What it is:
How it works (Example):
Let's assume Company XYZ decides to buy back some of its shares because it feels that Company XYZ shares are undervalued in the market right now. When Company XYZ acquires those shares, they become treasury stock.
Treasury stock appears at cost or at par value in the shareholders equity section of the balance sheet and thus appears as a "negative" in the shareholders equity section (known as a contra equity account). It is important to note that if and when Company XYZ decides to resell treasury stock, there can be no income statement recognition of gains or losses on treasury stock transactions. That is, if the company profits (or loses) from the resale of treasury shares, it simply records an increase in cash and a corresponding decrease in shareholders' equity.
Note that purchases of treasury stock are uses of cash, and some states limit the amount of treasury stock a corporation can own at a given time (this ensures that shareholders do not jeopardize the interests of debtholders).
Why it Matters:
In general, an increase in treasury stock can be a good thing because it indicates that the company thinks the shares are undervalued. By buying back its stock, a firm reduces the number of shares outstanding, which in turn gives each shareholder a larger piece of earnings. Likewise, the lower number of shares can improve EPS and other ratios. However, treasury stock can be abused. Managers who repurchase shares solely to increase ratios are violating their fiduciary duty to the shareholders.