Gaming the Float: How Managers Respond to EPS-based Incentives

EPS forecasts more frequently or will use less earnings management (or both) following an increase in shares
outstanding.
H6: The likelihood of meeting (missing or beating) EPS forecasts increases (decreases) following increases
in shares.
H7: The usage of accounting and real earnings management tools decreases following increases in shares.
2.3 Short-term rounding effects
Discussion up to this point has focused on the long-run effects of shares on the size of the earnings target.
Given that the number of shares persists from quarter-to-quarter, we expect managers to choose shares in
response to long horizon trade-offs and expectations. However, it is possible that managers ignore long term
effects and adjust shares outstanding in light of private information regarding current period earnings. To
the best of our knowledge, reported earnings must reflect splits that occur during the period between the
fiscal quarter end and actual earnings report date. Therefore, it is possible that managers adjust shares in
order to affect current period EPS outcomes. Prior evidence suggests that managers use stock repurchases
to affect current period EPS outcomes (Bens et al. (2003) and Hribar et al. (2006)).
If managers observe that current period earnings are lower than expectations, they may choose to increase
the target size such that they meet (the split adjusted) EPS expectation. This seems unlikely for a few
reasons. First, we do not observe managers rebalancing shares each quarter - if a firm splits in one quarter
for short-term reasons, the firm would prefer to reverse split in the next quarter to return to the optimal
target size. More importantly, there is a well established positive market reaction to stock splits. This
evidence is not consistent with managers splitting because of negative temporary earnings shocks.
However, there may be scope for short term considerations to affect not whether the firm should split, but
by how much. For example, perhaps the manager has determined that the firm needs to roughly double the
number of shares. The manager might choose a 7-for-3 split instead of a 2-for-1 split, so that the change has
an accretive effect on current period EPS. 13 We hypothesize that if managers choose split ratios out of short
term considerations, then we should observe atypical ratios more frequently in the period after earnings are
13 An example of an accretive split is the following: The manager observes current period net income to be $15.4. The firm
has 100 shares outstanding, and analysts’ forecasted EPS is 0.15. If the manager issues a 7-for-3 split, split-adjusted expectation
is 0.06. However, the manager will report split-adjusted EPS as 0.07.
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