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

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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. 12
ealized but before they are reported. We also expect that these splits should more frequently be accretive than dilutive. 3 Data and Results 3.1 Data The sample analyzed in this study is compiled from four major databases. The primary data sample is gathered from the quarterly CRSP/COMPUSTAT Merged database and combined with analyst forecast data obtained from I/B/E/S. Our sample starts in 1984 since we require 12 previous quarters of analyst forecasts in our main tests. Our sample ends in 2011. We include stock return data from CRSP. Only common stock with CRSP share code 10 or 11 are included. We merge in institutional ownership obtained from the Thomson Reuters 13(f) institutional holdings database. For a subset of tests, we include compensation data from ExecuComp. To distinguish between changes in shares outstanding due to stock splits, repurchases, or equity issuances, we use distribution codes from CRSP. Stock splits have a distribution code equal to 5523. In our sample, we assign a split to a fiscal quarter if the CRSP payment date (PAYDT) occurs after the prior earnings report date, but before the earnings report date as reported in COMPUSTAT. If the earnings report date is missing, a split is assigned to a fiscal quarter if it occurs within the fiscal quarter begin and end dates. A key prediction in our study centers on the link between shares outstanding and the volatility of earnings. We create three measures of earnings volatility. Net Income Volatility is calculated as the standard deviation of net income over the past 12 quarters. This directly measures the variance in net income, however it does not capture predictable, seasonal net income variation. Net Income Volatility - Naive Forecast is the standard deviation of seasonally adjusted net income over the past 12 quarters. This proxy captures the variance around a time-varying mean using a simple forecast for the mean based on seasonality and prior growth in net income. Net Income Volatility - Analysts Forecast is calculated as the standard deviation of (Net Income - median IBES forecasted earnings) over the past 12 quarters, where median IBES forecasted earnings is the median EPS forecast multiplied by shares outstanding. The benefit of this measure is that it captures actual earnings expectations in each period. However, the drawback is that it requires data from IBES which reduces the sample. [Insert Table 1 Here] 13
Page 1 and 2: Gaming the Float: How Managers Resp
Page 3 and 4: earnings will choose more shares ou
Page 5 and 6: targets. Managers change the target
Page 7 and 8: it does not increase as the firm’
Page 9 and 10: meeting that forecast. This leads t
Page 11: 2.2 Time series determinants of sha
Page 15 and 16: A and incentive compensation in Pan
Page 17 and 18: elationship between incentive compe
Page 19 and 20: the view that increases in forecast
Page 21 and 22: In columns 2 and 3, we measure our
Page 23 and 24: atypical amount. In Table 9, we rep
Page 25 and 26: price levels observed in the data.
Page 27 and 28: management tools. 27
Page 29 and 30: De Angelis, D. and Y. Grinstein (20
Page 31 and 32: A Appendix We show that a drop in a
Page 33 and 34: Figure 1: Example of the relationsh
Page 35 and 36: Figure 3: Median Shares Outstanding
Page 37 and 38: Table 2: Determinants of Shares Out
Page 39 and 40: Table 4: Shares Outstanding: First
Page 41 and 42: Table 6: Changes in Shares Outstand
Page 43 and 44: Table 8: Changes in Shares and Acco

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