income statement,” he says. “There’s a bit of a policy implication there.”

Miller says companies need to be cautious when they undertake ASRs to ensure they understand the accounting consequences, which can vary based on the specific agreement’s terms and conditions. “The negative accounting consequences can be avoided if you properly structure the arrangement,” she say. “If adjustments to the terms are worded inappropriately, for example, you could cause the instrument from an accounting perspective to be considered not indexed to the entity’s own stock, and so not accounted for in equity. You can generally achieve your goals without the negative accounting consequences.”