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

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.
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