What is a Stock Split? – Definition
Stock split is an increase in the number of outstanding shares with a proportionally decreasing par or stated value.
In various circumstances, the board of directors of a corporation may wish to take steps that will alter the number of outstanding shares of stock without affecting the firm’s assets or liabilities. Large increases in the number of shares are accomplished through stock splits and large stock dividends, generally for the purpose of stimulating activity in the stock by reducing the trading value of each share, with the ultimate goal of increasing the total value of the shares. Small increases in the number of shares are accomplished through small stock dividends and apparently are distributed in order to provide stockholders with a symbolic return on their investment that does not require a cash distribution.
Achieving an increase in the number of shares by a formal stock split necessitates a potentially difficult legal process primarily because the action requires an amendment of the corporate charter granted by the authorities. In particular, the corporation must obtain a change in the par value (if any) and an increase in the number of authorized shares. Approval must be obtained from not only the state authority but also the stockholders through a vote.
Because there is no change in either the total stockholders’ equity or any of the individual components, it is not appropriate for a journal entry to be recorded at the time that a formal split is made. When financial statements are issued, the information regarding the stock split and the new par value per share must be disclosed. Disclosures related to prior years should be restated retroactively to include the effects of the split. For example, the prior year’s earnings per share figure is altered to include the larger number of shares.
Stock splits effected as stock dividends
A significant increase in shares accomplished by the declaration of a large stock dividend be described as a split instead of a dividend. As a compromise, the action can be described as a stock split effected in the form of a dividend. While a large stock dividend has the same purpose as a stock split, it is more easily executed than a split when there is a sufficient number of authorized and unissued shares. Instead of going through the legal steps required for a split, the board of directors can simply declare a large stock dividend and distribute the shares to the stockholders.
The accounting for a stock dividend is based on the form of the transaction rather than its substance and thus is more complicated than the practice for a split. Because there has been a change in the number of outstanding shares but no change in the par value per share (or its equivalent), there must be a credit to the capital stock account equal to the par value of the newly issued shares. While there has been no disagreement concerning the amount to be used or the account to be credited, accounting practice shows two different accounts being debited.
Some firms debit the full amount to the Retained Earnings account in the reflection of the fact that the new shares were distributed as a dividend. When state law requires a transfer, under the circumstances of a split effected as a dividend there is no need to capitalize retained earnings, other than to the extent occasioned by legal requirements.
As an alternative to debiting Retained Earnings (if allowed by state laws), some firms choose to debit Additional Paid-In Capital or Capital in Excess of par. The reasoning behind the approach is that it does not alter the total amount of paid-in-capital or retained earnings and thus more clearly reflects the split nature of the stock dividend. The actual practice seems to be mixed between these two approaches. The choice of one or the other has little impact on the description of the firm’s financial position provided in the balance sheet.
Example (Disclosure of Stock Split)
Following example illustrates the disclosure of a stock split effected in the form of a stock dividend by Prime Computer, Inc.
In February 2018 the Board of Directors approved a 2-for-1 split of the Company’s common stock in the form of a 100% stock dividend. In order to effect this stock split, the stockholders approved an increase in the authorized common stock from 10,000,000 to 25,000,000 shares. All references to per share data and stock option data have been adjusted to reflect this stock split.