Norlin  G. Rueschhoff
ASSOCIATE PROFESSOR
UNIVERSITY OF NOTRE DAME

THE  EVOLUTION  OF ACCOUNTING   FOR CORPORATE TREASURY STOCK  IN   THE   UNITED  STATES

Abstract: Is treasury stock an asset or a reduction of net equity? This study is concerned with the process of accounting for treasury stock from as early as 1720 to date. It illustrates the many methods which have been used to create funds by the purchase and sale of treasury stocks and concludes with a consideration of the effects of the Internal Revenue Act of 1934 and the Security Exchange Act of 1934 on the treatment of treasury stock.

In 1919, William A. Paton stated that treasury stock is a reduction of equity, not an asset. Fifty years later he reaffirmed this view, pointing out that treasury shares have substantially the same status as unissued shares and, like unissued shares, can never be con­strued as owned property. Paton asserted that acquisition of treas­ury stock is a partial liquidation of equity and must be so recorded.¹

Some financial writers hold that treasury stock may be an invest­ment.² Others state that the repurchase of stock can not be treated as an investment decision as the term is commonly defined. Since repurchasing stock does not add to the earning power of a concern, theorists hold that the decision by a firm to buy its own stock should be regarded either as a financing decision or a dividend distribution decision.³

Part of the confusion in accounting over the nature of treasury stock has been caused by the practice of reporting treasury stock at cost, first on the asset side of the balance sheet and later as a reduction of shareholders’ equity in a contra-equity account. To im­prove our understanding of current practice, this paper traces the history of accounting for treasury stock and shows how its valua­tion at cost evolved—and created problems.

Early Accounting & Financial Practices

Prior to 1925 the “treasury stock device” was frequently used to obtain working capital in new and speculative enterprises. Organ­izers received fully-paid shares for their contributions of property or services, and they in turn donated some of these shares back to the corporation. The donated shares were recorded at their ex­pected reissue price to the public which added,to contributed capi­tal even if the recorded amount was below par value. The acquisi­tion of treasury shares without consideration did not change the amount of the recorded assets. The procedure circumvented the legal requirement of full liability on par value stock, but was con­sidered a legitimate practice.⁴ The use of the method can be traced back to England where it was used as early as 1720 by the York Buildings Company.⁵

Another early use of treasury stock occurred primarily in bank and insurance companies. Treasury shares of a debtor corporation were acquired by acceptance of the corporation’s shares in settle­ment of a debt owed. This occurred when debtor corporations were required to purchase treasury shares as security for a loan or mort­gage, and then defaulted.⁶

During these early times, the use of the par value method for re­cording treasury shares was advocated by accounting textbooks writers.⁷ If the treasury shares were recorded at par, any difference between par and the amount paid would have to be charged to the other contributed capital accounts on a pro rata basis and the re­mainder charged to retained earnings. The par amount of the treas­ury shares would then be subtracted from the total par of issued shares to derive the net total par value of the shares outstanding. The treasury stock was a direct reduction of the shareholders’ equity, and therefore not an asset. This method, although theoreti­cally sound, was not generally followed. Because of legal consid­erations, many corporations preferred to report treasury stock at cost, as an asset, to avoid the explicit reduction of‘ the owners’ equity.

Corporations acquiring their own shares ran a risk of an illegal reduction of capital. But by classifying the treasury stock as an asset there was no reduction of capital. It is not surprising to find in a 1932 survey of 587 firms listed on the New York Stock Exchange that 197 of 404 firms with treasury shares classified them as assets. Thirty-four showed treasury shares in both the asset section and the net worth section of the balance sheet.⁸ This inconsistency in bal­ance sheet classification caused confusion as to the nature of treas­ury stock.

A spate of treasury stock activity started in late 1929 and con­tinued into the early 1930’s. The emphasis was on the purchase of treasury shares to support the market price of the stock, to effect corporate adjustments, particularly when a retained earnings deficit existed, and finally, as an “investment” because of the decline in prices.⁹ This increase in treasury stock activities, along with legal and tax developments, caused a reconsideration of the asset classi­fication for treasury shares.

Legal and Tax Developments

Most early state laws in the U.S. implied that in the absence of an express prohibitory provision, the corporation had power to pur­chase and hold treasury stock.¹⁰ Not all states had originally recog­nized the right of the corporation to acquire its own shares, but by 1925 its legality was generally recognized.¹¹

With general acceptance, certain limitations were placed on treas­ury share acquisitions. The limitations were designed to safeguard the positions of creditors and of other shareholders.¹² Court cases evolved two legal tests—the “surplus” test and the “solvency” test. Under the surplus test, the corporation is said to have a surplus and may acquire its own stock when, after the purchase, its assets ex­ceed its total liabilities and capital stock. The surplus test provides that no distribution may be made beyond the amount of such sur­plus. The solvency test is more liberal and allows a treasury stock acquisition unless the purchase renders the corporation insolvent or makes its insolvency imminent.¹³ The intent of these treasury stock laws was the maintenance of legal capital for the protection of the creditors.

The 1918 Revenue Act made treasury stock transactions non-taxable. Gains on sale of treasury stock had been treated as tax­able under the Revenue Acts of 1916 and 1917, but the 1918 Act prescribed that the sale of treasury stock was a capital transaction and thus did not constitute income to the corporation. Without sub­stantial change, the provision was continued in the regulations under subsequent acts until 1934.¹⁴

Treasury stock activity during the 1929-1933 period brought on a wave of regulatory action designed to diminish the extent of such transactions. The New York Stock Exchange required regular re­porting of treasury stock activity by listed corporations. The Federal Securities Act of 1933 included treasury stock in its definition of securities which required full disclosure by registered corpora­tions.¹⁵ But probably the most important influence in the reduction of treasury stock purchasing was the 1934 Internal Revenue regu­lations, These established that gains on sales of treasury stock were taxable income to the selling corporations.   Paton called this one of the real errors in income tax history because a switch in accounting methods could nullify the effect of the regulations.¹⁶

Under the 1934 Internal Revenue regulations, when the treasury shares were first recorded at cost and later sold at a price unequal to the cost, a gain or loss resulted from the transaction. For the next twenty years, such gains were to be considered taxable corporate income although it could be avoided by cancelling the treasury shares and issuing other authorized shares. In the 1954 Internal Revenue Code the taxation of such capital transactions was again eliminated.¹⁷ This 1954 revision provided incentives for various uses of treasury stock in stock option plans and in acquisitions and mergers.

Accounting Developments

Regulatory actions following the 1929-1933 surge in treasury stock activity were accompanied by a change in accounting presen­tation on the corporate balance sheet by many corporations. After 1933, treasury stock was reported as a reduction of stockholders’ equity by many firms previously reporting treasury stock as an asset. Two methods of presentation were suggested: 1) as a deduction from total net worth; or 2) as a deduction from retained earnings.¹⁸ In both cases, the treasury stock was to be shown on the balance sheet at cost. Treasury stock at cost deducted from total share­holders’ equity became the most popular method for presenting treasury stock in the balance sheet.

To avoid the tax consequences of the 1934 Revenue regulation, reacquired shares were often held, in treasury, indefinitely and the related asset valuation principles such as the “lower of cost of market” rule were applied. For example, in 1955, two firms (of 238 holding treasury common stock) valued shares at the lower of cost or market. In 1963, another firm with stockholder approval, reduced the carrying value of the treasury stock from an average cost of over $25 per share to the then approximate market value of $12 per share. At the end of 1965, there were four firms (of 377 with treasury com­mon stock) showing the shares at a carrying value less than cost.¹⁹ Of course, had the shares been recorded at par, these capital ad­justments would not have been necessary.

With the more recent use of treasury shares for stock options, acquisitions and mergers, another aspect of the cost method has become a problem. What method of cost determination should be used? Does the FIFO rule generally applicable to investments apply?   Or are cost determinations methods used for inventories applicable? A 1965 survey of cost methods disclosed that seven of twenty-four corporations derived the cost of the issued treasury shares by specific identification, ten used an average cost method, six corporations used the first-in, first-out method and one company used the last-in, first-out method.

Each firm justified its method for determining the cost of reissued shares. For example, the firm using the last-in, first-out method had acquired treasury shares over an interval of fifteen years. Using the latest purchase cost first seemed to be the most logical, just as it would be in some instances of inventory purchases. But what differ­ence did it make? The shareholders were no longer interested in the price paid for the treasury shares fifteen years previously. There was no capital gain, in the accounting sense nor any gain for income tax purposes.

The presentation and valuation of treasury shares as an asset is still permissible as a generally accepted accounting principle, al­though only a few firms still use it (8 of 600 in 1975).²° When shares are acquired for the specific purpose of resale to employees or others, corporations have the option of recording the shares sep­arately at cost on the asset side of the balance sheet, provided the reason for the treatment is fully disclosed. This asset treatment of treasury shares is a continuation of the pre-1934 classification. However, such shares cannot be considered an investment in mar­ketable securities because treasury shares cannot be readily sold in the open market. An issue of treasury shares of listed stocks in the open market requires the same registration procedures as an issue of previously unissued shares. The definition of “security” in Section a(1) of the Federal Securities Act of 1933 includes treasury stock.

A Concluding Remark

In the context of the historical cost system, assets are recorded at cost upon acquisition. When treasury stock was reported as an asset, recording the balance at cost was consistent with asset re­cording  principles.

The Securities Act of 1933 defined treasury stock as an owner’s equity security. This means that treasury shares may not be sold in the open market unless SEC registration procedures are followed. Further, stock exchange reporting requirements in listing agree­ments today require that the stock exchange be notified promptly of any direct or indirect purchase of treasury shares at a price in ex­cess of the prevailing market price.   In addition, all treasury stock activity must now be reported to the Securities and Exchange Com­mission along with the reporting of other changes in shareholders’ equity. Internal Revenue regulations definitely consider treasury stock transactions to be owners’ equity transactions.

If treasury stock had not been originally classified as an asset, asset recording principles probably would not have been used in reporting treasury shares and treasury shares would not have been reported at cost. Then the par value method as advocated by Paton in the early part of this century might have been followed, and the relevant Internal Revenue and Federal Securities regulations would have been unnecessary.

FOOTNOTES

^I  Paton, “Some Phases”, pp. 328-335 and Paton, “Postscript”,  pp. 276-283.
Walsh, p. 7.

³Van Horne, p. 279-281.

⁴Mead, p. 116.

⁵DuBois, pp. 7-8.

⁶Moore, pp. 372-379 and Levy, “Purchase”, p.  11-12.

⁷Finney, Chapter 8, pp. 15-17.

⁸Field, p. 101.

⁹Holt & Morris,  pp. 505-510.

¹⁰Wormser, pp. 178-181; Berle and Means, pp. 174-176.

I^I  Levy,  “Purchase”,  pp.  13-17.

1²Morawetz, pp.  188-197;  Levy, “Rights”, pp. 430-432.

1³Ballantine and Hills,  p. 230.

1⁴Carlisle, pp. 560-561.

¹⁵Nussbaum, pp. 1004-1006.

¹⁶Paton,  “Postscript”,   p.   280.

1⁷Rankin, pp. 71-77.

¹⁸Barr, pp. 78-85; Marple, p. 61.

1⁹AICPA, 1966, p. 156.

²°AICPA, 1976, p. 189.

BIBLIOGRAPHY

American  Institute of Certified   Public Accountants, Accounting  Trends and Tech­niques, New York, 1976, and 1966 editions. Ballantine,   Henry W.   and   Hills,   George   S.,   “Corporate   Capital   and   Restrictions

Upon Dividends Under Modern Corporation Laws,” California Law Review, March

1935. Barr,   Berten  Joseph,   Some Aspects of Treasury Stock on  the  Balance   Sheet,

Northwestern  University, Chicago,  Illinois,  1957. Berle, Adolf A. Jr., and Means, Gardiner C.,  The Modern Corporation and Private

Property, The Macmillan Company, New York, 1933. Carlisle, Russell E., “Treasury Stock and Section 1032”,  (Editorial  Notes), George

Washington Law Review, April 1955. DuBois, Armand  Budington,  The English Business Company After the Bubble Act

1720-1800, The Commonwealth Fund, New York, 1938.