Definition of Treasury Stock
Treasury stocks are shares that a company buys back or repurchase from its already issued shares to the public. Or sometimes, these shares are kept in the company’s kitty from the start and are never issued to the public at all. The principle is that these shares or stocks remain in the company’s own treasury, which is why the name treasury stock is given to such shares.
Explanation
When a company buys back the shares or avails the option of treasury stock, the number of shares in the market is reduced. Therefore, this stock is also known as a contra-equity account. Also, treasury stocks result in a decrease in the outstanding number of shares in the open market; therefore, these shares are not included in the distribution of dividends or the calculation of earnings per share.
They are also excluded from voting rights since they are no longer issued to the general public. The number of shares a company can repurchase as treasury stocks or keep in its own treasury is mostly regulated by a national regulatory authority in different countries. These stocks are repurchased by the company to be kept in reserve for future investments, improving financial ratios or sometimes for maintaining controlling interest.
How to Record Treasury Stock
They are two methods of recording these stocks:
1. Cost Method
The cost method ignores the par value of the share of the company. Under the cost method, if the treasury stock is purchased, the following entry is passed with the actual amount of purchase.
| Dr | Treasury stock (Repurchase amount) |
| Cr | Cash(Repurchase amount) |
When these shares are sold at a later stage, the following entry is passed:
Case: Sales consideration exceeds the cost of purchase
| Dr | Cash (Amount received) |
| Cr | Treasury stock (Repurchase amount) |
| Cr | Additional paid-in capital (Difference) |
Case: Sales consideration is less than the cost of purchase
| Dr | Cash (Amount received) |
| Dr | Additional paid-in capital (Balance available) |
| Dr | Retained earnings (Difference if any) |
| Cr | Treasury stock (Repurchase amount) |
If the additional paid-in capital amount is insufficient, then only the balance amount is charged to retained earnings.
2. Par Value Method
Under par value method, the following entry is passed at the time of repurchase:
| Dr | Treasury stock (Par Value) |
| Dr | Additional paid-in capital (Difference) |
| Cr | Cash (Repurchase amount) |
Here, the paid-in capital is debited to reduce the value by the excess amount to par value received at the time of the share issue. When such shares are reissued, the same is accounted for as the normal issue of shares.
Example of Treasury Stock
XYZ limited had 1,000 shares in the open market at the par value of $2 per share, and each share had been issued at a value of $22. After analyzing the market and other factors, the company found that its shares are undervalued and therefore decided to repurchase 500 shares at $30 per share for a total value of $15,000.
Solution:
Now, in this case,
- Common stock at par value $2 × 1,000 = $2,000
- Additional paid-in capital (APIC) = ($22-$2) × 1,000 = $20,000
The repurchase or buyback will create a contra-equity account:
- Cost method: Treasury stock will be debited by $15,000, and cash will be credited by $15,000.
- Par value method: Treasury stock will be debited by par value i.e. (500 X $2) $1,000, APIC will be debited by the excess to par value i.e. (500 x $28) $14,000, and cash will be credited by $15,000 as agreed.
Treasury Stock Journal Entry
We have already seen the journal entries to be passed at the time of the repurchase of these stocks and their subsequent sale. Let us understand the journal entries in a case when the entity decides not to issue back these shares and instead retire them permanently.
| Dr | Additional paid-in capital |
| Cr | Treasury stock |
Accounting for Treasury Stock
Apart from the above points, there is one more thing to keep in mind while accounting for treasury stock i.e. in either method, cost or par value method, treasury stock transactions do not impact retained earnings.
The only other account which is impacted apart from treasury stock or contra equity account is the paid-in capital account. Most of the time, auditors look for this type of error in the financial statements of the companies.
Advantages
Some of the advantages are given below:
- It helps companies keep funds in reserve for future investment purposes such as acquisition, purchase of equipment, etc.
- It helps companies in maintaining controlling interest.
- It helps in boosting the undervalued share price in the market.
- Companies buy back shares to improve financial ratios like return on asset and return on equity. This happens because treasury stocks are not included in the number of outstanding shares in the open market.
Limitations
Some of the disadvantages are given below:
- Treasury stocks do not have voting rights entitlements.
- They are not included in the distribution of dividends.
- They are not included in calculating the number of outstanding shares in the open market, thus, not included in the calculation of earnings per share.
- In case of liquidation, treasury stocks do not receive anything from the net assets remaining,
- There are different laws that regulate the treasury stock phenomenon in different companies. There is a maximum limit that should not be exceeded by the companies when they buy back treasury stock.
Conclusion
It is similar to shares that are not issued to the general public in the open market; these shares reduce the share capital on the balance sheet and are shown as a negative number under the contra-equity account. The method helps in maintaining the price of undervalued shares of the company, which generally leads to hostile takeovers from competitors.
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