Question

It is December 15, 2016. Phillip Groth, CFO, and Carver Smith, Controller, both employees of Caravan International, are seated in a conference room with Hank Weatherspoon, an investment banker for the ?rm of Waynesboro and Franklin. Weatherspoon requested the meeting to discuss a proposal for Caravan’s stock buyback program. Caravan has engaged in a number of previous large stock buybacks to make shares available for its employee stock option plan and for use as currency in acquisitions of other companies. Caravan has a large number of employee stock options that will most likely be exercised in the near future. Therefore, Weatherspoon is anticipating that Caravan will soon initiate a large stock buyback to minimize outstanding shares and thus avoid diluting its earnings per share. Because Weatherspoon believes that he can structure Caravan’s stock buyback in a more bene?cial fashion, he scheduled a meeting with Groth and Smith.

On the date of the meeting, Weatherspoon began his presentation after a brief exchange of pleasantries:

Weatherspoon: In your past stock repurchases you have typically announced your intentions to repurchase anywhere from 500,000 to 1,000,000 shares over the subsequent 12-month period. You then repurchased the shares in two to four open-market repurchases scattered throughout the year. This approach enabled you to repurchase the shares when you thought the price was advantageous. However, this approach has the disadvantage of delaying some of the stock buyback’s bene?cial aspects.

Groth: What do you mean by that?

Weatherspoon: One of the primary bene?ts of a stock buyback is that it reduces the number of outstanding shares, and thus increases reported earnings per share. Suppose that you plan to purchase 1,000,000 shares in the coming year. Under your usual approach, your stock repurchases are scattered throughout the year; therefore, the bene?cial impact on earnings per share that results from reducing shares is much reduced. Using our approach, you would instead record a 1,000,000-share reduction in the number of outstanding shares immediately after executing the buyback plan, all at a pre-agreed price.

Groth: That does sound good.

Weatherspoon: An additional bene?t of a stock buyback is that, by executing the transaction at the beginning of the buyback period, you send a more credible signal to the market by actually acting on your stated intentions. Otherwise, in some past instances, due to either cash shortfalls or increases in the cost of shares, you have only partially executed your announced share repurchase plan. For example, two years ago you only repurchased half as many shares as you had originally stated that you would. By not ful?lling your originally stated plan, you potentially left some investors skeptical about your real intentions.

Groth: How does your plan work?

Weatherspoon: Our approach, a fairly common one, is called an ‘‘accelerated share repurchase.’’ Let me explain the steps. After you announce your share repurchase plan, you buy all of the shares at a pre-agreed price from our ?rm. For example, Caravan’s stock is currently selling for $45 dollars. If we arranged for a repurchase of 1,000,000 shares today, then you would give us $45,000,000, and we would give you 1,000,000 shares.

Groth: I didn’t realize that you are holding so many of our shares.

Weatherspoon: We aren’t, but our institutional clients are. We simply borrow the shares from them, and then sell them to you. This process enables you to purchase more shares than are currently available in the market, and you do so without driving the price up. However, as a result of borrowing shares from our clients, we are in a short position on your shares. So, to protect us against loss on this short position, we require that you agree to a forward sale contract. Under this forward contract, you agree to sell our ?rm shares at a price equal to the price at the initiation of the transaction, or in this case, $45. Any difference between the market price and the agreed price at the date of settlement is payable in either cash or additional shares, at your discretion. Throughout the buyback period, we close out our short position by buying shares in the market to replace the shares we borrowed from our clients. For example, suppose that we purchase 1,000,000 shares at an average price of $60. You would either pay us $15,000,000 [($60 – $45) * 1,000,000] or 250,000 additional shares ($15,000,000/$60). On the other hand, if we only pay $30 for the shares, then we would pay you $15,000,000.

Smith: What about the accounting? What is the accounting treatment for this transaction? It would seem that Caravan’s forward sale contract would be treated as a derivative. If that’s the case, then the gains and losses on the contract that result from changes in Caravan’s stock price would ?ow directly into net income, negating much of the earnings per share bene?t.

Weatherspoon: That’s the beauty of it. By using an accelerated share repurchase plan, you get an immediate boost to EPS because of the immediate reduction in shares outstanding. Furthermore, under an Emerging Issues Task Force (EITF) ruling issued in the late 1990s, the forward sale contract does not get derivative treatment because the contract is an instrument indexed to Caravan’s own stock. In fact, Caravan has the option of settling in shares. As a result, gains or losses on the contract are recorded as adjustments to equity, rather than as a component of income. In other words, if the gain or loss is paid in cash, then the amount directly increases or decreases stockholders’ equity. Just so you know, for diluted EPS calculations, if your intent is to pay the difference in cash, then the numerator of EPS is adjusted for the gain or loss. On the other hand, if you intend to settle by issuing additional shares, then the additional shares increase the shares outstanding. Thus, if your share price changes, then the initial EPS improvement gained at the inception of the deal may change to some extent.

I have prepared the following example for a hypothetical company to illustrate the accounting treatment. Suppose that XYZ Company engages in an accelerated share repurchase (ASR) on January 2, 2017 for 20,000 shares at an initial price of $20 per share. XYZ makes the following entry to record the ASR:

Treasury Stock                 400,000

               Cash                                    400,000

Assume XYZ had 2016 net income of $360,000 and that earning per share for 2016 was $1.80 ($360,000 net income / 200,000 shares outstanding). If XYZ estimates that 2017 net income will also be $360,000, then its EPS for 2017 will increase to $2 [$360,000 / (200,000 - 20,000) shares outstanding]. If XYZ’s share price decreases to $15 during the settlement period, ending June 30, 2017, then the company will receive a $100,000 [($20 - $15) * 20,000 shares] cash payment from Waynesboro and Franklin on settlement of the forward sale agreement. This payment reduces the net cost of the share repurchase program to XYZ and is reported as a direct increase to stockholders’ equity.

Groth: Thank you for your presentation. We would like to do some additional analysis before we make a decision. I will call you within a week.

After Weatherspoon departs, Groth and Smith meet to discuss the ASR proposal.

Groth: I am still concerned that this opportunity might be too good to be true. Even if the transaction is legal and the accounting is in accordance with GAAP, I’m not sure that it will be perceived positively by our shareholders. I’m afraid the transaction may be perceived as an arti?cial mechanism to boost EPS. I would like you and your staff to determine the impact of an ASR on Caravan’s ?nancial statements and to verify the GAAP treatment that Weatherspoon presented.

Answer the following. Direct quotes from the ASC can be single spaced but otherwise your answer should be double spaced. Use a 12 point font. Your answers to the first seven questions should not be longer than three pages and could be satisfactorily done in two pages.

1.     Using the financial statement data presented in Exhibit 1 compute Basic Earnings per Share for 2017 (estimated) and 2016 (actual). You may assume that no equity transactions occurred during 2016 and 2015 and the December 31, 2016 balance sheet balances are representative for December 31, 2015.

     

2.   Assume that Caravan buys back 200,000 shares on March 31, 2017, and 800,000 shares on September 30, 2017, at a price of $45 on each date, using a traditional repurchase program.

a.      What entry is made on each of the dates that treasury stock is repurchased?

b.     What is the total amount paid to execute the traditional share repurchase program?

Calculate estimated Basic Earnings per Share for 2017. Support your calculation by citing the location of a similar example within the ASC. You do not need to include any details of the example; just simply provide the location of the example within the ASC via proper citation. (You can ignore pending content.)

3.   Assume that Caravan enters into an ASR agreement to repurchase 1,000,000 shares on January 2, 2017 at a price of $45, and cash settles the forward contract on September 30, 2017.

Prepare the journal entries at January 2, 2017 and September 30, 2017. Assume that Caravan's share price holds steady such that the average settlement price at September 30, 2017 is $45 per share.

b.     What is the total amount paid to execute the share repurchase program?

c.      Calculate estimated Basic Earnings per Share for 2017. Why does it differ from what you calculated in #2 above?

4. Again, assume that Caravan enters into an ASR agreement to repurchase 1,000,000 shares on January 2, 2017 at a price of $45, and cash settles the forward contract on September 30, 2017.

Prepare the journal entries at January 2, 2017 and September 30, 2017. Assume that the average settlement price for Caravan shares at September 30, 2017 is $50 per share.

b.     What is the total amount paid to execute the share repurchase program?

6. Using the ASC verify the accounting for ASRs as articulated by Weatherspoon. Explain the accounting treatment with appropriate citations to the ASC. Specifically support the argument that the ASR transactions are equity transactions and the forward contract is not accounted for as an asset or liability under derivative accounting.

7.   Assuming Caravan decides to enter the ASR, if Caravan prepares financial statements on June 30, 2017, when its share price is $50, is the value of the ASR reflected in Caravan's financial statements on that date? What risk does the ASR create for Caravan that it would not face under a traditional plan, and are the potential consequences of this risk adequately reported under the current standards? Explain in 3-4 sentences.

8.   Prepare a double-spaced 12-point font memorandum that briefly summarizes ASRS, how they are accounted for, the costs and benefits of using the ASR and whether you believe Caravan should or should not use the ASR.

EXHIBIT 1: Caravan International Financial Statements
Balance Sheets at December 31 (dollars in thousands)	2017 (Estimated)		2016
Cash	$195,006		$110,768
Accounts Receivable	295,993		263,087
Inventory	80,756		102,892
Other Current Assets	20,696		25,169
Total Current Assets	592,451		501,916
Property, Plant, and Equipment, net	263,849		288,127
Other Assets	84,162		97,945
Total Assets	$940,462		$887,988
Accounts Payable	$107,943		$105,656
Notes Payable	58,761		63,250
Unearned Revenue	38,315		54,700
Total Current Liabilities	205,019		223,606
Long-Term Debt	146,743		144,001
Total Liabilities	351,762		367,607
Common Stock ($1 par; 10,000,000 shares issued and outstanding)	10,000		10,000
APIC: Common Stock	41,454		41,454
Retained Earnings	651,292		582,973
Treasury Stock	(114,046)		(114,046)
Total Stockholders’ Equity	588,700		520,381
Total Liabilities and Stockholders’ Equity	$940,462		$887,988

Income Statements for the Year Ended December 31 (dollars in thousands)	2017 (Estimated)		2016		2015
Sales	$1,543,927		$1,424,184		$1,318,126
Cost of Sales	1,200,487		1,115,761		1,033,281
Gross Pro?t	343,440		308,423		284,845
Selling Expenses	124,422		97,638		114,212
General and Administrative Expenses	113,962		102,278		101,094
Operating Income	105,056		108,507		69,539
Interest Expense	5,472		6,248		9,486
Other Expense (Income)	(3,975)		(2,612)		(2,353)
Income Before Income Taxes	103,559		104,871		62,406
Income Taxes	35,240		33,413		23,237
Net Income	$68,319		$71,458		$39,169

Answer 1

Ans 1. EPS 2016= Net profit available to ordinary shareholders/Weighted average no of ordinary shares outstanding during the period

=$ 71458000/10000000=$ 7.15

EPS 2017=$ 68319000/10000000=$ 6.83

Ans 2(b). Under the traditional repurchase programme:

Cash paid on 31.03.2017= $ 45 X 200000 share= $ 9000000

Cash paid on 30.09.2017= $ 45 X 800000 share= $ 36000000

Hence total cash outgo= $ 45000000

Weighted average no of equity shares for 2017= 10000000 - (200000 X 9/12) - (800000 X 3/12)= 9650000

Hence EPS= $ 68319000/9650000=7.08

Ans 2(a). Date Particulars Dr($) Cr($)

31.03.2017 Treasury Stock A/c Dr 9000000

To Cash 9000000

(Being shares bought back for cash)

30.09.2017 Treasury Stock A/c Dr 36000000

To Cash 36000000

(Being shaes bought back for cash)

Ans 3(b). Total amount paid to execute the share repurchase programme=$ 45 X 1000000= $ 45000000

Ans 3(c) Weighted average no of shares= 10000000-1000000=9000000

EPS=68319000/9000000=7.59

Here the EPS has increased due to the difference in calculation of weighted average no of equity shares.

Ans 3(a). Date Particulars Dr($) Cr($)

30.09.2017 Treasury Stock Dr 45000000

To Cash 45000000

(Being shares repurchased for cash)

Ans 4(b). Amt paid to execute share repurchase programme= $ 50 X 1000000=$ 50000000

Ans 4 (a). Date Particulars Dr($) Cr($)

30.09.2017 Treasury Stock 50000000

To Cash 50000000

(Being shares repurchased for cash)

Note: All EPS calculations have been made in accordance with the principles of IAS 33.