How Does Buying Back Stock Affect Stockholders Equity?

Companies repurchase their own shares for various reasons -- for example, to try to boost a sagging stock price, to thwart a hostile takeover or to gather up shares to distribute to employees through stock options or awards. Whatever the reason, the effect on stockholders' equity is the same: Equity declines by the amount spent to buy back the shares.

Stockholders' Equity

Every corporation is owned by its stockholders, and the equity section of a company's balance sheet gives you a sense of what those stockholders actually own. Equity is simply the difference between the company's assets (the stuff it owns) and its liabilities (its debts and obligations to others). In layman's terms, if the company were to sell off all of its assets and pay off its liabilities, then equity would be what's left over for the company's stockholders.

Contributed Capital

Stockholders' equity has two elements: contributed capital and earned capital. Contributed capital is the money the company got from selling stock. If you buy a share of stock from a company for $100, then that company's contributed capital total rises by $100. Note that contributed capital reflects only the money that the company gets when it sells a share to the public. When those shares later change hands on the open market, the company doesn't see any of that money, so those sales have no effect on contributed capital. The second portion of stockholders' equity is earned capital, which is the aggregate total of all its retained profits and losses since the company started operating.

Stock Buybacks

When a company buys back stock from the public, it is returning a portion of its contributed capital to shareholders. Those shareholders are literally cashing in their equity. As a result, total stockholders' equity declines. It's important to note, however, that the remaining shareholders -- those who didn't sell their shares back to the company -- don't really "lose" anything when equity declines through buybacks. After a buyback, there is less equity in the company, but there are also fewer shareholders with a claim on that equity. In fact, by reducing the supply of company stock available in the market, buybacks tend to push share prices up, which leaves the remaining shareholders with stock that's more valuable than before.

Accounting Treatment

A stock buyback is solely a balance sheet transaction, meaning that it doesn't affect the company's revenue or profits. When a company buys back stock, it first reduces its cash account on the asset side of the balance sheet by the amount of the buyback. Say a company repurchases 100,000 shares for $50 each. The company would subtract $5 million from its cash balance. In the equity section, the company increases the "treasury stock" account by $5 million. Treasury stock represents money paid out to reacquire stock; it is a "contra equity" account that offsets contributed capital, so increasing treasury stock $5 million has the effect of reducing net contributed capital $5 million. The balance sheet is back in balance.

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About the Author

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.

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