When it comes to understanding corporate finance, it’s important to have a grasp on all the different tools and techniques that companies use to manage their finances. One such tool is treasury stock, which plays a crucial role in a company’s financial operations.
However, many people are unaware of what treasury stock actually is and how it can be used to benefit a company’s finances. In this article, we’ll take a closer look at the role of treasury stock in corporate finance, exploring its purpose, benefits, and potential drawbacks.
Whether you’re a seasoned financial professional or just starting to learn about corporate finance, this article will provide valuable insights into this important aspect of financial management.
What Is Treasury Stock?
Treasury stock refers to shares of a company’s stock that have been issued and subsequently bought back by the company. These shares are then held by the company as a financial asset on its balance sheet, rather than being held by investors.
Companies may choose to repurchase their own shares of stock for a variety of reasons, such as to increase the value of remaining shares or to use the shares as a form of executive compensation.
Treasury stock is often considered a “contra-equity” account, meaning that it reduces the total amount of equity that the company has on its balance sheet.
To understand it further let’s compare common stock vs treasury stock. Common stock represents ownership in a company and is issued to investors to raise capital.
What Happens To Treasury Stock?
Treasury stock can be held by the company indefinitely, resold back to the market, or retired. When a company holds treasury stock, it reduces the total number of outstanding shares in the market, which can have several implications.
One of the most important benefits of treasury stock is that reducing the number of outstanding shares can increase the earnings per share metric, making the company appear more profitable.
Additionally, if the company decides to resell its treasury shares, it can use the proceeds for various purposes, such as funding new projects or paying off debt.
However, if the company decides to retire its treasury stock, it is effectively canceling the shares, and they will no longer be available for sale in the market.
Overall, the fate of treasury stock depends on the company’s financial goals and objectives, as well as market conditions and other factors that may impact the value of the shares.
What Are Shares Authorized, Issued, and Outstanding?
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Authorized Shares
Authorized shares refer to the maximum number of shares of stock that a company is permitted to issue, as outlined in its corporate charter. This number can be increased or decreased by a vote of the company’s shareholders.
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Issued Shares
Issued shares refer to the total number of shares that the company has actually issued to its shareholders. This includes both outstanding shares (those held by investors) and treasury shares (those held by the company).
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Outstanding Shares
Outstanding shares refer to the total number of shares that are currently held by investors. These are the shares that are actively traded in the market and determine the company’s market capitalization.
The number of outstanding shares can change over time, as the company issues new shares or repurchases its own shares (which become treasury shares).
Why Buy Back Shares?
Companies buy back their own shares for several reasons, and these reasons can vary depending on the company’s financial goals and objectives. Here are some of the most common reasons why companies choose to buy back shares:
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Increase Shareholder Value
By buying back shares, the company reduces the number of shares outstanding in the market, which can increase the value of the remaining shares.
This can lead to higher earnings per share and a higher share price, which can benefit existing shareholders.
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Stabilize The Share Price
When a company buys back its own shares, it effectively reduces the supply of shares available in the market. This can help to stabilize the share price by limiting the number of shares available for trading, which can make the stock more attractive to investors.
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Executive Compensation
Companies may use treasury shares as a form of executive compensation, either by issuing them directly to executives or by using them to fund stock option programs.
This can help to align the interests of executives with those of the company’s shareholders and can be a more tax-efficient way of compensating executives than cash payments.
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Avoid Dilution
By using treasury shares for compensation or to fund acquisitions, companies can avoid diluting the value of existing shares by issuing new shares.
This can help to maintain the value of the company’s stock and prevent existing shareholders from losing value due to dilution.
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Return Excess Cash To Shareholders
If a company has excess cash on hand that it does not need for operations or future investments, it may choose to use that cash to buy back shares instead of paying out a dividend.
This can be a tax-efficient way of returning value to shareholders and can help to boost the company’s share price.
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Signal To The Market
By buying back shares, a company may be signaling to the market that it believes its shares are undervalued and represents a good investment opportunity.
This can help to boost investor confidence in the company and lead to an increase in the share price.
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Improve Financial Metrics
By reducing the number of shares outstanding, a company can improve financial metrics such as earnings per share and return on equity. This can make the company appear more profitable and attractive to investors.
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Defend Against Potential Takeovers
By reducing the number of shares available for purchase in the market, a company can make itself less attractive to potential acquirers and defend against potential takeovers.
Accounting For Treasury Stock
Accounting for treasury stock involves the recording of transactions related to the company’s repurchased shares.
These transactions include the issuance of common stock, acquisition of treasury stock, and re-issuance of treasury stock at a profit or loss. Here’s a detailed overview of each transaction:
Issuance Of Common Stock
When a company issues new shares of common stock, it increases its equity capital. The amount of the new equity capital is recorded as a credit to the common stock account and a debit to cash or another asset account.
For example, if a company issues 10,000 shares of common stock at $50 per share, the entry would be:
- Debit: Cash – $500,000
- Credit: Common Stock – $500,000
Acquisition of Treasury Stock
When a company buys back its own shares, it decreases its equity capital. The cost of the treasury stock is recorded as a debit to the treasury stock account and a credit to cash or another asset account.
For example, if a company repurchases 1,000 shares of common stock at $60 per share, the entry would be
- Debit: Treasury Stock – $60,000
- Credit: Cash – $60,000
Reissuance of Treasury Stock At a Profit
If a company reissues its treasury shares at a higher price than its acquisition cost, it realizes a profit. The profit is recorded as a credit to the treasury stock account and a debit to additional paid-in capital, which increases the company’s equity capital.
For example, if a company reissues 500 shares of treasury stock at $80 per share, the entry would be
- Debit: Cash – $40,000
- Credit: Treasury Stock – $30,000
- Credit: Additional Paid-in Capital – $10,000
Reissuance of Treasury Stock At a Loss
If a company reissues its treasury shares at a lower price than its acquisition cost, it realizes a loss. The loss is recorded as a debit to the treasury stock account and a credit to additional paid-in capital, which decreases the company’s equity capital.
For example, if a company reissues 500 shares of treasury stock at $50 per share, the entry would be:
- Debit: Cash – $25,000
- Debit: Additional Paid-in Capital – $5,000
- Credit: Treasury Stock – $30,000
In summary, accounting for treasury stock involves the recording of transactions that affect the company’s equity capital and treasury stock account.
Recording Treasury Stock
Recording treasury stock involves the bookkeeping process of a company’s repurchased shares. The acquisition of treasury stock is recorded as a reduction in shareholders’ equity, and it is reported as a contra-equity account on the balance sheet. Here’s a detailed explanation of how treasury stock is recorded:
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Acquisition of Treasury Stock
When a company buys back its own shares, the cost of the treasury stock is recorded as a debit to the treasury stock account, which is reported as a contra-equity account on the balance sheet. The credit is recorded to cash or another asset account.
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Retirement of Treasury Stock
If the company retires the treasury shares, the treasury stock account is debited, and the common stock account is credited for the same amount.
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Reissuance of Treasury Stock
If the company decides to reissue the treasury shares, it can either sell them at a profit or a loss. In the case of a profit, the company debits the treasury stock account, credits cash or another asset account for the sale price, and credits additional paid-in capital account for the difference between the sale price and the cost of the treasury shares.
If there is a loss on the issuance of treasury shares, the company debits the treasury stock account, credits cash or another asset account for the sale price, and debits the additional paid-in capital account for the difference between the sale price and the cost of the treasury shares.
Treasury Stock Example
Imagine a company with 10,000 shares of common stock trading at $50 per share. It decides to repurchase 1,000 shares of its own stock for $60 per share. To demonstrate how Treasury Stock would be recorded, here is an example:
Acquisition of Treasury Stock
A company would debit the treasury stock account for $60,000 (1,000 shares x $60 per share) and credit cash or another asset account for the same amount.
- Treasury Stock account: Debit $60,000
- Cash account: Credit $60,000
Retirement of Treasury Stock
In the event that a Company decides to retire the 1,000 shares of treasury stock, it will debit the treasury stock account for $60,000 and credit the common stock account with the same amount.
- Treasury Stock account: Debit $60,000
- Common Stock account: Credit $60,000
Reissuance of Treasury Stock
Assuming a Company decided to reissue 1,000 shares of Treasury stock at $70 per share, the transaction would be recorded as follows:
- The treasury stock account would be debited for $60,000 (the cost of the shares).
- The cash account would be credited for $70,000 (1,000 shares x $70 per share).
- The additional paid-in capital account would be credited for $10,000 ($70,000 – $60,000).
- Treasury Stock account: Debit $60,000
- Cash account: Credit $70,000
- Additional Paid-in Capital account: Credit $10,000
As a result of the issuance of Treasury shares, the Company generated a profit of $10,000.
What Are Retired Shares?
Retired shares refer to the company’s own stock that has been repurchased and then canceled, so it is no longer considered outstanding. When a company retires shares, it reduces the number of outstanding shares and increases the ownership percentage of the remaining shareholders. The company may decide to retire shares for a variety of reasons, such as:
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To Increase The Value Of The Outstanding Shares
By reducing the number of outstanding shares, the company can increase the value of each share.
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To Improve Financial Ratios
Retiring shares can also help improve financial ratios such as earnings per share (EPS) and return on equity (ROE).
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To Signal Confidence In The Company
Retiring shares can be a signal to investors that the company is financially healthy and confident in its future performance.
When shares are retired, they are removed from the company’s balance sheet, and the corresponding amount is removed from the common stock account. Any additional paid-in capital related to the retired shares is also removed from the company’s books.
What Is The Cost Method Of Accounting For Treasury Stock?
The cost method of accounting for treasury stock is a commonly used method in which a company records the repurchase of its own stock at the price it paid for it. This method records treasury stock as contra-equity to reduce total shareholder equity by recording it at cost.
Whenever a company repurchases its own shares, it debits its treasury stock account and credits its cash account. The cost of treasury stock is calculated as the total amount paid for the repurchase of shares, including any transaction costs such as brokerage fees or taxes.
The cost method specifies that treasury stock is held indefinitely, and any subsequent sale or reissue will be accounted for at the new transaction price.
When the company reissues treasury stock at a higher price, any excess over the cost is added to the paid-in capital.
Treasury stock is generally accounted for using the cost method since it is simple to implement and reflects the true cost of treasury stock.
However, it ignores changes in the market value of repurchased shares, causing a discrepancy between recorded cost and fair value.
What Is The Par Value Method Of Accounting For Treasury Stock?
The par value method of accounting for treasury stock is an accounting method that records the repurchase of a company’s own stock at its par value.
Under this method, the treasury stock account is debited for the par value of the shares repurchased, and any excess over the par value is recorded as additional paid-in capital.
This method assumes that the treasury stock will be held indefinitely and any subsequent sale or reissue of the stock will be recorded at the new transaction price.
However, this method is less commonly used than the cost method, as par value is often considered to be a nominal amount that does not reflect the true market value of the shares.
Conclusion
To conclude, treasury stock plays a crucial role in a company’s financial management strategy. A company can increase earnings per share, enhance shareholder value, and manage its capital structure more effectively by repurchasing its own shares.
Another benefit of treasury stock is that it also can be used as a tool for mergers and acquisitions or for employee stock options. Nevertheless, companies should carefully examine the potential impact of treasury stock on their financial statements, shareholder equity, and liquidity position.
By understanding the accounting and reporting requirements of treasury stock transactions, companies can make informed decisions that align with their overall financial goals and strategies.
