Welcome to the world of finance and accounting, where treasury stock is a concept that often raises questions among those new to the field. Simply put, treasury stock refers to shares of a company’s own stock that it has repurchased from shareholders and is holding in its own treasury. But why would a company buy back its own shares? And what role does treasury stock play in a company’s financial management?
In this blog post, we will explore the definition of treasury stock and its significance for companies. We will examine the reasons why companies might choose to repurchase their own shares, including the potential benefits and drawbacks of this strategy. Additionally, we will delve into the accounting implications of treasury stock, including how it affects a company’s balance sheet, income statement, and shareholder equity.
Whether you’re an aspiring accountant, a business owner, or simply curious about how companies manage their finances, this post will provide you with a comprehensive understanding of treasury stock and its role in the corporate world. So, let’s dive in and explore the world of treasury stock together.
What Is Treasury Stock?
Treasury stock (also known as treasury shares) refers to the stock the issuing company keeps in its treasury. When a company sells shares of stock on the open market, it will usually retain a certain amount of treasury stock due to pricing, corporate control, or compensation.
A company might again buy back outstanding shares of its issued stock for similar reasons. When a stock-issuing corporation buys back its own stock, making those shares into treasury stock, it decreases the company’s overall equity. The company uses its assets, usually its cash flow, to purchase those shares.
2 Treasury Stock Accounting Methods
Accounting-wise, treasury stock is not an asset. The standard accounting formula for a company subtracts liabilities from assets to determine the shareholders’ equity. There are two accounting methods for treasury stock:
- 1. Cost method: In this type of accounting, companies record repurchased shares by debiting the treasury account for the amount equal to the stock’s price. Accounting credits the cash account for the same amount, creating a record of the cash expenditure. For this method, companies include treasury stocks as part of the shareholders’ equity section of the balance sheet.
- 2. Par value method: A company lists the par value, or value of the shares, in the company charter. In this accounting method, the company debits the treasury account and the common stock APIC account (additional paid-in capital account) to make up for the difference between the par value and the current market value.
How Companies Use Treasury Stock
There are a few different ways a company might use treasury stock over time:
- As authorized shares: When a new company decides to raise money by issuing stock, by law, it can only sell a predetermined set of shares, known as authorized shares. Companies list authorized shares on the equity section of the balance sheet. Most companies retain a certain number of shares when they put stocks up for sale on the stock exchange to allow them to have a reserve of treasury stock to sell later if they want or need to do so.
- As issued shares: When a company decides to sell shares publicly, either through an initial public offering (IPO) or later on, these shares are known as issued shares. A company might repurchase some of its own shares to keep its investors happy since this share buyback process usually boosts the share price. The buying back of shares should not affect the company’s price per share valuation.
- As reissued shares: Repurchased shares are decommissioned or retired shares, and the company can no longer list the treasury shares on its financial statements; however, it can reissue the shares. If stock prices have gone up, issuing them can mean a cash windfall for the company, which is good for the balance sheet and the investors.
3 Advantages of Treasury Stock
Treasury stock has some distinct advantages for companies and shareholders in that it:
- 1. Attracts and rewards executives: A company will often offer shares of stock as a way to compensate top executives. Since this is only possible if they have shares to offer, a supply of treasury stock can provide executives with an attractive set of terms, including stock options.
- 2. Boosts the share price: Since purchasing stock reduces the number of shares in circulation, one common effect of a company returning some of its stock to treasury stock is a higher share price. This can be an alternative to paying out a cash dividend to stockholders.
- 3. Defends against hostile takeovers: Some companies must face the challenge of a hostile takeover attempt in a merger or acquisition. In this scenario, an investor or investors can purchase a controlling interest in the company by buying enough stock. If the company buys back its shares, adding to its treasury stock, it is harder for other investors to gain a controlling stake.
3 Disadvantages of Treasury Stock
Treasury stock has some drawbacks for companies and shareholders in that it:
- 1. Decreases equity: While the share price might rise, the company’s balance sheet always takes a hit from a stock buyback since the company is reducing the stockholders’ equity by reducing the amount of outstanding stock. This means it has less cash for other uses, such as investment in research and development, employee raises, and diversification.
- 2. Decreases price: While a stock’s price might increase, there’s also the real possibility that it will decrease. If a company needs to raise cash quickly, selling treasury shares is often the best way to do so. If their share price is down, however, selling these shares will result in a loss, and the company will have to take a lower price than they paid when they bought the shares in the first place with excess cash.
- 3. Reduces value: Unlike other types of stock, like preferred or common stock, treasury shares do not pay out distributions, and they cannot increase the company’s retained earnings. They also lack voting rights, meaning their benefit to the corporation is indirect. On their own, they do very little, but buying and selling them can significantly alter the corporation’s fortune.