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

Finally, TSM has implications for a variety of per-share metrics such as analyst dispersion and forecast
error.
In this sense, our findings compliment Dechow and You (2012), in which the authors make the
observation that the precision of an EPS number is greater for higher levels of EPS. 10 We show in Section
3.3 that the scale invariance of analysts’ forecast errors (Degeorge et al. (1999), Cheong and Thomas (2011),
and Ball (2011)) is the expected endogenous outcome of target size management.
Our paper proceeds as follows: Section 2 motivates our hypothesis and describes the mechanism we test.
Section 3 describes the data and empirical results. Section 3.3 discusses the implications of our findings, and
Section 4 concludes.
2 Discussion and Hypothesis Development
The convention of rounding EPS to the nearest penny creates a range of net income that will generate a
given EPS number. The size of this range is determined by the number of shares outstanding. Specifically,
the range of net income that meets expectations is: (E[EP S] ∗ s −
s
s
200
, E[EP S] ∗ s +
200
), where E[EP S]
is the analysts’ EPS expectation and s is the number of shares outstanding. The expected Net Income,
E[EP S] ∗ s, is the total earnings implied by the per share forecast and is the midpoint of this range. The
highest and lowest earnings that will round to the forecast are determined by s. At a maximum, each share’s
1
worth of earnings will be rounded by half a penny (or in dollar terms,
200
). For example, Microsoft Corp.
has roughly 8 billion shares outstanding. So, in any given quarter the total size of their earnings target is 80
million dollars, ± 40 million centered around the amount of total earnings implied by the forecast. In dollar
terms this amount might seem large, but relative to the magnitude of the firm’s earnings, perhaps less so.
The size of the earnings target relative to the size of the firm’s total earnings is ± 0.5
E[|EP S|]
%. The average
firm in our sample has EPS of $0.20.
So, the typical firm will meet the earnings forecast by producing
earnings within ±2.50% of expected earnings. This amount of flexibility might be considered large by some
managers and small by others. For example, 2.50% may be relatively large for a firm with stable business
fundamentals and predictable net income. However, a manager whose compensation is highly concave in
earnings surprises may consider this range to be small.
Managers have flexibility over the size of this earnings target. In dollar terms, the size of the target is
fixed solely by the number of shares. If the manager prefers an earnings target twice as large, she can simply
double the number of shares outstanding. Because the size of the earnings target measured in dollars is fixed,
10 In the next section, we show that the target size as a percentage of the firm’s expected net income equals one-half of the
inverse of EPS.
6