Accounting for share buybacks

It is not uncommon to hear of companies purchasing their own shares from shareholders. Typical scenarios include shareholders who wish to sell their shares in a company where other shareholders may not wish to buy them or where the shareholders are unable to raise the cash to purchase them.

The accounting for such buy-backs can be tricky and there is a whole host of legalities to consider – some of which are obvious whereas others not so. This article will take a look at how the mechanics of accounting for such buybacks works and the legal considerations that should be made.

Companies Act 2006

Companies Act 2006 (CA06) deals with the acquisition by a company of its own shares in Part 18 in sections 658 to 737. Section 658 places a restriction on companies acquiring their own shares (whether by purchase, subscription or otherwise) unless the exceptions in section 659 apply. The exceptions are summarised as follows:

(1) A limited company may acquire any of its own fully paid shares otherwise than for valuable consideration.

(2) Section 658 does not prohibit:

Accounting issues

Section 686(1) of CA06 only allows redeemable shares to be redeemed if they are fully paid. The similar principle is contained in Section 691(1) which prohibits companies from purchasing their own shares if the shares are not fully paid. Section 691(2) also requires companies that purchase their own shares to pay for those shares on purchase.

Section 733 under Chapter 7 of CA06 Supplementary Provisions makes reference to the ‘capital redemption reserve’. Section 733(2) requires company whose shares are redeemed or purchased wholly out of the company’s profits to transfer a sum equivalent to the amount by which the company’s share capital is diminished on cancellation of the shares. This transfer is required to maintain the company’s capital and also to protect creditors.

In addition, section 733 also requires:

The company can only then use the capital redemption reserve to make a bonus issue of shares.

Example

The balance sheet of Company A Ltd is as follows:

A resolution was passed for the company to repurchase 4,000 shares at par value. The accounting for such would be as follows:

Redemption of share capital

Share capital redeemed – maintain share capital

Company A’s balance sheet will now look like this:

Share buy-back at a premium

There may be occasions when a company may decide to repurchase some shares at a premium. Using the same example as the one above, if we assume that the company repurchased the shares at a 50p premium, the journals would be:

Redemption of share capital at a premium of £2,000

A further journal would then be required in order that the capital of the company is maintained as follows:

To maintain the capital of the company

Company A’s balance sheet would now look like this:

The above is the step-by-step process, whereas CA06 expresses the accounting treatment as follows (which ends up with the same result):

The company has still maintained capital at £18,000 and the company has made the purchase out of distributable profits (because the total debited to profit and loss account reserves is the £6,000 which is equivalent to the consideration for the share buy-back).

Shares purchased out of a fresh issue of shares

The general rule is that any premium that is paid on the shares that a company acquires must be made out of distributable profits. However, section 687(4) CA06 says that if the redeemable shares were issued at a premium, any premium payable on their redemption may be funded from the proceeds of the new share issue. The amount of the premium that can be funded in this way is equal to the lower of:

Example

On 1 January 2008, Company B Limited issued 100,000 ordinary £1 shares. Included in this share issue are Fred’s 10,000 ordinary shares which were issued to him at a premium of 0.10p per share. Following this issue the balance on Company B’s share premium account was £3,500. On 1 January 2010, Company B made a bonus issue of shares to its shareholders and used the entire balance on the share premium account on the issuance of the bonus shares.

In 2012, Fred announced that he would like to retire and has asked the company to purchase his shares. The company has agreed to purchase his shares for £2.50 per share (hence at a premium of £1.50 per share) and in order to do this has made a further issue of 10,000 ordinary shares with a par value of £1 at a premium of 0.75p (hence issued at £1.75). The balance to purchase Fred’s shares of £7,500 has been made out of the bank account.

The premium on the purchase is the lower of the initial premiums the company received on the original issuance of the shares and the balance on the share premium account after the issue as follows:

To record the above in the accounts, the journals will be:

Being new share issue of 10,000 £1 shares at £0.75 premium

Being purchase of 10,000 ordinary £1 shares at a premium of £1.50

* Section 692(4) CA06 allows the share premium account to be reduced by part of the premium payable on the purchase/redemption that is allowed to be funded out of the proceeds of the new share issue rather than it being made out of profit and loss account reserves.

** See reconciliation above.

You will note that in this scenario there has been no amounts credited to the capital redemption reserve. This is because the par value of the shares purchased (£10,000) is less than the total proceeds of the new issue of (10,000 shares @ £1.75) £17,500 and therefore the company’s capital has been maintained, so there is no need for a transfer to the capital redemption reserve.

Permissible capital payments

Section 710 CA06 deals with the concept of the permissible capital payment (PCP). The PCP is the amount by which the purchase or redemption costs exceeds the amount of profits available for distribution plus the proceeds of any new share issue, hence is calculated as:

The objective of the PCP is to make sure that a company makes use of its available profits and any proceeds arising from new share issues before it makes any payments out capital.

Section 734(2) says that where the PCP is less than the nominal value of the shares redeemed or purchased, the difference is transferred to the capital redemption reserve. Conversely, where the PCP is greater than the nominal value of the shares redeemed/purchased section 734(3) says the excess can be used to reduce any of the following:

Example

The balance sheet of Company C Ltd is as follows:

One of the shareholders has expressed his disagreement with the way the company is being run and it has been agreed that the company should purchase 6,000 shares at par from the shareholder on the grounds that the relationship has become irretrievable. Clearly the company has insufficient reserves available to make the purchase and therefore a payment out of capital will be required. Company C Ltd is required to follow the rules in CA06 (sections 709 to 723) and once these procedures have been carried out, the journals will be as follows:

Payment to redeem shares

Maintenance of capital and protection of creditors

Company A’s balance sheet will now look like this:

In this example the PCP would be 6,000 £1 shares requiring redemption less profit and loss reserves of £4,000 equals £2,000 (or the shortfall on the profit and loss account reserves balance immediately before the purchase).

In the example above, the scenario indicated that the company would just be making an outright purchase of shares at par with no additional shares being issued. This is not always the case and it might be that the company issues new shares but still needs a PCP.

Example

Company D Ltd has the following balance sheet:

Company D wishes to buy 4,000 shares which were originally issued at par value to a shareholder that is retiring. The company has agreed to buy these shares back at a premium of 0.30p. The company has also agreed to issue a further 1,000 ordinary £1 shares at a premium of £2.00.

In order to get the above transaction into the accounts, the company will make the following journal entries:

Being issue of new shares at £2 premium

Effect of buy-back of 4,000 shares at a 30p premium

To maintain the company’s capital

Company D’s balance sheet will now look like this:

Conclusion

The issue of a company acquiring its own shares can become very complex and there are many legal and ethical considerations that need to be considered. CA06 also requires strict procedures to be carried out before a payment out of capital can be made and these are summarised as follows:

Category: Accounting and standards