What are the Characteristics of Firms that Engage in Earnings Per Share Management Through Share Repurchases?

• Author: Kathleen A. Farrell,Jin Yu,Yi Zhang
• DOI: http://doi.org/10.1111/corg.12029
• Date: 01 July 2013
• Published date: 01 July 2013

What are the Characteristics of Firms that

Engage in Earnings Per Share Management

Through Share Repurchases?

Kathleen A. Farrell*, Jin Yu, and Yi Zhang

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines US f‌irms’ share repurchases during1997–2006 to determine what factors are

associated with f‌irms that use share repurchases to manage earnings per share (EPS). Specif‌ically, we analyze f‌irm and

governance characteristics associated with f‌irms that engage in share repurchases that increase annual EPS by at least one

cent in a given year and that had EPS less than or equal to annual EPS forecast prior to the share repurchase.

Research Findings/Insights: We f‌ind that growth f‌irms are less likely to use share repurchases to increase EPS for earnings

management purposes. We also provide evidence thatf‌irms with a more independent board, a separationof the roles of CEO

and chairman of the board,or a low entrenchment index (E-Index) are less likely to engage in earnings management through

share repurchases. Finally, we f‌ind evidence that high CEO share ownership restrains managers from using share repur-

chases as a mechanism to manage EPS.

Theoretical/Academic Implications: Our empirical results support some of the best practices advocated by various share-

holders groups regarding corporate governance. Also, strong shareholder rights can mitigateincentives to manage earnings,

highlighting the importance of corporate governance mechanisms/provisions in ensuring the integrity of the f‌inancial

reporting system.

Practitioner/Policy Implications: This research is important to investors in the face of the growing popularity of share

repurchases. In particular, our study suggests strong corporate governance, strong shareholder rights, and high percentage

CEO stock ownership discourages repurchase-based earnings management.

Keywords: Corporate Governance, Share Repurchase, Earnings Management, CEO Stock Ownership and Option

Holdings

INTRODUCTION

Share repurchases, as a method of payout, have gained

more and more popularity over the past 30 years (e.g.,

Grullon & Ikenberry, 2000; Skinner, 2008). Much of the

research examines why f‌irms repurchase shares. Dittmar

(2000) shows that f‌irms repurchase shares to take advantage

of undervaluation, distribute excess cash to shareholders,

prevent takeover, and undo the dilutive effects of employee

stock options. More recently, Hribar, Jenkins, and Johnson

(2006) show that share repurchases can also be used to

manage earnings per share (EPS). The authors argue that

share repurchases can reduce the number of outstanding

shares and thus increase EPS under some conditions. Myers,

Myers, and Skinner (2007) examine f‌irms that report a long

string of consecutive increases in EPS. They f‌ind that f‌irms

with at least 20 successive quarters of non-decreasing EPS

purposely time share repurchases to avoid EPS decreases.

Because the market reacts negatively to f‌irms’ news of failing

to meet or beat analysts’ EPS forecasts and positively to the

news of meeting or beating earnings expectations, managers

have strong incentives to manage EPS upwards (e.g., Bartov,

Givoly, & Hayn, 2002; Burgstahler & Eames, 2006). Anecdot-

ally, the Securities Exchange Commission (SEC) settled an

investigation of three former executives from Krispy Crème

(Shwiff, 2009) that were accused of managing earnings for

2003 and 2004 to make it appear that the f‌irm was beating

analyst expectations by one cent.

With the exception of the studies noted above,much of the

attention in the earnings management literature has been on

*Address for correspondence: Kathleen A. Farrell, University of Nebraska-Lincoln,

Lincoln, NE 68588, USA. Tel: +1402 472 3005; Fax: +1 402 472 5140; E-mail: kfarrell2@

unl.edu

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Corporate Governance: An International Review, 2013, 21(4): 334–350

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12029

accruals management and real earnings management.

Dechow, Richardson, and Tuna (2000), Matsumoto (2002),

and Burgstahler and Eames (2006) provide evidence that

managers manage earnings upward through discretionary

(abnormal) accruals to meet or beat analysts’ forecasts. For

example, Matsumoto (2002) shows that there is a greater

frequency of positive discretionary accruals for f‌irms

meeting or beating analysts’ forecasts than for f‌irms falling

short of consensus forecasts. Real earnings management is

achieved by making sub-optimal business decisions such as

cutting R&D expenses to manage earnings upwards. In a

survey of more than 400 executives, Graham, Harvey, and

Rajgopal (2005) document that 78 percent of managers are

willing to give up economic value to meet earnings forecasts

of analysts to avoid the severe negative market reaction to

missing benchmarks.

Research has also shown that management ownership

and governance characteristics inf‌luence earnings manage-

ment. For example, García-Meca and Sánchez-Ballesta (2009)

meta-analyze the results of 35 studies that examine the

impact of f‌irms’ board characteristics and f‌irm ownership

structure on accruals management. Theyf‌ind that board size

and board independence are negatively related to total

accruals but no relation is found for discretionary accruals

models. Xie, Davidson, and DaDalt (2003) and Klein (2002)

f‌ind that outside director independence is negatively related

to discretionary current accruals and abnormal accruals,

respectively. Analyzing shareholder rights, Huang, Wang,

and Zhou (2013) f‌ind a negative relation between share-

holder rights and income-increasing discretionary accruals,

although the relation becomes insignif‌icant as insider

ownership becomes high. Warf‌ield, Wild, and Wild (1995)

f‌ind an inverse relation between managerial ownership

and the magnitude of accounting accrual adjustments.

Sánchez-Ballesta and García-Meca (2007) investigate the

relation between insider ownership and discretionary accru-

als and f‌ind a negative association when insider ownership

is below 40 percent. Alternatively, Klein (2002) f‌inds a posi-

tive relation between CEO shareholdings and accruals

management.

To contribute to the earnings management and gover-

nance literature, we examine US f‌irms’ share repurchases1to

explore f‌irm and governance characteristics that likely inf‌lu-

ence the use of share repurchases to manage earnings per

share. First, we argue that, since growth f‌irms have more

investment opportunities than value f‌irms, growth f‌irms

have less excess cash than value f‌irms to use for earnings

management purposes through repurchases. We hypoth-

esize that value f‌irms are more likely to engage in

repurchase-based earnings management. Next, we investi-

gate whether corporate governance plays a role in discour-

aging f‌irms’ repurchase activities that are intended for

manipulating EPS. Since share repurchase programs must

be approved by the f‌irm’s board and a formal announce-

ment must be made to the public once the program is

approved, the connection to the f‌irm’s board naturally links

corporate governance mechanisms with a f‌irm’s EPS man-

agement activities. Furthermore, we utilize a more compre-

hensive measure of corporate governance that considers

shareholder rights to explore whether strong shareholder

rights can help constrain f‌irms’ earnings management

activities through repurchases.2Finally,we examine whether

managerial stock ownership or option holdings can affect

f‌irms’ choice to engage in earnings management through

share repurchases. Theoretically, equity ownership should

more closely align the interest of managersand shareholders

(e.g., Warf‌ield et al., 1995), yet some evidence suggests that

higher stock ownership or exercisable options increases the

use of accruals-based earnings management (e.g., Cohen,

Dey, & Lys, 2008; Klein, 2002). Thus, the role of share own-

ership or option ownership in the use of share repurchases

as an earnings management mechanism is an empirical

question.

To explore the use of share repurchases to manage earn-

ings, we begin by identifying a sample of US f‌irms with

share repurchases from 1997 to 2006. Following Hribar et al.

(2006), we def‌ine share repurchases that increase EPS by at

least one cent as accretive share repurchases. From the set of

f‌irms engaging in accretive share repurchases, we def‌ine

f‌irms suspected of earnings management as those that also

have EPS assuming no buybacks less than or equal to the

mean annual consensus analyst forecast. These f‌irms have

greater incentive to manage earnings per share to meet or

beat analyst earnings expectations. To better control for other

factors that likely inf‌luence share repurchase activity, we

utilize a match sample approach that drawsfrom a sample of

non-accretive share repurchase f‌irms and matches on size

and industry. Bhushan (1989) shows that large f‌irms are

tracked by more analysts than small f‌irms, which suggests

that large f‌irms face more pressure to meet earnings bench-

marks. To the extent that our match sample construction

does not adequately control for size differences, we further

control for f‌irm size in all of our regressions. Our total

sample identif‌ies 2,225 unique f‌irms suspected of earnings

management and includes 5,742 US f‌irm-year observations

over a ten-year period from 1997 to 2006.

Consistent with the notion that growth f‌irms have more

investment opportunities and less free cash f‌lows, we f‌ind

that growth f‌irms are less likely to engage in share repur-

chases for earnings management motives. Examining the

corporate governance of the repurchase f‌irms, we f‌ind that

f‌irms with a more independent board and that separate the

roles of CEO and Chairman of the board are less likely to

engage in earnings management through repurchases. Simi-

larly, f‌irms with strong shareholder rights, measured by an

entrenchment index (E-index), engage in less earnings man-

agement through repurchases. This evidence supports our

argument that f‌irms with stronger corporategovernance and

stronger shareholder rights are less likely to manage EPS

through repurchases. We also f‌ind evidence that f‌irms with

high percentage CEO stock ownership are less likely to

engage in earnings manipulation through repurchases, sug-

gesting that percentage share ownership helps mitigate the

agency problem. We do not f‌ind any evidence that options

play a role in the use of share repurchases for earnings

management purposes.

Our study extends the current empirical literature on

earnings managements and, more specif‌ically, the use of

share repurchases to manage earnings, by identifying f‌irm

and governance characteristics that may impact the f‌irm’s

likelihood of engaging in earnings manipulation through

share repurchases. For example, Cornett, McNutt, and

EPS MANAGEMENT THROUGH SHARE REPURCHASES 335

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