I'm Larry Walter.
This is principlesofaccounting.com Chapter 14.
In this module we will look at stock splits and stock dividends.
Let's being by looking at stock splits.
Stock splits occur when a company issues additional shares of
stock to existing shareholders.
For example, maybe there's a two-for-one stock split, so
the company doubles the number of shares outstanding and
issues the additional shares to the current owners of the shares.
This will cause a corresponding decrease in par value, so
that a two-for-one split will result in a halving of the par value.
A 3-for-1 stock split would result in the par value being reduced to one-third
of what the par value was before the shares.
Importantly, each shareholder maintains their proportional ownership interest.
If you own 100 shares of a company that does a 3-for-1 split, after the split,
you'll own 300 shares.
All of the shareholders will own three times as many shares.
There's no effective change in the percentage ownership in the company,
you simply have more shares representing your ownership.
The total par value is unaffected by this transaction.
If we’re increasing the shares and proportionally decreasing the par
per share, the product of multiplying the number of shares times the par value gives
you the same total par value for the entity.
Perhaps an illustration will help prove the point.
Here before a split, we have common stock $1, and
we have 400,000 shares issued and outstanding.
Now, this gives us total par value for all the shares.
$1 times 400,000 or $400,000 is the total par value for
the common stock of this entity.
After the split, notice now we've got 1,600,000 shares,
that's four times as many.
But the par value is only $0.25 per share, a significant reduction here,
one-fourth what it was beforehand.
Now, $1,600,000 shares times $0.25 per
share still gives us $400,000 of total par value for the entity.
What is the rationale behind a stock split?
Well a stock split will decrease the market value per share of the stock.
In other words if there's four times as many shares outstanding for the entity,
you would expect each share to be worth one-fourth as much, or
approximately one-fourth as much.
Current holders will not be disappointed in this price decrease however because
they have more shares.
That can cause the stock to become more attractive to potential future investors.
They may feel like they're able to buy stock at a lower price point per share, so
the shares may become more marketable.
Stock splits are oftentimes used when a stock price is rising and rising and
rising, and it's seen as being at such a high price point per share that it becomes
unattractive to a certain or investors or potential investors.
Stock splits can come in odd proportions.
You can have a 3-for-2, a 5-for-4, even a 1,000-for-1.
There's nothing that says it has to be 2-for-1 or 3-for-1 or
some simple, round number.
Reverse splits are also possible, for example, a 1-for-5 split is possible, or
a 1-for-6 or a 1-for-10.
This will decrease the number of shares outstanding and
it should increase the price per share.
After a stock split, the price per share should go up in the marketplace.
Reverse splits are sometimes not looked upon with favor by stockholders who
somehow feel like something's been taken away from them, however,
they still own the same proportion of the company after the split.
And a company that has found its stock trading below a dollar per share, for
example, for a long period of time,
certain stock exchanges require a minimum price point per share.
The reverse split is simply a way for
the price per share to be increased to maintain a listing requirement.
Now, very similar to stock splits or stock dividends, this is the issue in some
additional shares to existing shareholders again on a proportional basis.
It's similar to stock splits.
For example, a shareholder who owns 100 shares of stock,
will own 125 shares after a 25% stock dividend.
So in that respect, they're very similar.
It's essentially therefore the same as a 5-for-4 stock split.
There is a big difference however, that primarily affects the accountants.
A stock dividend requires a journal entry.
The par value per share is not changed for
a transaction that is effective as a stock dividend.
So we need to move amounts from retained earnings to paid-in capital
to reflect an amount that we calculate related to a stock dividend.
The amount that we're going to move from retained earnings to capital stock
depends on the size of the distribution.
Small stock dividends, generally those that are less than 20 to 25%,
are deemed to not materially affect the market price per share.
And whether it's valid logic or not, we therefore base the accounting upon
the fair value of the shares involved in the stock dividend.
Whereas a large stock dividend, generally greater than 20 to 25%,
is deemed to materially affect the price per share,
in other words, there's a proportionate decrease in the price per share.
Therefore we used par value to record the accounting for a large stock dividend.
This is very arbitrary based on specific accounting rules.
Let's look at an example,
Childers Corporation had 1,000.000 shares of $1 par value stock outstanding.
The market price was $20 per share and on that date, they declared and
issued a stock dividend.
If this was a small stock dividend, that is 100,000 shares,
10% of a million, 100,000 shares are issued and we would capitalize or
record retained earnings, a debit, to retain earnings at $2 million.
That's the fair market value of 100,000 shares.
I'll assume the market price is $20 a share.
Notice the credits there, credit common stock for
the par of the shares being issued, that's $1 times 100,000.
And the other 1,900,000 goes to paid-in capital.
On the other hand, if this was a large stock dividend, the same facts except I'm
going to assume that Childers is now going to issue a 40% stock dividend.
That's a large stock dividend and
the accounting rules would dictate that it be based on the par value of the shares.
The calculations here, 1,000,000 shares outstanding times 40% is 400,000.
Additional shares are issued and
those shares have a par value of $1 per share, so
we will debit retained earnings and credit common stock for the par of the shares.
So I would like to close with just a quick summary here.
A stock split results in additional shares being issued to the existing shareholders.
The accounting however, there's no journal entry needed because
when there's a stock split, the par value per share is reduced, and
the number of shares outstanding are increased.
The product of those two should be the same total par value.
A small stock dividend is to be accounted for based at fair value, that is,
we are going to move from retained earnings to paid-in capital.
The fair value of the shares issued in a small stock dividend.
A large stock dividend is essentially the same accounting except it's based upon
the par value of the shares.
In substance, there's very little difference between these transactions, but
there is a significant difference in terms of what the accountant needs to do to
account for a stock split, a small stock dividend, and a large stock dividend.