Problem 11 - Accounting

Question

Mountain Springs Inc. bottles and distributes spring water. On May 2 of the current year, Mountain Springs reacquired 3,000 shares of its common stock at \(\$ 72\) per share. On August 14, Mountain Springs sold 2,500 of the reacquired shares at \(\$ 76\) per share. The remaining 500 shares were sold at \(\$ 70\) per share on November 7 . a. Journalize the transactions of May 2, August 14, and November 7 . b. What is the balance in Paid-In Capital from Sale of Treasury Stock on December 31 of the current year? c. I?or what reasons might Mountain Springs have purchased the treasury stock?

Step-by-Step Solution

Answer

a) May 2: Debit Treasury Stock $216,000, Credit Cash $216,000; August 14: Debit Cash $190,000, Credit Treasury Stock $180,000, Credit Paid-In Capital $10,000; November 7: Debit Cash $35,000, Debit Paid-In Capital $1,000, Credit Treasury Stock $36,000. b) $9,000 in Paid-In Capital from Sale of Treasury Stock. c) Possible reasons: employee stock plans, increase EPS, future needs, stock undervaluation.

Step 1: Journalize May 2 Transaction

On May 2, Mountain Springs Inc. reacquired 3,000 shares of treasury stock at \(72 per share. The journal entry is as follows:- Debit Treasury Stock for the cost of shares -> \(3,000 \times 72 = 216,000\)- Credit Cash for the payment made -> \(3,000 \times 72 = 216,000\)**Journal Entry:** Debit Treasury Stock: \)216,000 Credit Cash: $216,000

Step 2: Journalize August 14 Transaction

On August 14, 2,500 of the reacquired treasury shares were sold at \(76 per share. We calculate the difference between the selling price and the purchase price:- Sale proceeds for 2,500 shares: \(2,500 \times 76 = 190,000\) - Purchase cost for 2,500 shares: \(2,500 \times 72 = 180,000\) - Additional Paid-In Capital from Sale of Treasury Stock: \(190,000 - 180,000 = 10,000\) **Journal Entry:**- Debit Cash: \)190,000 - Credit Treasury Stock (cost basis): \(180,000 - Credit Paid-In Capital from Sale of Treasury Stock: \)10,000

Step 3: Journalize November 7 Transaction

On November 7, the remaining 500 treasury shares were sold at \(70 per share, which is below the purchase price:- Sale proceeds for 500 shares: \(500 \times 70 = 35,000\) - Purchase cost for 500 shares: \(500 \times 72 = 36,000\) - The loss must be charged to the Paid-In Capital from Sale of Treasury Stock: **Journal Entry:**- Debit Cash: \)35,000 - Debit Paid-In Capital from Sale of Treasury Stock: \(1,000 (recognizes the reduction due to sale below cost) - Credit Treasury Stock (cost basis): \)36,000

Step 4: Determine End of Year Balance for Paid-In Capital from Sale of Treasury Stock

Initially the Paid-In Capital from Sale of Treasury Stock was $0. After the August 14 sale, it increased by $10,000. On November 7, it decreased by $1,000 due to the loss on sale of shares. - Balance after August 14: $10,000 - Adjusted Balance after November 7: $10,000 - $1,000 = $9,000 The balance in Paid-In Capital from Sale of Treasury Stock on December 31 is $9,000.

Step 5: Reasons for Purchasing Treasury Stock

Common reasons companies might purchase treasury stock include: - To reissue the shares to employees under stock compensation plans. - To increase the earnings per share by reducing the number of outstanding shares. - To have shares available for future acquisitions or financing needs. - To signal to investors that the management believes the stock is undervalued.

Key Concepts

Journal Entries in Accounting

Journal entries are the backbone of accounting, documenting every transaction that occurs. They involve recording the debits and credits to different accounts as needed. Let’s look at how Mountain Springs Inc. handled their treasury stock transactions.

• On May 2, the company reacquired 3,000 shares, resulting in a debit to the "Treasury Stock" account for $216,000 and a corresponding credit to "Cash" for the same amount. This entry decreases cash, reflecting the purchase of their own stock.
• On August 14, when Mountain Springs sold 2,500 shares at a higher price than they paid, they recorded a debit to "Cash" for $190,000, credited "Treasury Stock" for $180,000, and added a new credit of $10,000 to "Paid-In Capital from Sale of Treasury Stock." This transaction not only replenished some cash but also increased their paid-in capital.
• On November 7, the remaining 500 shares were sold at a loss, creating a journal entry where "Cash" was debited for $35,000, "Paid-In Capital from Sale of Treasury Stock" was debited for $1,000 (to offset part of the loss), and "Treasury Stock" was credited for $36,000. This entry shows a decrease in the company’s paid-in capital to cover the loss from selling below the cost price.

Each entry tells a part of the financial story, showing how capital and other resources flow in and out of the company.

Paid-In Capital from Sale of Treasury Stock

Paid-In Capital from Sale of Treasury Stock represents the gains a company makes from reselling its treasury shares above the original purchase price. When Mountain Springs Inc. managed to sell some of their reacquired treasury stock at a price higher than the repurchase cost, they gained additional equity.

• For the sale of 2,500 shares, the company recorded a $10,000 credit to this account, representing the profit from the transaction.
• Later, selling 500 shares below the cost made them debit $1,000 to this account to absorb the loss, reducing the earlier gain.

Over the course of these transactions, the Paid-In Capital from Sale of Treasury Stock ended the year with a net increase of $9,000. This balance reflects the additional capital provided by investors when a company resells treasury stock for more than it paid to reacquire these shares.

Reasons for Treasury Stock Acquisition

Companies like Mountain Springs Inc. may buy back their own shares and hold them as treasury stock for a variety of strategic financial reasons.

• **Employee Stock Plans:** One common reason is to reissue shares for employee stock compensation plans. Companies often use treasury stock to avoid diluting existing shares.
• **Increase EPS:** Buying back shares can decrease the total shares outstanding, thus increasing the earnings per share (EPS). This can be appealing to investors looking for strong financial performance indicators.
• **Future Needs:** Having treasury stock on hand allows a company to have available shares for future acquisitions or financing needs without issuing new stock.
• **Market Signals:** When management believes the current stock is undervalued, repurchasing shares can signal confidence, potentially boosting stock prices.

Companies utilize treasury stock as a tactical part of their broader corporate strategy, helping to manage their capital structure effectively.