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

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target size. 6 Importantly, changes to target size as a result of stock splits are quite common. In a typical year, roughly 5% of firms split. Over the full sample, almost all firms adjust the target size to keep up with firm growth. 7 This suggests that TSM is economically important and widely used. Some firms, however, may find it too costly to manage the target size. We find that TSM is limited by costs associated with having a large quantity of shares. A firm with a large target size will have a low stock price. A low stock price may lower stock liquidity, potentially to the point of delisting. For firms with low liquidity, we find a minimal response to exogenous changes in net income volatility. Our analysis is complicated by the fact that the predictability of earnings is itself a managerial choice variable. Managers can explicitly manage the volatility of net income using accruals or real investments (e.g. Beidleman (1973), Subramanyam (1996), Healy and Wahlen (1999)), and they can use guidance to manage the forecast. In order to demonstrate that our effects are evidence of TSM and not due to some other factor related to the use of accruals or guidance, we employ an instrumental variable approach that uses an exogenous change in analyst coverage (Hong and Kacperczyk (2010), Degeorge et al. (2012), Derrien and Kecskés (2012), Kelly and Ljungqvist (2012)) to instrument for changes in the predictability of the firm’s net income. This instrument captures the fact that fewer analysts will result in noisier estimates on average. Therefore, the firm experiences an increase in the probability of missing earnings forecasts that is unlikely to be related to the fundamentals of the firm. The causal effect is large. A one standard deviation increase in instrumented volatility results in an increase in shares of one-half of one standard deviation. Managerial payoffs are also endogenous. Compensation contracts and the market reaction to EPS surprises (and therefore the change in value of the manager’s stock and option holdings) are likely to be determined based on the underlying fundamentals of the firm, including the predictability of the earnings. 8 Using the same instrumental variable approach, we examine if an exogenous shock to this predictability has a greater effect on shares among firms whose managers have pay that is ex-ante highly sensitive to EPS outcomes. We find that the relation between shares and instrumented volatility is primarily driven by managers with high incentive compensation. To summarize, on balance our evidence is consistent with TSM. In the cross section, firms with more unpredictable earnings and firms with managers more sensitive to negative EPS outcomes choose larger 6 Passive changes to float occur as a result of certain policies, such as ESOP plans. We find that these changes do not drive our results. 7 Berkshire Hathaway is a notable example of a firm that does not appear to engage in TSM. The size of Berkshire Hathaway’s earnings target is small relative to the size of the firm’s earnings. They must realize earnings within ±0.00005% of the consensus forecasts to meet expectations. 8 Evidence of this endogeneity can be seen in Dechow and You (2012). They document that the market reaction to EPS surprises is weaker for firms with higher EPS levels which, holding earnings fixed, is equivalent to firms with lower shares outstanding. 4
targets. Managers change the target size in response to changes in the predictability of those earnings. Importantly, these effects are stronger for firms with higher incentive compensation, weaker for firms with low liquidity. Finally, following an increase in the target size, firms meet forecasts more frequently and earnings management drops. Our paper is related to, but distinct from, the broad literature on earnings management. Prior evidence suggests that earnings management occurs when managers face short term incentives to meet or beat a threshold. The manager privately observes the firm’s earnings, and chooses accruals, investment, stock repurchases, or some other corporate action such that the firm’s reported earnings meet the threshold. In contrast, our evidence suggests that managers manage the target size not to affect the current period EPS, but to affect the ease with which the firm will meet future EPS thresholds in the long run. No private information is required by the manager for TSM to be effective, and markets need not be fooled. TSM and earnings management are related, however, in the sense that TSM is a long-term substitute for earnings management. By setting the target size today, the manager is effectively determining the amount of earnings that will need to be managed in expectation over multiple periods in the future. 9 Our findings contribute most directly to the literature on the choice of earnings management tools. For example, recent literature focuses on the tradeoffs between earnings management tools (e.g. Cohen and Zarowin (2010) and Zang (2011)). As noted by Fields et al. (2001), it is important to examine the combined, net effect of all earnings management tools used together to meet EPS thresholds. Our results are important because they suggest that, prior to trading off these earnings management tools, managers decide the extent to which they will need to manage earnings in the first place. Our study highlights an important link between EPS reporting and capital market activities through the real effects of stock splits. Our evidence offers a new explanation for stocks splits based on the need for target size management. While previous explanations typically involve signaling motives or stock price levels, we show that stock splits could be a result of managerial concerns regarding EPS outcomes. Thus, we extend the prior literature that examines patterns in accounting metrics and their relationship to stock splits (e.g. Louis and Robinson (2005)). Furthermore, a TSM-based explanation of stock splits is consistent with prior literature that finds that splits follow earnings growth (Lakonishok and Lev (1987), Asquith et al. (1989)), as well as the literature that documents a “nominal price puzzle”(Weld et al. (2009)). We discuss this in more detail in Section 3.3. 9 Prior literature finds that firms use repurchases (which result in a change to the quantity of shares) to have an accretive effect on current period EPS (e.g. Hribar et al. (2006) and Bens et al. (2003)). Our results do not dispute these findings, but rather show that share changes can have long term effects on EPS outcomes. TSM is driven primarily through stock splits and not through repurchases. We find little evidence that stock splits have an accretive effect on EPS in the short run. 5
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Page 3: earnings will choose more shares ou
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 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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