A Penny for Your Thoughts: Sizing Up Manipulative EPS Rounding

For as long as public companies have been required to report earnings per share (EPS), there probably have been misguided managers who try to nudge it higher. We’ve written this article to unveil a method of manipulating EPS that, near as we can tell, hasn’t yet been described in print. Because any attempt to manipulate EPS creates uncertainty and uncomfortable risk for investors—which, in turn, could create capital market inefficiencies and produce discounted stock prices—we want to expose this inappropriate and unproductive gamesmanship and then help eliminate it. Our specific concern is that a troubling number of managers, and perhaps their auditors, have grown comfortable with manipulating EPS despite the questionable ethics of this practice. The most obvious method massages reported net income, the numerator of EPS. More subtle, but equally objectionable, is buying back stock to decrease the denominator. Our focus falls on the even more stealthy manipulation of the quotient through biased rounding of EPS to the higher penny. Even if it had been suspected, no one until now has assessed its prevalence and proposed policies to stop it. In the coming pages, we prove that abusive rounding is indeed going on and show when it’s most likely to happen. We then explain how anyone can determine whether a specific company’s management has decided to commit it over and over again. We also show that management’s choice of auditors makes these manipulations less (or more) likely. As a practical contribution, we recommend a very simple rule change that will totally eliminate the temptation to pick up a penny through rounding.We then tackle the much bigger issue of how to make income statements and EPS more useful