Question

1. What is treasury stock? Explain and discuss some of the reasons a corporation may purchase treasury stock.

2. What is a stock dividend? Describe and discuss reasons why a company would choose to give dividends in the form of stock rather than cash. In your response explain how issuance of a stock dividend affects the accounting records.

Answer 1

1. Treasury stock means the company purchases it's own shares from shareholders i.e. the company buy backs the shares that are already issued by the company. After purchasing the shares from shareholders the company cancels the shares, that means the company reduces it's outstanding share capital.

The reasons for treasury stock (i.e. why company purchases it's own stock) :

• One of the main reason to buy back it's own shares from shareholders is to increase the percentage of shareholding of promoters. As the shares bought back are cancelled the percentage of shareholding of promoters increases compared to other shareholders.
• When shares are bought back and cancelled the earning per share increases as the number of shares outstanding decreases. When EPS increases it attracts new investments into the company in future.
• When there are large number of shares outstanding it dilutes the ownership of the company. So to avoid that, shares are bought back by the company.
• When company has surplus funds and the company doesn't wants to utilize such surplus funds it pays back surplus funds to shareholders by purchasing shares.

2. Stock dividend means issue of shares as dividends to shareholders. Sometimes the company issues additional shares as dividend instead of cash to avoid certain tax implications. This is nothing but conversion of retained earnings to share capital.

The reasons to issue shares as dividend rather than cash are:

• When company has new investments plans it requires cash, so to retain the cash in the business company gives shares instead of cash.
• As said earlier,  the company issues shares as dividends because the stock dividend process converts retained earnings to share capital which the company can use to make further investments.
• When shares are given as dividend it increases the number of shares held by shareholdres, when number of shares increases it increases sense of ownership among shareholders and also increases future earnings of shareholders.
• When cash is paid as dividend government levies tax, this reduces net returns of shareholders. So to avoid that, dividend is paid in the form of shares.

Effect on accounting records : when shares are issued as dividend instead of cash then it increases share capital and reduces retained earnings (i.e. reserves and surplus). As cash not paid there is no change on asset side of balance sheet, only the equity part of balance sheet is affected. The journal entry would be -

Reserves and surplus (Dr)	$***
To Share capital (Cr)		$***