Q: We are a private company, and recently went through the buy- out of one of the partners. As part of the original agreement, one partner could buy out the other at 10 times trailing pre-tax earnings. The shares were repurchased with the use of company funds, bank debt, and a subordinated convertible debenture.
We would like to take the legal costs associated with the buy-out and include that as part of the cost of creating the treasury stock. The legal expenses are significant because the former partner challenged the original contract and lost through several appeals.
Our auditor is saying the costs should be capitalized as financing costs, and amortized over the length of the bank debt. Our position is the debt was a single purpose loan and used exclusively for the buy-out and belongs as part of the treasury stock. Prior to the buy-out we had never incurred any debt. Who is correct?
Santa Barbara, Calif.
A: There appear to be several, related issues here. First, the cost of the reacquired shares is indeed treasury stock, assuming the shares are not cancelled, and can be accounted for in several ways. The most common accounting method is the “cost” method, under which the entire cost of the stock purchase is charged to a “contra-equity” account (i.e., a reduction from total paid in capital) called treasury stock. Other methods, less popular, are the “par” and “constructive retirement” approaches.
If the company is incorporated in a state which has adopted the Uniform Business Corporation Act (or a variant thereof), reacquired shares revert to authorized but unissued status, and can be reported as if fully retired. That is, the portion of the reacquisition cost that is equal to the original proceeds from when the stock was issued is offset against paid-in capital, and any excess cost of the repurchase is charged to retained earnings. This is similar to the “constructive retirement” method described in standard reference books on generally accepted accounting principles.
Second, the question of how to account for the legal costs incurred in resolving the buy-back dispute is truly one where reasonable minds might disagree on the solution. It is probably supportable to conclude that legal costs strictly associated with the re-acquisition of the shares would be considered an additional cost, and accounted for as part of the cost of the treasury stock. The analogy is issuance costs on new shares offered, in which situation legal costs (among others) are directly offset against proceeds to the company.
The foregoing presumes that such costs are clearly identified with the stock transaction, and are not normal legal expenses — e.g., not an allocated part of the retainer arrangement with the company’s outside counsel. Normal legal expenses must be recognized currently in the income statement. On the other hand, expensing the legal costs on the current income statement, rather than adding to the treasury stock cost, would probably also be within reason, on the grounds that these pertain to a management/ownership dispute and constitutes a recurring, normal period expense.
You should be aware that, whether expensed or added to the contra- equity (treasury stock) account, most outsiders (e.g., creditors) will assess the entity’s net tangible capital as stockholders’ equity, net of treasury stock, and thus the impression of the balance sheet strength of the company will not be affected by the choice of accounting.
Note that there doesn’t appear to be any basis for capitalizing (i.e., deferring) the legal costs and amortizing them as additional interest cost. The legal costs were — it appears from your question — associated with acquiring the former owner’s shares, and not with arranging financing. Thus, there is no analogy to “points” or other financing fees.
Finally, normal financing costs (interest, etc.) should be charged to the income statement, and not considered part of the cost of the treasury stock. The reason is that financing costs are period costs, irrespective of how the borrowed funds are used (the sole exception: if used for long-term construction projects, the interest cost is added to the cost of the project). How your company raised the cash to execute the buy-back of shares is irrelevant to the cost of the treasury stock; if some or all of the funds were raised by borrowing, interest expense will be a period cost nevertheless.
Barry Jay Epstein, Ph.D., CPA
Partner, Gleeson Skar Sawyers & Cumpata, LLP
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