What Exactly Are Treasury Stocks?
Did you know a company can reacquire or buy back shares already issued to the public? For instance, Apple (NYSE: AAPL) reacquired $17.55 billion in shares in 2020, and Alphabet (NYSE: GOOGL) also reacquired $6.85 billion in shares.
What these companies have reacquired are better known as treasury shares or treasury stocks.
The reacquisition reduces the number of outstanding shares of the company in the market. Upon reacquisition, the company can cancel its shares or keep them as treasury shares. So, treasury shares are the shares reacquired by the issuing company from its stockholders.
Companies can reissue the non-canceled treasury shares into the market through dividends, capital raising schemes, and employee stock ownership plans (ESOPs). The canceled shares are called retired shares. Treasury shares are not included in the dividend distribution and EPS calculation. Additionally, the possession of treasury shares does not give any voting rights to the company.
Motives Behind Stock Buyback
Increase shareholder value
Companies repurchase shares to increase the shareholder value. Companies often pay a premium over the current stock price while buying back shares from stockholders. As companies acquire shares at a premium price than the current market price, shareholders receive more value than the current market value if they sell their shares.
Improve financial ratios
Treasury stock transactions also improve the financial ratios of the company. Since the repurchased shares reduce assets on the balance sheet, the return on assets (ROA) typically increases. As buybacks reduce the outstanding equity, the return on equity (ROE) would also increase. Higher ROA and ROE are signs of a financially healthy organization.
Reduce dilution
Most companies go ahead with the decision of share repurchase to reduce the dilution. Today, Employee Stock Options/Ownership Plans (ESOPs) have become a common way of compensating employees. ESOPs increase the number of outstanding shares in the open market and result in excessive dilution. This reduces the earnings per share (EPS) and weakens the financial appearance of the company. By reacquiring shares, companies reduce the dilution and improve the EPS.
Treasury Stock Examples: How Do They Work?
When a company issues stock to the public, it records the same in the equity section of the company’s balance sheet under two columns, which include the common stock and additional paid-in capital. Whilst the common stock reflects the par value of shares, the additional paid-in capital reflects the premium that the company receives over the par value.
When a company reacquires the stock and keeps it as treasury stock, it records the same in the balance sheet through the following two methods:
- The cost method
- The par value method
Cost Method
The cost method ignores the par value and records treasury shares within the shareholder’s equity section at the cost they are reacquired from stockholders.
Upon repurchasing the stock, the accounting team debits the treasury stock account to decrease the shareholder’s equity and credits the cash account to record the expenditure. After reissuing the treasury stock, the accounting team credits the treasury stock account to increase the shareholder’s equity and debits the cash account. If the company reissues the stock at a price lesser than the price it was acquired, the accounting team debits the paid-in capital account. If the reissued price is higher than the acquired price, the accounting team credits the paid-in capital account.
Par Value Method
Under the par value method, upon repurchasing the stock, the accounting team makes two debit entries and one credit entry in the balance sheet:
- It debits the treasury stock account to decrease the shareholder’s equity, equivalent to the amount of the par value of shares being purchased.
- It also debits the common stock additional paid-in capital account to decrease it by the excess amount shareholders paid on the par value.
- It credits the cash account to record the expenditure worth the total amount paid to repurchase shares.
Let’s say XYZ Company issued 10,000 shares of common stock for $50 per share. The par value of shares is $10.
This means that the company issues a common stock worth $100,000 (10,000 shares * $10 par value of each share). The additional paid-in capital is $800,000 (10,000 shares * $40 excess amount paid on each stock by shareholders).
XYZ Company is a financially stable company with huge cash reserves. The top management of the company also believes that the stock is trading below its fair value. So, XYZ Company decides to reacquire 2,000 shares by paying a premium of $10 on each share. This means that the company wants to reacquire each share for $60 ($50 current trading price + $10 premium). The total amount that the company wants to spend on this share buyback is $120,000 (2,000 shares * $60).
XYZ Company can create the treasury stock contra equity account on the balance sheet through the cash method and par value method.
By using the cost method, the accounting team would debit the treasury stock account for $120,000 and credit the cash account for $120,000. By using the par value method, the accounting team would debit the treasury stock account for $20,000 (2,000 shares * $10 par value), additional paid-in capital account for $100,000 (2,000 shares * $50 excess amount on par value paid on each stock by shareholders), and credit the cash account for $120,000.
What Are the Effects of Treasury Stock Purchases on Shareholders’ Equity?
When the company buys back shares from investors, it reduces the shareholder’s equity by the amount paid to investors. Treasury stock creates a contra equity account under the shareholder’s equity section of the balance sheet. It is called a contra equity account because its balance counts against the total value of the shareholder’s equity of the company.
Though treasury stocks benefit investors as they may result in an increase of share price in the short term, they would weaken financial statements, mainly the balance sheet, of the company.
Shareholder’s Equity = Total Assets – Total Liabilities
Cash is an asset that the company would pay its investors to purchase its own stock. When the company pays out the cash, its current assets will go down. The reduction in current assets would reduce the shareholder’s equity.
Let us say the company has assets worth $50,000 and liabilities worth $20,000.
The shareholder’s equity = $50,000 – $20,000 = $30,000
Let’s assume that the company buys back 100 shares worth $5,000 and uses its current assets to complete this transaction.
In this case, the equation of shareholder’s equity would look like this:
Shareholder’s Equity = {(Assets – Share Buyback) – Liabilities}
= {(50,000-5,000) – 20,000}
= $25,000
So, the stockholder’s equity is reduced by $5,000 ($30,000 – $25,000).
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On the whole, treasury stock is the reacquired stock from the shareholders. Companies reacquire shares when they feel the stock is undervalued. Other motives of creating a treasury stock are to reduce dilution, increase shareholder value, and improve the financial appearance of the company. Accounting teams use the cost method and the par value method to make entries of treasury shares on the balance sheet. Treasury stocks reduce the number of shares outstanding on the open market and the shareholder’s equity.
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