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The Disadvantages of Issuing Treasury Stock

Original post by Walter Johnson of Demand Media

Treasury Stock, not to be confused with Treasury bills, does not refer to the U.S. Department of the Treasury. It refers to the treasury of a private firm. More specifically, treasury stock is issued either as stock that is not meant to be publicly traded, or bought back by the firm for a specific reason. The Securities and Exchange Commission monitors these buyback plans very closely because they have the potential for abuse.

Equity

When a firm buys back its own stock, it is listed in the accounting department as a loss. However, when it does so, the remaining stock traded on the market goes up in value. Depending on the size of the buyback, one important disadvantage is that it absorbs cash from the firm. As a result, the firm has less cash on hand than it did before.

Disguise

One of the more ominous problems with stock buyback plans is that it can disguise or manipulate the price or earning potential of the outstanding shares. In other words, the firm can try to fool the market into believing the shares are worth more than they actually are. Buying back stock is one way to increase the price of the remaining shares. This can make the remaining shares seem as if they are naturally growing in value. If the firm's earnings are flat or declining, a quickly executed share buyback program can quickly lead to an increase in share value. This can be abused to mislead the shareholders.

Fraud

The main reason why the SEC watches the buyback of firm stock is the potential for fraud. If buying stock from the market increases earnings per share, then a large-scale buyback can disenfranchise many smaller owners. In some cases, the firm can then massively increase the earnings per share of the remaining shares. If these remaining holders are the company favorites or powerful employees, there has just been a large wealth transfer without any increase in production or efficiency.

Profits

When a company buys back its own stock, this means the shareholders now have less. If the market is paying attention, a buyback scheme without any clear reason can signal bad management. The SEC also permits buybacks when the firm promises to resell the shares at a later date. If it does so, and the shares sell for more than the purchase price, then the firm has made a profit on nothing. If the shares increase in value because of the buyback program and the company then profits from its own buyback, then the profit is taken from shareholders without any increase in production. In a very real way, this is a scam. It can destroy a company's reputation in the long run.

                   

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About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

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