Treasury Stock - Explained
What is Treasury Stock?
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Table of ContentsWhat is Treasury Stock?How is Treasury Stock Reacquired? Limitations of Treasury StockMethods of Accounting for Treasury StockTreasury Stock Example Academic Research on Treasury Stock
What is Treasury Stock?
Treasury stock, also referred to as reacquired stock, is the outstanding stock that the issuing company buys back from its stockholders. Repurchase of treasury stock typically reduces the number of outstanding shares in the open market and allows the issuing company to either resell such stock to the public or retire (cancel) it.
Although stock repurchase is regarded as a viable alternative to paying dividends to stockholders, the issuing company will, by convention, never include such shares in the calculation of dividends or earnings per share (EPS).
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How is Treasury Stock Reacquired?
The stock repurchase option comes across as a tax-efficient procedure employed by companies to award lump sum cash payments to its shareholders in lieu of a dividend payout. Such repurchased stock is recorded as a negative or a contra account in the shareholders equity column in the balance sheet.
The repurchase of a finite number of shares from the shareholders increases the issuers equity while decreasing the equity of the shareholders by an equivalent amount, which is the total price paid for the repurchased stock. A company that increases its treasury stock is often interpreted as considering its shares to be undervalued.
This can prove to be beneficial for shareholders because a stock repurchase results in a reduction in the number of outstanding shares, which in turn, improves the EPS of the stock, and gives each shareholder a bigger chunk of the earnings. On the downside, managers sometimes abuse treasury stock to repurchase shares solely to increase ratios.
Limitations of Treasury Stock
There are certain limitations of treasury shares:
- A treasury stock is never included in the calculations of dividend or earnings per share (EPS).
- Treasury stocks have no voting rights.
- Lastly, there are limits to the total number of shares that any company can hold as treasury shares. This is decided by the regulatory body of the country in which the shares originate. Such a limitation safeguards the interests of debt holders from any self-serving activities of the shareholders.
Companies with Treasury stock can choose to retire (cancel) the stock or resell them to the public in the open market. On the other hand, retired shares are permanently canceled, and companies have no option to reissue them. However, it is possible to reissue non-retired treasury shares in the form of stock dividends or employee benefits or simply as a capital raising exercise.
The principal motivation behind issuing stock is to raise cash. When shares are issued, they result in a positive balance in both the common stock account as well as the additional paid-in capital (APIC) account in the equity portion of the company's balance sheet. While the common stock account is a general ledger account that records the par value of the company's shares, the APIC account indicates the value of share capital beyond its stated par value.
Methods of Accounting for Treasury Stock
There are two methods that companies usually employ in order to account for treasury stock:
- The Cost Method: This procedure debits the treasury stock account and credits the cash account with the total amount paid for repurchasing the treasury stock. The cost method essentially ignores the par value of shares while recording the purchase of treasury stock.
- The Par Value Method: This procedure debits the treasury stock account with the total par value of shares acquired and credits the cash account with the with the total amount of cash paid for repurchasing the treasury stock. In the event that the amount debited exceeds the amount credited, the difference between the amounts is credited to the additional paid-in capital (APIC) account from treasury stock. Conversely, if the amount credited exceeds the amount debited, the difference is debited to the APIC account from treasury stock. In case the APIC from treasury stock is unavailable or insufficient, the par value method debits the retained earnings account with the remainder of the amount.
Treasury Stock Example
The concept of treasury shares can be explained with the help of the following example: Company C1 believes that its shares are currently undervalued in the market, that is the stock is trading at a level well below its intrinsic value.
C1 has access to cash at hand and decides to spend $1 million from this cash reserve to repurchase 10,000 shares of its own stock at the rate of $100 per share. Now C1s equity account balance, i.e the sum total of common stock, APIC, and retained earnings is $2 million. The treasury stock repurchase creates a negative or a contra equity account in the shareholders equity column in the balance sheet. Therefore, an amount equivalent to the $1 million treasury stock repurchase will have to be deducted from the $2 million equity account balance of C1. This deduction results in an imbalance of $1 million in the balance sheet, which is adjusted by reducing the cash account on the asset side of the balance sheet by an equivalent $1 million.
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