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

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3.3.3 Stock price levels and idiosyncratic volatility Target Size Management has implications for the relationship between per share stock price levels and return volatility. One result documented in Brandt et al. (2010) is that lower priced stocks have higher return volatility. An interpretation of this relationship is that low priced stocks have higher volatility because they have a low price, and that this is a result of a retail trader clientele effect. TSM suggest that causality may run in the opposite direction. Firms with high earnings volatility may choose low prices as a result of EPS incentives. To the extent that earnings volatility and return volatility are correlated, we would expect to see similar empirical outcomes but with causality running in the opposite direction. In unreported tests, we observe a nearly identical relationship between per share price levels and return volatility (Brandt et al. (2010)) and per share price level and net income volatility (TSM). Distinguishing between these two possible explanations is beyond the scope of this paper. However, this highlights an example of potential implications of target size management that are beyond financial reporting and EPS outcomes. 4 Conclusion A range of net income numbers will generate the same EPS number. This is because earnings per share are rounded to the nearest penny. So, for any given EPS forecast, there is a range of total earnings that will meet that forecast. We refer to the magnitude of this range as the size of the earnings target. The size of the earnings target is a function of the number of shares outstanding. We find evidence consistent with the view that managers engage in target size management - adjusting the firm’s quantity of tradeable securities to affect the size of the range of net income numbers that meet EPS forecasts. We find that an exogenous decrease in the probability of meeting earnings estimates causes managers to split their stocks, thereby increasing the earnings target size. We find that this effect is stronger among firms whose managers’ compensation is highly sensitive to EPS surprises, and weaker among firms for which an increase in shares would be highly costly (e.g., highly illiquid firms). Target size management has real effects. We find that firms are more likely to meet EPS expectations following an increase in shares. Simultaneously, these firms use less accounting and real earnings management tools. Both of these associations are consistent with an increase in shares increasing the earnings target size. Our results suggest that the magnitude of the firm’s long run usage of earnings management tools is a managerial choice. This has implications for research examining the determinants of traditional earnings 26
management tools. 27
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 and 12: 2.2 Time series determinants of sha
Page 13 and 14: ealized but before they are reporte
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: price levels observed in the data.
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

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

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