Apr

15

Accounting for share buybacks

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legal1[1]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:

  • the acquisition of shares in a reduction of capital duly made;
  • the purchase of shares in pursuance of an order of the court under:
    • section 98 (application to court to cancel resolution for re-registration as a private company);
    • section 721(6) (powers of court on objection to redemption or purchase of shares out of capital);
    • section 759 (remedial order in case of breach of prohibition of public offers by private company); or
    • Part 30 (protection of members against unfair prejudice);
  • the forfeiture of shares, or the acceptance of shares surrendered in lieu, in pursuance of the company’s articles, for failure to pay any sum payable in respect of the shares.

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:

  • a transfer to the capital redemption reserve where shares are redeemed or purchased wholly or partly out of the proceeds of a fresh issue; and
  • the aggregate amount of the proceeds is less than the aggregate nominal value of the shares redeemed or purchased (section 733(3(a) and (b)).
  • The amount by which a company’s share capital is diminished in accordance with section 729(4) (on the cancellation of shares held as treasury shares) must be transferred to the capital redemption reserve.

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:

 

£

Cash at bank

40,000

 

Ordinary share capital (£1 shares)

18,000

Profit and loss account

22,000

 

40,000

 

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

DR ordinary share capital

4,000

CR cash at bank (4,000)

 

Redemption of share capital

DR profit and loss account

4,000

CR capital redemption reserve (4,000)

 

Share capital redeemed – maintain share capital 

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

 

£

Cash at bank

36,000

 

Ordinary share capital (£1 shares)

14,000

Capital redemption reserve

4,000

Profit and loss account

18,000

 

36,000

 

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:

DR ordinary share capital

4,000

DR profit and loss account (4,000 shares x 0.50p)

2,000

CR cash at bank

(6,000)

 

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:

DR profit and loss account

4,000

CR capital redemption reserve (4,000)

 

To maintain the capital of the company

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

 

£

Cash at bank

34,000

 

Ordinary share capital (£1 shares)

14,000

Capital redemption reserve

4,000

Profit and loss account

16,000

 

34,000

 

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

CR cash at bank

(6,000)

DR profit and loss account

6,000

DR ordinary share capital

4,000

CR capital redemption reserve (4,000)

 

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:

  • The aggregate of the premiums the company received on issuance of the shares that it is now  redeeming; or
  • The amount of the company’s share premium account after crediting the premium (if any) on  the new issue of shares it makes to fund the purchase or redemption.

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:

 

£

£

Par value of shares purchased

10,000

Lower of:

– initial premium on share issue

1,000

  (10,000 shares at 10p premium)

– balance on share premium account including premium on new issue of shares

7,500

1,000

Total (which cannot exceed proceeds of new issue)

11,000

Balance funded from distributable profit

14,000

Cost of purchase of Fred’s shares

25,000

 

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

DR cash at bank

17,500

CR share capital (10,000)
CR share premium account

(7,500)

 

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

DR share capital

10,000

DR share premium

1,000*

DR profit and loss account

14,000**

CR cash at bank

(25,000)

 

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:

  •       purchase price of shares less (distributable profit + proceeds from new share issue) = PCP

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:

  • Capital redemption reserve
  • Share premium
  • Fully paid up share capital
  • Revaluation reserve

Example

The balance sheet of Company C Ltd is as follows:

 

£

Cash at bank

20,000

 

Ordinary share capital (£1 shares)

16,000

Profit and loss account

4,000

 

20,000

 

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:

DR ordinary share capital

6,000

CR cash at bank (6,000)

 

Payment to redeem shares

Profit and loss account

4,000

Capital redemption reserve (4,000)

 

Maintenance of capital and protection of creditors

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

 

£

Cash at bank

14,000

 

Ordinary share capital (£1 shares)

10,000

Capital redemption reserve

4,000

 

14,000

 

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:

 

£

Cash at bank

14,000

 

Ordinary share capital (£1 shares)

10,000

Share premium account

2,500

Profit and loss account

1,500

 

14,000

 

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.

 

£

Purchase cost (4,000 x £1.30)

5,200

Profit and loss account reserves

(1,500)

Proceeds from new share issue (1,000 x £3)

(3,000)

Permissible capital payment

700

 

Value of purchase at par value

4,000

Proceeds from new share issue

(3,000)

Permissible capital payment

(700)

Transfer to capital redemption reserve

300

 

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

DR cash at bank

3,000

CR ordinary share capital

(1,000)

CR share premium account

(2,000)

 

Being issue of new shares at £2 premium 

DR ordinary share capital

4,000

DR profit and loss account reserves

1,200

CR cash at bank

(5,200)

 

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

DR profit and loss account

300

CR capital redemption reserve

(300)

 

To maintain the company’s capital 

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

 

£

Cash at bank and in hand

11,800

 

Ordinary share capital (£1 shares)

7,000

Share premium

4,500

Capital redemption reserve

300

Profit and loss account

Nil

 

11,800

 

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:

  • The payment out of capital must be approved by way of special resolution
  • A statement must be made by the directors
  • The company’s auditors must include a report annexed to the directors’ statement
  • A notice of the proposed capital payment, together with information required by s719 CA06 must be published in the Gazette within a week of the date of the special resolution
  • A notice of the proposed capital payment, together with the information required by s719 CA06 must be published in a national newspaper, or written notice given to each creditor.

 

 

Category: Accounting and standards

About the Author ()

Steve Collings is the audit and technical director at Leavitt Walmsley Associates Ltd and the author of 'Interpretation and Application of International Standards on Auditing'. He is also the author of 'IFRS For Dummies' and 'The AccountingWEB Guide to IFRS'. More about Steve's publications can be found by clicking on the 'Published Work' tab on the homepage. Steve is also a regular contributor of articles to www.accountingweb.co.uk, the UK's largest resource for professional accountants on a free subscription basis and is a member of the Society of Authors. Steve is an Editorial Board member for Wiley Insight IFRS and sits on the AAT's Financial Reporting Technical Panel. In 2011 Steve was named 'Accounting Technician of the Year' at the British Accountancy Awards and won 'Outstanding Contribution to the Accountancy Profession' by the Association of International Accountants in 2013. Follow Steve on Twitter - @stecollings

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