What is a Stock Split? – Definition
The stock split is an increase in the number of outstanding shares with a proportionally decreasing par or stated value. A stock split happens when a corporation increases the number of its common shares and proportionally decreases its par or stated value.
The end result is a doubling, tripling, or quadrupling of the number of outstanding shares and a corresponding decrease in the market price per share of the stock. This price decrease is the main reason that a corporation decides to split its stock. When the market price per share is too high, the stock loses its attractiveness to many investors, because it is most economical to purchase stock in round lots of 100.
A stock price that is too high makes round-lot purchases impossible for some potential investors. For example, if a firm’s stock is currently selling for $240, and the firm splits its stock 4 for 1, the price per share will fall to around $60. Thus, it takes only $6,000 rather than $24,000 to purchase 100 shares.
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 a 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.
Accounting for stock splits
To demonstrate the accounting for stock splits, assume that the Moreno Corporation’s stockholders’ equity accounts are:
The corporation’s stock is currently selling at $90 per share. The firm decides to issue a 3-for-1 stock split. As a result, the corporation reduces the par value of its stock from $15 to $5 and increases the number of shares issued and outstanding from 50,000 to 150,000. Although no journal entry is required, some firms will make a memorandum entry noting the stock split. Immediately after the stock split, the Moreno Corporation’s stockholders’ equity accounts are:
As you can see by comparing the corporation’s stockholders’ equity accounts before and after the stock split, there is no change in either total stockholders’ equity or the individual components. Only the par value and the number of issued and outstanding shares are different.
From the investor’s viewpoint, each stockholder receives two additional shares for each share owned. In effect, the old shares are canceled, and shares with the new par value are issued. Because the price of the firm’s stock is likely to fall to $30, the total market value of each stockholder’s investment immediately after the split will be about the same as it was before the split.
Similarities between Stock Splits and Large Stock Dividends
Stock splits and large stock dividends are quite similar. They both serve to reduce the market price per share and increase the number of shares issued and outstanding. In each circumstance, total stockholders’ equity remains the same because there has been neither an increase nor a decrease in the entity’s net assets. For example, a 2-for-1 stock split is similar to a 100% stock dividend. In both cases, the number of shares issued and outstanding doubles, and the market price per share will fall accordingly.
However, if this event is a stock dividend, there will be no change in the stock’s par or stated value, but there will be a decrease in the Retained Earnings account and an increase in the Common Stock account. If this event is a stock split, there is no change in either Retained Earnings or Common Stock, just a decrease in par value and an increase in the number of issued and outstanding shares.
Stock dividends and stock splits affect the number of common shares outstanding, which in turn affects the EPS calculation. The current year’s EPS calculated by using the number of common shares after any stock dividends and splits. This means that when comparative statements are issued, or 5- and 10-year summaries are presented, the number of common shares on which EPS is in these statements must be retroactively adjusted for these dividends or splits. This ensures that the EPS figures will be comparable.
These points regarding stock splits and EPS are illustrated in the following note taken from an Atlantic Richfield annual report:
Note 2: Common Stock
On May 6, 1980, the shareholders approved a proposal that the common stock of Atlantic Richfield be split, on the basis of two shares for one, by an amendment to the Articles of Incorporation by which (a) Atlantic Richfield’s authorized common stock would be increased from 150,000,000 shares having a par value of $5.00 per share to 300,000,000 shares having a par value of $2.50 per share, and (b) each issued share of common stock having a par value of $5.00 per share outstanding would be reclassified as two shares of common stock having a par value of $2.50 per share. The amendment became effective on May 9, with distribution of shares on June 30, 1980. Aggregate and per share data included in Atlantic Richfield’s Consolidated Financial Statement and Notes to Consolidated Financial Statements have been restated for the stock split.
Example (Disclosure of Stock Split)
The 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.