Firms sometimes repurchase their own outstanding shares and hold them for future use. Such repurchased shares are termed treasury stock and are no longer outstanding, although they continue to be labeled as “issued.”
A variety of motives lead managers to acquire treasury stock. For example, managers may consider the stock to be undervalued in the stock market and to be a “good buy” that can be resold later at a higher price. Also, treasury stock purchases can be preferable to dividend payments as a way of reducing a firm’s shareholders’ equity. Note that this use of treasury stock depends on income tax features that are beyond the scope of this text. In addition, treasury stock purchases can enable managers to “buy out” certain groups of shareholders in order to re-align votes on future issues of corporate policy. Treasury stock can also be distributed to employees under an employee stock option plan.
The acquisition of treasury stock reduces both cash and shareholders’ equity. In this sense, treasury stock acquisitions are the opposite of a shareholder investment. The cost of treasury shares is usually subtracted from total shareholders’ equity. For this reason, the purchase price of treasury stock is a contra-equity account.