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Discuss about the ACC204 Advanced Financial Accounting. Thus, large companies including PSUs prefer buy backing their own shares and utilizing the excessive cash balance by releasing it back to the investors.

Concept of buy back of shares

Part A:

When a company holds substantial cash balance to such extent that the board feels the need of utilizing it some way. Thus, large companies including PSUs prefer buy backing their own shares and utilizing the excessive cash balance by releasing it back to the investors  (Alvarez, 2013).

Buy back is a concept of companies of purchasing its own shares from the existing shareholders at a price usually higher than the price prevailing in the market. When a company decides to buy back its shares, it decreases its outstanding shares in the market which in turn, increases the shareholding percentage for the existing shareholders (Easton, 2010). At times, the company adopts the technique of buying its shares from the open market instead of from the shareholders themselves.

The reasons for buy back of shares can be:

  • Earnings per share are being improved and increase the long term value for shareholders. Also, helps the company to achieve its optimum capital structure targets ;
  • When shares are valued at a lesser price or aren't trade much on the market, buy back provides a way to shareholders to release such shares to the company at a favorable price. It helps in providing satisfactory returns to its shareholders in the form of cash (Fridson & Alvarez, 2012).
  • One of the main reasons of choosing buy back for reducing the capital is not requiring the consent of any court or National Company Law Tribunal (NCLT).

The funds for the buy back is required to he utilized from free reserves, proceeds from the issue of some other class of shares, securities premium, capital reserves, etc. Buy back can be made from shareholders or security holders already existing on either proportionate basis or purchasing from employees where shares were issued under ESOP or from the open market.

  • The buyback shouldn't be more than 25% of the total of free reserves and paid up capital subject to approval in the general meeting through special resolution. However, in case the percentage doesn't exceed 10%, authorization through special resolution is not required. A board resolution would do the needful.
  • It is to be considered that along with the limit of 25% of total paid up capital and free reserves which is applicable in case of all shares while in case of only equity shares, 25% of total paid up share capital is also considered (Girard, 2014).
  • Such buyback of shares should be authorized in the articles of association of the company. After the buy back, the debt equity ratio shouldn't fall below 2:1.
  • A company isn't allowed to buy back its shares again after the first buy back for the next one year from the date of closing of previous buyback offer.
  • As soon as the special resolution or Board resolution is passed, as per the case, the buyback procedures and formalities should be completed within a period of one year from the date of passing of such resolution.
  • The respective law requires a company to physically destroy shares bought back within a time period of 7 days as soon as the buyback procedures are completed.

Coming to accounting entries, the company might be buying back shares either at a premium or a discount. So, assuming that the buy back is made at a premium, in the books of accounts of a company, the share capital is debited with the face value amount along with premium on buy back and the concerned shareholder's account is credited. In the next entry the shareholder's account is debited and the cash or bank account is credited with the buyback amount to be paid to the shareholders  (Ittelson, 2009).

The buyback premium, being an expense, is written off from securities premium account or any other free reserves. At the same time, capital redemption reserve is created and a sum equal to the face value of the shares bought back is transferred to the capital redemption reserve.

When the buyback procedures are finally undertaken by the company, the following information should be disclosed in the reports for the financial year in which buy back took place :

  • The number of shares bought back of each class along with percentage ;
  • The cost of acquisition of the shares bought back ;
  • The amount that has been credited or debited to reserves, securities premium account and paid up capital ;
  • Effect on retained profits or accumulated losses or any other equity related accounts ;
  • A summary of the nature of shares bought back and the terms or conditions applicable or any other information that the company thinks to be material and therefore, should be disclosed for better understanding of the transactions.

Usually, buy back is interpreted in a way that the issuing company is enjoying a strong financial position. It is often interpreted as giving back the company's profit to its shareholders as a way of appreciating them for the investments they have made (McLaney & Adril, 2016). This is somewhat like the company used the equity capital for its business and as the business starts generating revenue enough to fund its own operations, the company tends to return the capital investment back to its owners.

It can also be assumed that the company might have found some other way of financing such as finance through debts is being made at a lower cost because of the less risk on the lender's head. The company might also be in an agreement of some hostile takeover where the said company is to be taken over and therefore, it is paying off its liabilities (Parrino, 2013).

EPS (Earnings Per Share), being a metric used for measuring the effectiveness of company’s management, if shows changes to a great extent just after buy back can be interpreted that a large portion of profits have been transferred to its executives.

A buyback cannot truly reflect the positive or negative financial health of a company; it is considered when decisions are to be made for potential investments  (Penman, 2012).

When a company is on a good position and doesn't require the cash balances for growth or expansion and is contented with significant cash amounts, it may take the step of restoring its shares from the shareholders through buy back. However, the challenging side of taking a decision of buying back shares depends on two factors, that is, short term buoyancy from shareholders and long term goals for more growth. Such decision has to be made from both the long term and short term perception and requires careful judgment.

Part B:

The total impairment loss amounted to $9000. Out of this 3000 is written off against goodwill and the remaining is distributed among other assets in the ratio of their carrying amounts.

The distribution is shown below:

Particulars

 Carrying Amount

 Ratio

 Impairment Loss

Patent

16000

       0.53

                       2,030

Building

10000

       0.33

                       1,269

Inventory

4000

       0.13

                           508

                       30,000

 

                       3,807

The journal entries are as follows:

Particulars

Dr Amt

Cr Amt

Accumulated Impairment Loss ...…..Dr

       9,000.00

 To Plant

       2,193.00

 To Patent

       2,030.40

 To Building  

       1,269.00

 To Inventory  

           507.60

 To Goodwill  

       3,000.00

 (Being impairment on assets realised)

 Impairment loss……Dr

       9,000.00

 To accumulated impairment loss

       9,000.00

Alvarez, F. (2013). Financial statement analysis. Hoboken, N.J.: Wiley.

Easton, P. (2010). Financial statement analysis & valuation. Cambridge, UK: Cambridge Business Publishers.

Fridson, M., & Alvarez, F. (2012). Financial Statement Analysis: A Practitioner's Guide. New York: John Wiley & Sons.

Girard, S. L. (2014). Business finance basics. Pompton Plains, NJ: Career Press.

Ittelson, T. (2009). Financial Statements: A Step-by-Step Guide to Understanding and Creating Financial Reports. Franklin Lakes, N.J.: Career Press.

McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United Kingdom: Pearson.

Parrino, R. (2013). Fundamentals of Corporate Finance, 2nd Edition. Milton: John Wiley & Sons.

Penman, S. (2012). Financial statement analysis and security valuation. Boston, Mass.: McGraw-Hill.

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