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

1 Introduction
Earnings per share (EPS) is a widely followed and heavily scrutinized financial indicator in the US. Evidence
suggests that managers care about EPS targets (Graham et al. (2005)). A large literature documents a
variety of actions that managers take to affect the gap between earnings realizations and EPS forecasts by
changing earnings, forecasts, or both. 1 This literature generally takes the concept of “meeting”, “beating”,
or “missing” forecasts as given. We show that, even if two managers have identical earnings and forecasts,
one can “miss” while the other “meets”. The rules of the game are actually the manager’s choice. In this
paper, we show that managers can affect the likelihood that their firm meets future EPS forecasts without
affecting their firm’s reported earnings or guiding forecasts. They do so by choosing the number of shares
outstanding.
For any given EPS forecast, there exists a range of total earnings that will meet that EPS forecast.
For example, a firm with 1000 shares outstanding and EPS forecast of $0.20 will meet the forecast with any
earnings ∈ [$195, $205). This range exists because per-share earnings are rounded to the penny. Importantly,
the amount of rounding is a choice variable; it is an increasing function of the number of shares outstanding.
If the same firm has twice as many shares outstanding, the firm meets the forecast for any earnings ∈ [$190,
$210). The wider this range, the higher the probability of meeting EPS forecasts, more specifically:
P r(meet) = P r(µ − s ∗ 0.5¢ ≤ x < µ + s ∗ 0.5¢)
where x represents the realization of total earnings, s is the number of shares outstanding, and µ is the
forecasted total earnings implied by the EPS forecast. Increasing the number of shares increases the size of
this range (the “target size”). To put it simply, the practice of rounding EPS outcomes has a bigger effect
the more shares a firm has. Managers can exploit this fact to influence the probability of meeting all EPS
forecasts going forward. However, this is not costless; as managers increase the number of shares, the share
price drops mechanically. This can have liquidity costs and, in the limit, result in delisting.
We develop and test several implications of the hypothesis that managers engage in target size management
(TSM) - adjusting shares outstanding to affect the size of the range of total earnings that meets
EPS forecasts. 2 Our primary hypothesis is that managers of firms that are likely to miss EPS targets due to
chance in the future will choose a larger target size. This is equivalent to saying that firms with unpredictable
1 For comprehensive reviews of the earnings management literature, see Healy and Wahlen (1999), Dechow and Skinner
(2000) and Dechow et al. (2010).
2 We focus on EPS forecasts as the relevant threshold, however target size management could apply to any threshold, as long
as the threshold is measured and rounded at the share level.
2