Companies often announce share buybacks, and shareholders very often bid up the price of the shares of a company following these announcements. Share buybacks are one of the two ways to return capital to shareholders with the other being dividends. The reasons for a share buyback are many, and the journal entry impacts cash and shareholder's equity.
A share buyback is one way to return capital to shareholders. It involves the process of a company buying back shares that investors own in public or private transactions. The effect of a share buyback is decreasing the number of shares outstanding and increasing the value of each share. For example, a company has 100 shares outstanding worth $10 each. The value of the company is just 100 shares times $10 or $1,000. The company announces a share buyback of 10 shares and completes it. The company now has 90 shares outstanding and the value is still $1,000. The per-share value now is simply $1,000 divided by 90 shares or $11.11 per share.
The journal entry for a share buyback is straightforward. For example, a company announces and completes a $1,000 share buyback of 100 shares at $10 each. The journal entry is a decrease to cash of $1,000 and an increase to treasury stock of $1,000. Treasury stock is a contra shareholder's equity account, so it decreases the value of shareholder's equity.
The reasons for doing a share buyback are many, but the most important ones are that the shares of the underlying company are undervalued, and the need to return capital to shareholders. A buyback is very beneficial for shareholders when the stock is undervalued because the company is able to buy back more shares due to the shares selling at a cheaper price. For example, if a company's shares are trading at $5 versus $10, the company is able to buyback twice as many shares. Share buybacks also are a good way to return capital to shareholders. There also are no tax implications as there are with dividends.
If a company is buying back its shares at an overvalued price, that is destructive to shareholder value. For example, the fair value of a company's share is $10 and it is at $20 and the company announces a share buyback. The company is destroying $10 of shareholder value for every share repurchased. The probability that the market price of the shares will stay at this elevated level are low, so it is better for the company to wait for prices to fall.