Last Updated on September 23, 2023 by BFSLTeam BFSLTeam
A company can raise money by selling its stock to the public, but sometimes it may want to reduce the number of shares that are traded on the market. There is a legal limit on how much stock a company can issue. This is called the authorised amount of stock.
Out of this amount, some shares are owned by investors, including the people who work for the company or have special rights to buy the stock. These are called the shares outstanding. The rest of the shares are available for anyone to buy and sell. These are called floats.
A company can also keep some shares in its own treasury. These are called treasury stocks or treasury shares. They may have been bought back from the investors or the float, or they may have never been sold to the public in the first place.
Also Read: Floating Stock
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How Do Treasury Stocks Work?
When a company buys its own shares from the market, these shares become “treasury stock” and are taken out of circulation. Treasury stock means that they have no value by themselves. It does not have any rights or benefits. But sometimes, the company may want to limit the number of outsiders who own its shares. Buying back stock also makes the share price go up, which makes the investors happy.
A company can keep the treasury stock as long as it wants, sell it again to the public, or even destroy it.
Key Terms to Learn for Understanding Treasury Stocks
Before we explain what treasury stock is, let’s review some key terms that are related to it. When a company is formed, it has a certain number of authorised shares that it can legally sell to investors. This number is specified in the company’s charter. However, the company may not sell all of its authorised shares at once. It may keep some shares in reserve for future financing needs. The shares that the company actually sells to the public are called issued shares.
Another term that you may see in a company’s financial statements is outstanding shares. This is the number of shares that are currently owned by all investors. This number is used to calculate important measures such as earnings per share.
Usually, the number of shares that a company sells to the public and the number of shares that are owned by all investors are the same. However, this can change if the company buys back some of its own shares. These shares are called treasury stock. They are still part of the company’s issued shares, but they are not counted as outstanding shares. Sometimes, the company may decide to cancel the treasury stock. In that case, the number of issued shares will also decrease.
A company may want to reduce the number of its shares that are available to the public. It can do this by either making an offer to buy back some shares from its current shareholders, who can choose to accept or reject the offer, or by buying some shares gradually on the open market. The company usually says that this will increase the value of each share for the remaining shareholders. This is logical. When there are fewer shares in circulation, each share becomes more valuable.
A buyback is a way for a company to increase the price of its shares, instead of paying a cash dividend to its investors. In the past, buybacks had a tax benefit because dividends were taxed more than capital gains in the U.S. But this advantage has disappeared in recent years, as dividends and capital gains have been taxed at the same rate.
Companies may buy back some of their own shares for different reasons, not just to make their investors happy. For example, a company may want to attract talented executives by offering them stock options as part of their pay. By having some treasury stock, the company can fulfil these contracts in the future.
Buybacks can also help a company avoid being taken over by another company that it does not want to merge with. This is called a hostile takeover. With fewer shares in the hands of the public, it becomes more difficult for the other company to buy enough shares to control the company.
If the company wants to prevent a hostile takeover, it can either keep the treasury stock on its balance sheet, hoping to sell it later at a higher price, or cancel it altogether.
Acquisition of Treasury Stock
Let’s use the same example from before. The company wants to buy back some of its own shares from the market. It buys 4 million shares at the current price of $30 per share. The company pays $120 million for this purchase, which reduces its “Cash” account. It also records the value of the treasury stock as a negative amount under the “Stockholders’ Equity” section. This shows that the treasury stock reduces the total equity of the company.
Also Read: Cyclical Stock
Reissuance of Treasury Stock at a Profit
Let’s say the company does not want to keep or cancel the treasury stock, but sell it at a higher price. Suppose the price of the company’s stock goes up to $42 per share, and the company sells all of its treasury stock.
The company receives $168 million from this sale, which increases its “Cash” account (4 million shares sold x $42/share). The company also removes the value of the treasury stock from its balance sheet, which adds back $120 million to its “Stockholders’ Equity” section. The difference between the sale price and the purchase price is $48 million. This is a profit for the company, which is recorded as a positive amount in an account called “Paid in Capital—Treasury Stock.”
Selling Treasury Stock at a Loss
Sometimes, the company may not be able to sell the treasury stock at a price higher than what it paid to buy it back. For example, suppose the company sold 4 million shares of treasury stock at $25 per share, which is lower than the original cost of $30 per share. How would this affect the accounting entries?
The credit to “Treasury Stock” would still be the same as before, $120 million, because it is based on the original cost of the shares. However, the debit to cash would be only $100 million, because that is the amount of money received from the sale. The difference of $20 million represents a loss for the company, and it reduces the stockholders’ equity. Therefore, “Retained Earnings” would be debited by $20 million to balance the entry.
Bottom Line
Companies may choose to buy back their own shares for various reasons, such as preventing hostile takeovers, rewarding employees with stock options, or improving their financial ratios. For an investor who wants to analyse a company’s performance, it’s important to know how the purchase of treasury stock affects the numbers and the items on the balance sheet.
