Treasury stock is the name for previously sold shares that are reacquired by the issuing company. When a corporation buys back some of its issued and outstanding stock, the transaction affects retained earnings indirectly. Since both retained earnings and treasury stock are reported in the stockholders' equity section of the balance sheet, amounts available to pay dividends decline. The cost of treasury stock must be subtracted from retained earnings, reducing amounts the company can distribute to stockholders as dividends.
Earnings Per Share Ratios
Sometimes a company wants to improve its earnings-per-share ratio. When a corporation buys back some of its own stock, it reduces the number of shares issued and outstanding, increasing the corporation's earnings per share and making its stock more attractive to investors. For example, a company with earnings of $50,000 and 20,000 shares outstanding has an earnings per share of $2.50 -- a number reached by dividing the earnings by outstanding shares. If the company buys back 5,000 shares, its earnings per share increases to $3.33, when $50,000 is divided by the 15,000 outstanding shares.
Undervalued Stock Price
Senior management may believe the company's stock is undervalued in the market as reflected by its selling price. By reacquiring its own stock, if it's truly undervalued, the company helps its remaining shareholders by removing some available stock from the market. Supply and demand theory states that if demand for something remains constant and the supply of something decreases, the price will increase. Treasury stock, while decreasing stockholders' equity and retained earnings, can generate a stock price increase in the market.
Stockholder or Employee Incentives
Companies wishing to increase incentives by offering stock options often buy back some of their outstanding shares, creating treasury stock. Stockholders benefit, as they can purchase more shares -- typically below current market prices. Corporations can also use treasury stock to offer employee stock options as part of their compensation packages. Although this effectively lowers dividends, by subtracting treasury stock costs from retained earnings, share prices may increase for stockholders. If the stock is undervalued, the company can buy it back for lower-than-true-value prices.
Treasury stock shows up as a debit, or minus, in stockholders' equity on the corporate balance sheet. Other accounts in this section are credits, or pluses, for common stock authorized -- the initial number of shares created at par value -- and stock issued and outstanding, the number of shares sold to investors. Because treasury stock is stated as a minus, subtractions from stockholders' equity indirectly lower retained earnings, along with overall capital. However, treasury stock does directly affect retained earnings when a company considers authorizing and paying dividends, lowering the amount available.