Definition of Treasury Stock and Reasons for Acquisition

Treasury Stock: Common stock issued and fully paid, which the company repurchases from its shareholders in the secondary market and holds in its treasury. These shares remain legally outstanding but voting and dividend rights are suspended, and they are not counted among outstanding shares. Accounting-wise, they are recorded as a deduction from equity, not as an asset, and can be reissued or permanently canceled.

Reasons for Acquisition:

• Increase stock price: Reducing outstanding shares increases demand and raises price through supply and demand laws
• Incentive programs: Distribute as bonuses and grants to employees and senior management instead of issuing new shares
• Profitable investment: Purchase when prices fall below fair value as temporary investment
• Improve earnings per share: Reducing denominator (number of shares) increases earnings per share even with stable profits
• Protection from takeover: Reduce shares available to potential acquirers and speculators
• Invest surplus: Deploy excess liquidity in company shares instead of low-yield deposits
• Improve ratios: Increase return on equity and return on assets by reducing equity base

Accounting Treatment of Treasury Stock

Various methods exist for accounting treatment of treasury stock:

Upon Acquiring Treasury Stock:

When company purchases its shares from market, recorded at cost as contra account (negative) within equity, not as asset, reducing total shareholders' equity by amount paid:

From Treasury Stock to Cash

Upon Reissuing Treasury Stock:

Treatment differs based on sale price compared to original cost:

When selling above cost: Record difference as treasury stock premium:

• From Cash to Treasury Stock
• To Treasury Stock Premium

When selling below cost: Charge difference to previous treasury stock premium or retained earnings:

• From Cash
• From Treasury Stock Premium (or Retained Earnings) to Treasury Stock

Upon Canceling Treasury Stock:

Remove par value from capital stock and settle remaining amount with reserves or retained earnings:

• From Capital Stock (par value)
• From Original Share Premium to Treasury Stock
• To Retained Earnings (for remaining balance)

Where Treasury Stock Appears in Financial Statements

Treasury stock appears in statement of financial position as deduction from equity at end of shareholders' equity section, reducing total equity. In statement of changes in equity, purchase and sale transactions are recorded as outflows and inflows. In cash flow statement, appears under financing activities, with additional details in notes regarding number of shares, prices, and purposes.

Advantages and Disadvantages of Treasury Stock

Advantages of Treasury Stock:

• Increase earnings per share: Reducing outstanding shares raises earnings per share even with stable profits, improving performance indicators
• Support stock price: Reducing market supply creates buying pressure and prevents price decline during volatility periods
• Invest surplus: Deploy excess liquidity in company shares instead of low-yield deposits or external investments
• Incentive programs: Provide ready shares for employee bonuses without issuing new shares that dilute ownership
• Protection from takeover: Reduce shares available to acquirers and increase hostile takeover cost
• Improve financial ratios: Increase return on equity and return on assets by reducing equity base

Disadvantages of Treasury Stock:

• Drain liquidity: Use available cash for expansion and investment in productive assets or R&D
• Negative signal: Investors may interpret as lack of profitable investment opportunities or unclear future vision
• Reduce liquidity: Fewer outstanding shares reduce trading volume and increase price volatility
• Opportunity cost: Lost potential returns from investing amount in other projects or assets
• Regulatory restrictions: Most regulations limit maximum percentage (10-20%) of capital for purchase
• Timing risk: Possibility of buying at high prices or selling at low prices based on market conditions

Practical Examples and Impact on Shareholders

Practical Examples:

Company with one million shares:

• Purchases 100,000 treasury shares at 50 SAR
• Outstanding shares drop to 900,000 shares
• Earnings per share rises from 4 to 4.4 SAR

Impact on Shareholders:

Positive:

• Increase earnings per share: Distributing same profits over fewer shares raises per-share portion
• Stock price increase: Reducing supply creates buying pressure that may raise price 5-15%
• Increase ownership percentage: Each shareholder owns larger percentage of company without buying additional shares

Negative:

• Reduce distributions: Using cash to buy shares instead of distributing as cash dividends to shareholders
• Lost growth opportunities: Used cash could have been invested in expansion projects increasing future profits
• Negative market signal: Investors may interpret purchase as lack of profitable investment opportunities for company
• Reduce stock liquidity: Fewer outstanding shares reduce trading volume and increase price volatility