In corporate business, enterprises usually return profits to their shareholders in one of two ways: paying cash dividends at regular intervals and repurchasing stock on the market. When a company purchases stock, it is recorded in an equity account called treasury stock, and cash is dispersed to the sellers. Understanding this process involves learning about the way that a treasury stock sale affects the company’s equity.
Basics of Treasury Stock
Treasury stock is the repurchase of shares of ownership in the company that were previously sold to investors. The board of directors is responsible for voting on whether to repurchase stock, including how many shares to repurchase and at what price. Some companies buy back stock fairly regularly, while for others it is a one-time transaction.
For example, the company may decide to use its earnings to purchase stock instead of paying dividends because a treasury stock purchase reduces the number of shares outstanding and often increases the company’s stock price.
In addition, treasury stock purchases can reduce a company’s risk of a “hostile” takeover through open market purchases of a controlling share of its stock.
Treasury Stock Effect on Stockholders' Equity
When a company buys stock back from its investors, it has the effect of reducing the company’s total equity. As a result, treasury stock is a contra-equity account – its balance counts against the total value of the company’s equity.
The reason for this is that shareholder’s equity represents the total amount of money owed by the company to its investors, and as investors are paid off, this amount is decreased. In addition, the company often uses cash to repurchase stock, which decreases its assets.
Effects of Treasury Stock Sales on Equity
In some cases, the company will decide to sell its treasury stock to investors. As would be expected, sales of treasury stocks by the company have the reverse effect. Equity is increased because shareholders invest more money into the company.
It is important to remember that treasury stock is not always sold for the same price for which it was purchased. Any losses or gains on the sale of treasury stock are either debited or credited to additional paid-in capital from treasury stock – an equity account that records capital invested in the company in excess of the value of its stock. If additional paid-in capital is depleted, the loss is drawn from retained earnings.
Retirement of Treasury Stock
The company’s directors may decide to cancel the treasury stock when they repurchase it, thus making it unavailable for future sale. This transaction also has the effect of decreasing equity – shareholders are still owed less money by the company – but the balance is not recorded in a treasury stock account.
Instead, the balance is drawn out of the additional paid-in capital treasury stock account until its balance is depleted. Any remainder is drawn from the company’s retained earnings.
Matt Petryni has been writing since 2007. He was the environmental issues columnist at the "Oregon Daily Emerald" and has experience in environmental and land-use planning. Petryni holds a Bachelor of Science of planning, public policy and management from the University of Oregon.