A startup’s preferred path is that of progress. As the business grows, so do operations. Such an expansion comes with a need to manage the capital structure better. This is more so in the US since the number of financial structures are quite high. One way of doing so is by means of a stock split. What is it, why is it important and how does it impact your startup? Read on to find out.
What is a Stock Split?
A stock split is an equity event in which the number of shares is increased by the management while keeping the total value of the stock unchanged. Naturally, the par value of each individual share decreases, which is reflected in its market value by a proportionate decrease. In other words, a stock split is basically ‘splitting’ the total stock of a company into smaller pieces or shares.
According to the Big 4 audit firm PricewaterhouseCoopers, a stock split is the issuance of common shares to existing shareholders for the purpose of reducing the market price per share. Lowering price per share increases their marketability to a wider population of investors without diluting the ownership interests of the existing common shareholders.
A stock split can be better understood by way of an illustration. Consider the following situation:
A company, X Ltd, currently has 1000 shares that are issued, subscribed, and fully paid up. The par value per share is $3. The company’s management decides to go in for a 3:1 stock split.
Impact: This means that for each existing share, 2 additional shares need to be issued, i.e. the number of existing shares is multiplied by 3. The par value of the new shares will be one-third of the original share’s par value.
Recording the change in the Balance Sheet:
Before the stock split:
Common Stock (1000 fully paid-up shares of $3 each) $3000
After the stock split:
Common Stock (3000 fully paid-up shares of $1 each) $3000
As you can see, there is no change in the value of the common stock.
A stock split is a major managerial decision that has a profound impact on the par and market values of individual shares of a company. However, it does not have a significant accounting impact. A stock split does not require a journal entry to be passed.
Consequently, there is no change in the ledger accounts and balances. However, it needs to be recorded by way of a memo entry, since it is a significant equity event. In the US, accounting for a stock split has to be compliant with Accounting Standards Codification 505 (ASC 505) issued by the Financial Accounting Standards Board (FASB).
If the stock split occurs prior to the date of the balance sheet or financial statements, the change in the number of shares and par value per share needs to be reflected in the financial statements, as shown in the illustration.
If a stock split occurs after the date on the financial statements, the SEC states that the changes in the capital structure must be given retroactive effect in the balance sheet. An appropriately cross-referenced note should disclose the retroactive treatment, explain the change made and state the date the change became effective.
A reverse stock split or simply a reverse split (a.k.a. stock consolidation) is the opposite of a stock split. Stock consolidation occurs by reducing the number of shares and increasing the par value per share. Companies may do this to increase the market value of their share price.
Understanding the Impact of a Stock Split
A stock split does not increase the value of equity, nor does it impact any single account. If not in this way, how does a stock split impact a company? Is it good or bad?
A stock split is generally perceived as good news because it is indicative that the company’s management wants to increase the number of shares as the company is expanding. This expansion has the potential for generating greater returns, which is in favor of all the stakeholders of the company. Typically, the market value per share increases after a stock split.
Additionally, the liquidity of the stock increases. This is because when the par value reduces, the market value follows suit. Buyers will be more willing to purchase the share at this lowered price, compared to the price prior to the stock split, thus increasing the liquidity of the company’s shares.
A stock split is a major decision that may impact the Earnings per Share (EPS). However, existing investors will not be affected by this since the number of shares they hold will increase, thus having no impact on their income from investing in the company’s shares.
A stock split involves additional tasks like altering the Statement of Equity and updating the holdings of each investor. This may cost money and the time of the company’s management. To avoid this, opt for a cap table service that can automate these tasks and make the process of a stock split very easy from an operational viewpoint. Click here to read the advantages of a cap table.
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