What Is Treasury Stock? Definition, How They're Used, and Example (2024)

Offering stock to the public is often an effective way to raise capital, but there are certain times when a company may want to reign in the number of shares circulating on theopen market.Every company has an authorized amount of stock it can issue legally.

Of this amount, the total number of shares owned by investors, including the company's officers and insiders (the owners of restricted stock), is known as the shares outstanding. The number available only to the public to buy and sell is known as the float.

Treasury stocks (also known as treasury shares)are the portion ofsharesthat a company keeps in its own treasury.They may haveeither come from a part of the float and shares outstanding before being repurchased by the company ormay have never been issued to the public at all.

What Happens to Treasury Stock?

When a business buys back its own shares, these shares become “treasury stock” and are decommissioned. In and of itself, treasury stock doesn’t have much value. These stocks do not have voting rights and do not pay any distributions.

However, in certain situations, the organization may benefit from limiting outside ownership. Reacquiring stock also helps raise theshare price, providing investors with an immediate reward.

A company can decide to hold onto treasury stocks indefinitely, reissue them to the public,or even cancel them.

Authorized, Issued, and Outstanding Shares

To better understand treasury stock, it’s important to know a few related terms. When a business is first established, its charter will cite a specific number ofauthorized shares. This is the amount of stock the company can lawfully sell to investors.

When the organization undergoes a public stock offering, it will often put fewer than the fully authorized number of shares on theauctionblock. That’s because the company may want to have shares in reserve so it can raise additional capital down the road. The shares it actually sells are referred to asissued shares.

A company’s financial statements will sometimes reference yet another term: outstanding shares. This is the portion of stock currently held by all investors. The number of outstanding shares is used to calculate keymetricssuch asearnings per share.

The number of issued shares and outstanding shares are often one and the same. But if the company performs abuyback, the shares designated as treasury stock are issued, but no longer outstanding. Additionally, if management eventually decides to retire the treasury stock, the amount is no longer considered issued, either.

Why Buy Back Shares?

There are a number of reasonswhy a company will try to curtail its outstanding supply of stock, either through atender offerto current shareholders—whocanaccept or reject the price that's put forward—or bypurchasing shares piecemealon the open market. The explanation that firms typically offer is that reducing the amount of stock in circulation boostsshareholder value. This makes sense. With fewer shares floating around, each share becomes worth more.

Take as an example Upbeat Musical Instruments Co., which trades in the market at $30 per share. The company currently has 10 million shares outstanding but decides to buy back 4 million of them, which become treasury stock. The company’s annual earnings of $15 million aren’t affected by the transaction, so Upbeat’s earnings-per-share figure jumps from $1.50 to $2.50. Naturally, the remaining shares will command a proportionally higher price than its currentmarket price.

Since a buyback boosts the share price, it’s an alternative to rewarding investors with acash dividend. Previously, buybacks offered a clear tax advantage because dividends were taxed at the higher “ordinary income” level in the U.S. But in recent years, dividends andcapital gainshave been taxed at the same rate, all but eliminating this benefit.

Beyond making investors happy, corporations mayhave other motives for consolidating ownership. For example, with skilled executives in high demand, a company may offerstock optionsas a way to sweeten their compensation package. By accumulating treasury stock, they have the means to make good on these contracts down the road.

Buybacks also represent a defensive strategy for businesses that are targeted for ahostile takeover—that is, one that the management team is trying to avoid. With fewer shareholders, it becomes harder for buyers to acquire the amount of stock necessary to hold a majority ownership position.

If this is management’s goal, it can choose to keep the treasury stock on its books—perhaps hoping to sell it later at a higher price—or simply retire it.

Accounting for Treasury Stock

Though investors may benefit from a share price increase, adding treasury stock will—at least in the short-term—actually weaken thecompany’s balance sheet.

To grasp why this is the case, consider the basicaccounting equation:

$\text{Assets} - \text{Liabilities} = \text{Stockholder’s Equity}$Assets−Liabilities=Stockholder’sEquity

The organization has to pay for its own stock with an asset (cash), thereby reducing its equity by an equivalent amount.

Issuance of Common Stock

Let’s take another look at Upbeat Musical Instruments. If the company originally sold 10 million shares for $35 each, the transaction would appear as follows. The amount it receives would be a debit to “Cash” and a credit to “Common Stock.”

Acquisition of Treasury Stock

Following the example above, let’s say the company decides to buy back 4 million of these shares at the current market price: $30 a share. The transaction will costUpbeat $120 million, which is credited to “Cash.” It debits “Treasury Stock”—which appears under the “Stockholders' Equity” section as adeduction—for the same amount.

Reissuance of Treasury Stock at a Profit

In many cases, a company will either hold on to this treasury stock for strategic purposes or decide to retire it. But imagine that Upbeat’s stock jumps up to $42 per share, and the company wants to sell it at a profit.

The proceeds of the transaction result in a $168 million debit to cash (4 million shares bought back x $42/share). Because all the treasury stock is liquidated, the entire $120 million balance is credited back. The remaining $48 million represents a gain over its acquisition price. This amount is a $48 million credit to an account called “Paid in Capital—Treasury Stock.”

Reissuance of Treasury Stock at a Loss

This happens to be a pretty rosy scenario for the organization. But what happens if the company had to sell those same 4 million shares at $25 instead, an amountbelowits acquisition cost?

Since the account is depleted, "Treasury Stock" would still get a credit of $120 million. But due to the lower stock price, the debit to cash is only $100 million. "Retained Earnings"is debited the remaining $20 million, reflecting the loss of stockholders' equity.

The Bottom Line

Reducing the number of outstanding shares can serve a variety of important goals, from preventing unwanted corporatetakeoversto providingalternate forms of employee compensation. For an active investor, it’s important to understand how the acquisition of treasury stock affects key financial figures and various line items on the balance sheet.