Treasury stock is a potent tool in the top management's arsenal. It can be used to support the stock price as well as various other strategic purposes. Since treasury stock will have significant influence on the fortunes of shareholders, it is important to learn how to recognize changes in treasury stock levels by reading the balance sheet.
A company's own shares, which it has bought and is keeping in its treasury, are referred to as treasury stock. The primary reason companies buy their own stock is to elevate the stock price in the market. Owning treasury stock creates a higher market price for the remaining shares in two ways. First, buying shares results in additional demand, just as any purchase would, and elevates the stock price. Secondly, treasury stock results in fewer outstanding shares in the marketplace, which means the same total cash distributed to shareholders in the form of dividends results in a higher dividend per share, which makes the shares more attractive to buyers.
When the firm purchases its own shares, it makes a debit entry to treasury stock and a credit entry to cash in the same amount. In other words, cash goes down and treasury stock goes up by the same amount. When calculating the net shareholders' equity, treasury stock will be subtracted from shareholders' equity. Therefore, the result of an increase in treasury stock is an equivalent decrease in net shareholders' equity. As such, treasury stock shows up as the last line in shareholders' equity as a separate line, preceded by the word less. This signifies that it must be subtracted from the line above, which is net shareholders' equity.
If the firm's stock is trading at $10 per share and management buys a million shares, the total cash outlay will be $10 million. The resulting entry will be a debit to treasury stock and credit to cash, for $10 million each. Note that, at this stage, the accountant will record only the absolute cash outlay and not the number of shares or cost per share. Then, the accountant will add a new line to the balance sheet, called "Less: treasury stock (1 million shares)." By simply dividing the net amount in treasury stock by the number of shares in parentheses, you can calculate the cost at which these shares were acquired. As a result of this new line, shareholders' equity will decline by $10 million since this much will now be subtracted from total shareholders' equity.
Selling Treasury Stock
When the firm sells treasury stock, the total sales proceeds will be entered as a debit to cash, while an equal amount will be credited to treasury stock. Total cash on the balance sheet will go up, while treasury stock will decrease by the same amount. Since treasury stock goes down, shareholders' equity will increase by the same quantity. If the firm sells the treasury stock for more than it originally paid for it, it will have added value and shareholders' equity will go up compared with before the original purchase of the treasury stock.
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