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Treasury stock

In the United Kingdom, treasury stocks refer to government bonds or gilts. The British equivalent of treasury stock as used in the United States is treasury share.

In the United States, a treasury stock or reacquired stock is stock which is bought back by the issuing company. It reduces the number of outstanding stocks on the open market ("open market" including insiders' holdings). On the balance sheet, treasury stock is listed under shareholder equity as a negative number. Stock repurchases are often used as a tax-efficient method to put cash into shareholders' hands, rather than pay dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Other times, companies do this to provide a "bonus" or incentive compensation plan for employees. Rather than receive cash, recipients receive an asset that might appreciate in value faster than cash saved in a bank account.

Limitations of treasury stock include:

After buyback, the company can either retire the shares (however, retired shares are not listed as treasury stock on the company's financial statements) or hold the shares for later resale. Buying back stocks reduces the number of outstanding shares. However, the smaller number of shares outstanding is not the reason why stock prices usually increase after announcements of buybacks. To see this, note that accompanying the decrease in the number of shares outstanding is a reduction in company assets, in particular, cash assets, which are used to buy back shares. The correct reason for the price jump is that by buying back its own shares, the company, who supposedly knows more about the true value of its stock than investors, sends a signal to investors that the stock is currently undervalued. The stock price increases as a response to this positive signal.

One way of accounting for treasury stock is with the cost method. In this method, the paid-in capital account is reduced in the balance sheet when the treasury stock is bought. When the treasury stock is sold back on the open market, the paid-in capital is either debited or credited if it is sold for more or less than the initial cost respectively.

Another common way for accounting for treasury stock is the par value method. In the par value method, when the stock is purchased back from the market the books will reflect the action as a retirement of the shares. Therefore, common stock is debited and treasury stock is credited. However, when the treasury stock is resold back to the market the entry in the books will be the same as the cost method.

In either method, any transaction involving treasury stock cannot increase the amount of retained earnings. If the treasury stock is sold for more than cost, then the paid-in capital treasury stock is the account that is increased not retained earnings. In auditing financial statements, there is a common practice to check for this error to detect possible attempts to "cook the books".

If you believe in efficient market theory, a company buying back its stock should have no effect at all on its stock price. If the market fairly prices a company's shares at $50/share, if a company buys back 100 shares for $5000, it now has $5000 less cash but there are 100 fewer shares outstanding; the net effect should be that the value per share is unchanged. However, buying back shares does improve certain per-share ratios, such as price/earnings (earnings per share is increased due to fewer shares outstanding), but that is only because valuing a company's shares according to those ratios is not accurate when a company is holding a lot of cash. If a company's shares are underpriced, then a company can benefit its other shareholders by buying back shares. If a company's shares are overpriced, then a company is actually hurting its remaining shareholders by buying back stock.

One other reason for a company to buy back its own stock is to reward holders of stock options. Option holders are not rewarded by dividends, if issued, since holders of options have not invested any capital into the company. Option holders are often employees and executives of the company that benefit from the rise in stock. If you believe that share buyback programs increase the share value, at least temporarily, the option holder is the benficiary if she/he sells the options.


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Regulatory

In the UK, the Companies Act of 1955 disallowed companies from holding their own shares. However, the Companies Act of 1993 later repealed this.

See also

Categories


Generally Accepted Accounting Principles | Stock market | Corporate finance

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