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Do Firms Follow GAAP When They Record Share Repurchases?

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Do Firms Follow GAAP When They Record Share Repurchases? Advances in Accounting, incorporating Advances in International Accounting 34 (2016) 41–54 Contents lists available at ScienceDirect Advances in Accounting, incorporating Advances in International Accounting journal homepage: www.elsevier.com/locate/adiac Do firms follow GAAP when they record share repurchases? Monica Banyi a,⁎, Dennis Caplan b a College of Business and Economics, University of Idaho, Moscow, ID 83843, United States b University at Albany (SUNY), Albany, NY, United States article info abstract Article history: This paper examines U.S. firms' accounting for share repurchases and the accounting choice provided to Received 4 May 2016 Delaware-incorporated firms between the treasury and retirement methods. This accounting choice does not Received in revised form 15 July 2016 affect income, cash flows, or net assets, but it nevertheless affects financial reporting transparency and the allo- Accepted 19 July 2016 cation of equity between retained earnings and contributed capital. According to Generally Accepted Accounting Available online 4 August 2016 Principles (GAAP), the accounting choice to record share repurchases should reflect management's intended disposition of the repurchased shares. We compare characteristics of Delaware-incorporated treasury and retire- Keywords: fi fi Share repurchases ment rms and nd that the choice between the two accounting methods is not always consistent with GAAP, Treasury stock but neither is it random; rather, this choice is related to a number of firm characteristics including firm growth, Accounting choice industry membership, trading exchange, and price–earnings ratio. We also find that a firm's accounting method for share repurchases is associated with a firm's propensity to make future share repurchases. © 2016 Elsevier Ltd. All rights reserved. 1. Introduction to the firm's financial motivation for repurchasing shares as well as the likelihood that the firm engages in future repurchases. Share repurchases have become an important component of If firms follow generally accepted accounting principles (GAAP), corporate payout policy. According to a 2016 Wall Street Journal article: then the accounting treatment for share repurchases depends on the “Since 1985, corporations have repurchased about $6.6 trillion of their firm's intended purpose for the repurchased shares. Treasury stock own stock,” and “in 2015, there were $831 billion of buybacks holdings are viewed as temporary and treasury stock transactions do authorized, the second-biggest dollar amount ever … Initial estimates not affect retained earnings. If a treasury stock account is used, the of the money actually spent on the buybacks [in 2015] was about repurchase represents the first step in a transfer of equity among share- $583 billion” (Driebusch, 2016). DeAngelo, DeAngelo, and Skinner holders. The company mediates this equity transfer and holds the (2009) identify eight advantages of repurchases over dividends that shares temporarily as an unallocated reduction in common equity. include the following five: potential tax savings to shareholders; greater Since the firm reports treasury stock separately in stockholders' equity financial flexibility for the company because there is no implied promise and provides both the number of shares held and the cumulative cost to continue payouts in the future; the ability to correct the market's of these shares, external stakeholders can easily determine the cumula- undervaluation of the company's stock; the reporting of higher earnings tive economic effect of the firm's repurchase programs and assess the per share; and removal of “low valuation” investors from the stockhold- likelihood that the firm will complete the transfer and reissue the er pool to reduce the likelihood of an unwanted takeover (p. 237). shares. The retirement method, however, is viewed conceptually as a A mature empirical finance literature has evolved to examine distribution to shareholders similar to dividends, and thus, usually these economic motivations, transaction structure, methods, market results in a reduction of retained earnings.1 Under both methods, the re- reactions, signaling effectiveness, and efficiency of share repurchases. purchase transaction's impact on the firm's book value of equity and However, there is a paucity of research examining how firms report earnings per share is the same. Apart from the financial reporting differ- information about these transactions to shareholders and whether the ences, there are potential economic implications of the accounting firm presents the information in a format consistent with the firm's economic motivation for the share repurchase. This paper seeks to fill fi fi this gap in the literature and nds systematic differences in rm charac- 1 ASC 505-30-30-8 indicates that the excess of repurchase price over par value may be teristics related to the accounting method a firm chooses to report share allocated between retained earnings and additional paid in capital (APIC) or entirely repurchase transactions. We find the firm's accounting choice is related against retained earnings. However, in practice, many firms use ARB 43, Chapter 1B, par- agraph 7 to support the allocation of the excess cost over stated value to APIC first, with additional amounts taken against retained earnings once the capital surplus is depleted. Thus, it is possible for a firm using the retirement method to record share repurchase ⁎ Corresponding author. transactions without reducing retained earnings by allocating the entire purchase cost E-mail addresses: [email protected] (M. Banyi), [email protected] (D. Caplan). against existing capital surplus. http://dx.doi.org/10.1016/j.adiac.2016.07.005 0882-6110/© 2016 Elsevier Ltd. All rights reserved. 42 M. Banyi, D. Caplan / Advances in Accounting, incorporating Advances in International Accounting 34 (2016) 41–54 method as well, since firms may use treasury shares as currency in positively related to a firm's repurchase activities, consistent with future corporate transactions. prior repurchase activity increasing the likelihood of future repurchase In this paper, we examine a firm's choice to account for share activity. Interestingly, we find differing relationships between the firm's repurchases. Prior research examining management's choice among ac- choice of accounting method and its repurchase likelihood, both across counting methods indicates that management may use the discretion time and across firm risk levels. allowed by GAAP to communicate transactions using the accounting Although idiosyncratic risk decreases the likelihood of a share repur- method that most efficiently conveys management's private informa- chase in general, when two firms face similar idiosyncratic risk levels, tion to shareholders. Alternatively, management may opportunistically we find the treasury firm is more likely to make share repurchases.3 elect the accounting method that provides a greater benefittotheman- Thus, researchers and practitioners should control for the systematic ager or to the firm. To understand the economic determinants of this ac- differences between the two groups of firms when examining capital counting choice, we compare the firm characteristics of two groups of payout polices involving share repurchases. Delaware-repurchasing firms, one group holding shares in treasury This paper contributes to our understanding of the accounting and the other group retiring all repurchased shares.2 choice between the treasury and retirement methods for share First, we explore the characteristics of firms that switch from the repurchases. Since this choice is not available to all firms, it is useful to treasury method to the retirement method or vice versa. We find that understand the determinants of the decisions of the firms legally only 6% of Delaware firms switched accounting methods over the permitted to make this choice. It is useful to understand whether the twenty-year sample period indicating that the method initially chosen accounting choice is merely cosmetic or whether management uses to communicate share repurchases seldom changes. We examine this the discretion provided by GAAP to communicate the firm's motivation small subset of switching firms using a conditional fixed effect logit for the share repurchase transactions. Specifically, does management's model that controls for firm characteristics related to share repurchase choice of accounting method reflect the underlying motivation for the transactions. We find only the size of the repurchase itself affects the firm's share repurchases or the intentions for the repurchased shares? likelihood that a firm switches to the treasury method. This understanding is important given an increasing number of states Since the choice of accounting method appears sticky, we next that do not permit the treasury method and hence, do not provide examine the firm characteristics related to the method choice for the firms the discretion to communicate information of the firm's intention full sample of Delaware repurchasing firms. We find that the accounting for the repurchased shares. Since we find systematic differences method used to account for share repurchase activities appears neither between firms electing to use the treasury method and firms that retire fully consistent with the guidance provided by GAAP nor random. While repurchased shares, a failure to appreciate these systematic differences we find evidence that this choice appears related to certain firm charac- could influence our understanding of corporate payout decisions. teristics suggested
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