Sometimes when the market moves, many businesses are at a disadvantage. At this time, businesses will find many ways to control the situation. One of them is the use of treasury shares. So what is a treasury stock and how does it work?
1. What are treasury shares?
Treasury shares is the equity shares of the company it has issued and subsequently repurchased; This stock is not subject to cancellation and is legally available for reissue. This stock reduces the number of shares outstanding but does not change the shares issued.
A company may redeem its own equity shares as this class of stock to: (1) cancel and dispose of the shares; (2) subsequent re-issuance of shares at a higher price; (3) reduce the number of shares outstanding and thus increase earnings per share; or (4) issue shares to employees. If the purpose of the buyback is cancellation and retirement, then this class of shares only exists until they are scrapped and canceled due to a formal reduction of the company’s capital.
For dividend or voting purposes, most state laws treat these shares as issued but not outstanding, since the shares are no longer owned by the owners of the shares. . In addition, accountants do not consider this class of shares outstanding in calculating earnings per share.
When companies request to buy this type of stock they record the shares at cost as a debit in the owner’s equity account known as Treasury Shares. They credit the reissues to the Treasury account at the original price paid to redeem the shares (not the stated par or par). Therefore, this stock class account is debited at cost when the shares are purchased and credited at cost when the shares are sold. Any excess of the reissue price over cost represents additional capital input and is credited to Capital Prepaid — Common (Preferred) Treasury Shares.
2. What are the pros and cons of treasury stocks?
The effect of this type of stock is very simple: reduce cash decrease and decrease total equity. This outcome occurs regardless of the initial issue price of the stock. Accounting rules do not recognize profit or loss when a company issues its own shares, nor do profit and loss recognition when a company buys back its own shares. This may seem odd, because it’s definitely different from the way people think about investing in stocks. But keep in mind that this is not a stock investment from the company’s point of view. Rather, it is an expansion or contraction of its own equity.
However, buying these stocks can be counterproductive if the company’s timing isn’t right. An example would be if a company engages in a buyback when the stock price is at an all-time high. Therefore, to buy the number of outstanding shares will require a lot of capital. Investors should also be wary of buybacks depending on the motivation behind them. For example, if a company is buying back shares with the intention of increasing its price to attract more investors, this could be a sign that the company is eager to raise capital.
Also, if the company is making buybacks to improve earnings per share (EPS), it doesn’t necessarily mean that investors will get any long-term benefits. This announcement could also mean that the company’s profits are dwindling. Or, this could mean operating costs are too high. This can compromise the financial security of the company.
The question is, should you be concerned if a company in which you own shares announces that they are buying shares and converting them into treasury shares? Unnecessary. It helps to understand the company’s motivations and get a more complete picture of the company’s financial strength.
3. Operation of treasury shares:
This class of stock must be accurately recorded on a company’s balance sheet to determine its financial value. Following are the steps to recognize this class of shares from the initial share value and buybacks, and then sell it back to the owners of the shares.
3.1. Issuance of common shares
Before a company can buy back shares, they must first be sold. Shares sold are referred to as “issued shares”. The initial sale of stock shares is recorded on a company’s balance sheet as common stock. Profit can be considered as cash in debit portfolio. The same amount should be listed as common stock in the form of a credit.
3.2. Recorded on the balance sheet as shareholders’ equity
When a company repurchases stock, the transaction is recorded differently on the balance sheet. The cost of the transaction is listed as a cash credit and the same amount is listed as stock when debited.
3.3. Choose an accounting method
There are two accounting methods a company can use when recording its cash books: the cost method and the par value method.
With the expense method, a company lists the reissuance amount in the reverse equity account. The total repurchase amount is listed as a debit and the total resale cost is listed as a cash credit. It does not assume the individual value of this class of shares.
With the par value method, the total value of these shares is listed as shares on a debit basis, while the total value of profits from the resale is listed as cash credit.
3.4. Re-issuance of treasury shares
If a company decides to sell its stock, it must make the appropriate changes to its balance sheet. There are two ways in which a company can recognize earnings after reselling its stock.
The first is a profitable stock. This recording method should be used if a company is selling its stock at a higher price than it was in the past. In this situation, a company will record the total amount of the transaction as a cash debit. The initial value of the shares listed is Treasury shares in the form of credit. The added value when the shares are resold are listed as paid-up equity shares in the form of credit.
The second way to record the company’s reissue of this type of stock is that the stock suffers a loss. This recording method should be used if a company resells its shares for less than the price paid to them. In this case, the company will list the reduction earned as cash on debit, and the stock value listed as Treasury shares credited. The amount of profit a company is left with will be listed as debited retained earnings.