Treasury stock represents stock shares that a company had issued and then later repurchased.
Treasury stock reduces the number of shares a company has outstanding.
Companies often repurchase outstanding shares for three primary reasons. First, a company’s management may believe that the shares are undervalued and thus represent a good investment. Second, a company that issues stock-based compensation to employees may repurchase shares in the open-market to offset the additional share issuance. Third, companies may repurchase shares to “return” money to shareholders. Share repurchases are considered a return of capital to shareholders because the reduction in outstanding shares increases the proportional ownership of the remaining shareholders.
Regardless of a company’s motive for repurchasing stock shares, the repurchases are accounted for in the shareholder’s equity section of the company’s balance sheet under an account called treasury stock. The repurchased shares are carried at cost. Treasury stock reduces the amount of equity on the company’s balance sheet.
To see how share repurchases affect a company’s balance sheet and the ownership of remaining shareholders, consider the following scenario: A mutual fund owns 10,000 shares in a company that has 1 million shares outstanding. The equity value on the company’s balance sheet is $50 million. The company has decided to use excess cash to repurchase 50,000 shares at a cost of $100 per share.
The impact of the share repurchase on the company’s balance sheet is to increase treasury stock by $5 million, thus reducing the balance sheet value of equity by the same amount.
Assuming that the mutual fund does not sell any of its shares, it sees its ownership in the company increase from 1% (10,000 / 1,000,000) to 1.05% (10,000 / 950,000).
