Stock Repurchases Effects on Earnings Per Share [The National Accounting Journal, Vol. 8, No. 2, Fall/Winter 2006, pp ]

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1 Stock Repurchases Effects on Earnings Per Share [The National Accounting Journal, Vol. 8, No. 2, Fall/Winter 2006, pp ] By C. P. Carter Kathryn M. Carter Sherre G. Strickland* * Dr. C. P. Carter and Dr. Sherre G. Strickland are faculty members in the University of Massachusetts Lowell s Accounting Department. Dr. Kathryn M. Carter is Dean of the University of Massachusetts Lowell s College of Management Abstract: This paper examines the possible use of stock repurchase programs as a means of managing earnings per share (EPS). Stock purchases and issuances over a five-year period of a sample of 25 large U.S. corporations are analyzed to answer the following specific questions. To what extent have large U.S. corporations been acquiring their own shares? How have stock purchases affected the corporations basic EPS? Why were shares repurchased? Has EPS been affected by stock repurchases that exceeded specific uses made of such shares? During the five years , companies' purchases of their own stock affected their EPS by significantly reducing the number of shares in the denominator of the EPS formula. The resulting EPS were higher they would have been if shares had not been purchased. The most common reason cited for stock purchases was for employee benefit plans. Upon further examination, however, even after adjusting for shares used in benefit plans, companies' purchases of their own stock affected their EPS. The resulting EPS were higher they would have been if excess shares had not been purchased. Specific recommendations for improving financial reporting are presented. I. Introduction Earnings manipulations have received a great deal of attention recently as companies like Enron, Tyco, and WorldCom have undergone repeated public scrutiny. Several top executives have been sentenced to significant terms of imprisonment, such as Enron's Andrew S. Fastow (10 years), Tyco's L. Dennis Kozlowski ( years), and WorldCom's Bernard J. Ebbers (25 years) as a result of their involvement in the earnings management process. Most recently, Jeffrey K. Skilling and the late Kenneth L. Lay of Enron Corp. were also found guilty. Mr. Skilling is awaiting sentencing. However, many avenues of potential earnings management still exist and continue to be of concern to regulators and investors. Typical avenues of earnings management have historically included discretionary accruals, revenue recognition options, reserve accounting, structuring of convertible bond transactions, and stock repurchase programs (Xiong 2006). Executives cite various reasons for managing earnings; principal among these is the desire to minimize investors' perceived increased risk associated with variability of earnings. Management therefore has an incentive to report a steady growth trend in earnings. One of the most often cited measure of earnings is earnings per share (EPS), which is a statistic designed to relate a company's net income to its investors by stating net income on a common stock per share basis. In simplest terms, EPS is calculated by dividing net income by the number of common shares owned by investors. Unlike studies of earnings management that analyzed effects caused by policies that influenced the EPS numerator, net income (McVay 2006), this study focuses on the effects on EPS due to influences on the EPS denominator, the number of common shares. This study examines the possible use of stock repurchase programs as a means of managing EPS. Stock purchases and issuances over a five-year period of a sample of large U.S. corporations are analyzed to answer the following specific questions. To what extent have large U.S. corporations been acquiring their own shares? How have stock purchases affected the corporations basic EPS? Why were shares repurchased? Has EPS been affected by stock repurchases that exceeded specific uses made of such shares? 1

2 Evolution of Earnings per share EPS data were first required to be prominently reported on the face of the income statement for fiscal periods beginning after December 31, 1968 (AICPA APBO , 15). Prior to 1968, it was "strongly recommended" that EPS be disclosed on the income statement (AICPA APBO , 31). Earlier still, prominent disclosure of EPS was discouraged as positioning any single measure of performance above others was considered inappropriate (AICPA ARB , 2). As EPS reporting became more common, the format of the reported data evolved to more informative and conservative calculations. While EPS reporting was discouraged prior to 1966, if EPS data were reported, companies were "strongly urged" to report EPS separately for extraordinary items and net income (AICPA ARB , 2). When EPS reporting became "strongly recommended", companies were to disclose EPS data for (a) income before extraordinary items, (b) extraordinary items (less income taxes), and (c) net income (AICPA APBO , 32). As part of the EPS calculation, the average common shares outstanding were to include "other residual securities" (AICPA APBO , 33). When Accounting Principles Board Opinion 15 was issued in May 1969, the term "other residual securities" was replaced with the term "common stock equivalents" (AICPA APBO , 10) and primary and fully diluted EPS data were required to be reported. The 3% dilution rule was also introduced in Any EPS reduction of less 3% did not need to be considered as dilution in the calculation and reporting of fully diluted EPS" (AICPA APBO , 10). The EPS calculations at that point were complex and the average investor would have had difficulty interpreting the results. Consequently, effective for periods ending after December 15, 1997, the reporting of EPS was simplified (FASB SFAS , summary). Primary EPS was replaced by basic EPS and fully diluted EPS was replaced by diluted EPS. The 3% dilution test was eliminated (FASB SFAS , 75). Common stock equivalents were not to be included in the calculation of basic EPS. Only income from continuing operations and net income EPS amounts were required to be reported on the face of the income statement (FASB SFAS , 36). Other amounts, such as extraordinary items EPS, could be presented on the income statement or in the notes to financial statements (FASB SFAS , 37). Potential EPS Effects of Stock Purchases As a result of the changes briefly described above, companies are currently required to report basic and diluted EPS amounts for income from continuing operations and net income on the face of the income statement. Basic EPS is calculated by dividing net income available to common stockholders by the weighted-average number of common shares outstanding for the period. One item under management s control that can significantly affect the number of weighted-average shares outstanding is a company's purchase of its own common stock. The effect of such a purchase would be a reduction of outstanding shares and a resulting increase in EPS. Formal stock repurchase plans are common today in publicly held firms. For example, in 2004, General Electric's board of directors authorized a new three-year, $15 billion share repurchase program and Bank of America's board authorized a stock repurchase program of up to 180 million shares at a total cost of up to $9 billion. II. Study To determine if stock repurchases could significantly affect EPS, this study examined stock, income, and basic EPS data for 25 of the top 27 U.S. revenue-generating companies. Two of the largest revenue-generating companies, Ford Motor and General Motors, were excluded due to the quality of their reported stock transactions data in the Securities and Exchange Commission s (SEC) EDGAR database. Data were analyzed for the final 25 companies for the five years 2000 to Data Summary As shown in Table 1, the 25 companies examined reported net income of almost $700 billion during Net income ranged from Exxon Mobil's high of $91.3 billion to McKesson's $1.4 billion. Average annual basic EPS for the five years ranged from Berkshire Hathaway's $3, to Hewlett-Packard's $.74. Average annual basic EPS growth ranged from Berkshire Hathaway's $ to Verizon Communications' low of -$.38. 2

3 Table 1 Net Income, Basic EPS, Basic EPS Growth, and Common Shares Purchased Net Income (billions) Average Annual Basic EPS Average Annual EPS $ Growth Shares Purchased (millions) Company Altria Group $46.8 $4.42 $ American International $33.9 $2.60 $ AmerisourceBergen $1.5 $3.12 $.57 3 Bank of America $48.5 $2.97 $ Berkshire Hathaway $23.9 $3, $ Boeing $8.0 $1.96 -$ Cardinal Health $5.5 $2.47 $ ChevronTexaco $32.9 $3.10 $ Citigroup $77.4 $3.06 $ ConocoPhillips $16.1 $6.22 $ Dell $11.2 $.88 $ Exxon Mobil $91.3 $2.72 $ General Electric $72.7 $1.45 $ Hewlett-Packard $10.0 $.74 -$ Home Depot $18.6 $1.63 $ IBM $35.4 $4.11 $ JP Morgan Chase $20.0 $1.91 -$ Kroger $3.3 $.83 $ McKesson $1.4 $.98 -$.09 9 Pfizer $35.9 $1.08 $ Procter & Gamble $21.9 $1.68 $ Target $9.2 $1.92 $ Valero Energy $3.4 $3.54 $ Verizon Communications $27.2 $1.98 -$ Wal-Mart $40.1 $1.83 $ Totals $ ,026 Table 1 illustrates that, except for Berkshire Hathaway and ConocoPhillips, 23 of the 25 companies examined purchased shares of their own stock during the time period. One might argue that Berkshire Hathaway operated under a unique high-end investor model, making stock repurchases uncommon. For example, Berkshire Hathaway s class A common stock ranged from a quarterly low of approximately $81,000 per share to a high of approximately $96,000 per share during ConocoPhillips, on the other hand, resulted from a merger on August 30, During 2005, the year after the last year in this study, ConocoPhillips paid over $1.9 billion to acquire 32 million shares of its common stock. Approximately 6 billion shares were purchased by the other 23 companies during the five-year period. Share purchases ranged from Bank of America's high of 923 million shares to AmerisourceBergen's low of 3 million shares. While stock purchases affect EPS simply by decreasing the number of shares outstanding, their effects will be offset if comparable numbers of additional common shares are issued in the same period. A review of the stock transactions of the 23 companies that purchased their own shares revealed that the vast majority of companies purchased more shares they issued in at least one of the years examined. The data in Table 2, column 2, show that 11 of the 23 companies actually repurchased more stock they issued for the entire five-year period. Sixteen companies repurchased more stock they issued in the most recent year under review, Column 8 illustrates that the companies repurchased more shares they issued in a total of 62 years of the possible 115 years (23 companies x 5 years). Additionally, column 9 indicates that 20 of the 23 companies purchased more shares they issued in at least one of the five years. 3

4 (1) Table 2 Purchased Shares (P) Versus Issued Shares (I) (2) (3) (4) (5) (6) (7) (8) Years Total P>I (9) P>I at least one year 5 years Company P>I P>I P>I P>I P>I P>I Altria Group Y N Y Y Y Y 4 Y American International N Y Y Y Y N 4 Y AmerisourceBergen N Y N N N N 1 Y Bank of America N Y Y Y Y Y 5 Y Boeing Y Y N N Y Y 3 Y Cardinal Health N Y Y N N N 2 Y ChevronTexaco Y Y N N N Y 2 Y Citigroup N N N Y N Y 2 Y Dell Y Y Y Y N N 3 Y Exxon Mobil Y Y Y Y Y Y 5 Y General Electric N N N N Y N 1 Y Hewlett-Packard N Y Y N Y Y 4 Y Home Depot Y Y Y Y N N 3 Y IBM Y Y Y N Y Y 4 Y JP Morgan Chase N N N N N N 0 N Kroger Y Y Y Y Y Y 5 Y McKesson N N N N N N 0 N Pfizer N Y N Y Y N 3 Y Procter & Gamble Y Y Y N Y Y 4 Y Target Y Y N N N Y 2 Y Valero Energy N N N N N N 0 N Verizon Communications N N N N N Y 1 Y Wal-Mart Y Y Y Y Y N 4 Y P>I total shares Y indicates shares purchased exceeded shares issued. N indicates shares purchased did not exceed shares issued. Research Methodology To determine the EPS effects of common stock purchases, it was necessary to adjust basic EPS for such purchases and recalculate EPS as if the repurchased shares were still outstanding. To adjust basic EPS amounts for common stock purchases, each company's weighted-average common shares outstanding were increased by the number of common shares repurchased. Assuming shares were repurchased evenly throughout the year, the increase in weighted-average shares outstanding was estimated to be one-half of the total shares purchased. As an illustration of this adjustment process, consider Cardinal Health, which is a company whose statistics closely approximate those of the average company examined. For the year ended 12/31/2000, Cardinal Health reported basic EPS of $1.61, calculated as follows. $708 million net income / million weighted average common shares outstanding = $1.61 basic EPS. During 2000, Cardinal Health purchased 7 million shares of its common stock. Cardinal Health's adjusted basic EPS for 2000 would be $1.60, calculated as follows. 4

5 $708 / [438.8 (weighted average shares outstanding during 2000) (7 million shares acquired during 2000 / 2)] = $708 / = $1.60. Continuing the Cardinal Health example, for 2001 Cardinal Health reported basic EPS of $1.90, calculated as follows. $841 million net income / million weighted average common shares outstanding = $1.90 basic EPS. During 2001, Cardinal Health did not purchase any additional shares of its common stock. Using 2000 as the base year for the calculations, Cardinal Health's adjusted basic EPS for 2001 would be $1.87, calculated as follows. $841 / [443.2 (weighted average shares outstanding during 2001) + 7 (shares acquired in 2000) + 0 (shares acquired in 2001/ 2)] = $841 / = $1.87. As the Cardinal Health example illustrates, the fact that the effects of stock purchases are cumulative makes the choice of a base year very important for the resulting statistics was used as the base year in this study because companies report five years of EPS statistics in their 10K s. Using 2000 as the base year allows the calculation of statistics for the five-year period It is important to note at this point that managing EPS through the buyback of stock has this distinctive cumulative advantage over other earnings management techniques. The repurchase of stock not only results in fewer outstanding shares in the year of purchase, but also results in fewer outstanding shares in every future period during which the shares are held. Fewer outstanding shares results in higher EPS. On the other hand, early recognition of revenues or deferred accruals of expenses has a one-year time advantage only. The next year's financial statements are immediately negatively impacted by that revenue previously recognized or the deferred expense immediately included. All Common Stock Purchases Effects on EPS Dollar Amounts Of the 25 companies examined, two, Berkshire Hathaway and ConocoPhillips, did not purchase any of their own common stock during As a result, there were no differences between their annual adjusted EPS and reported EPS. When EPS statistics for the 23 other companies were adjusted for all stock purchases, their average annual adjusted EPS dollar amounts were lower their reported EPS dollar amounts by an average of $.11 per year. The median difference between the average adjusted EPS and the average reported EPS was $.06. The data in Table 3 show that in only 14 of the 115 observations (12%) were the reductions in EPS less $.01. Three of these 14 observations were due to companies reporting losses. The effect of increasing the number of shares in a negative EPS is an increase in EPS. Table 3 Basic EPS Dollar Decreases When Adjusted for All Share Purchases Less $.01 Greater $.15 Totals* $.01 $.05 $.05 $.10 $.10 $.15 Number of EPS changes 14** Percent of EPS changes 12.2% 41.7% 16.5% 8.7% 20.9% 100% * Totals: 23 companies x 5 years of EPS data for each company = 115 observations. ** Includes instances of no stock purchases and periods of negative earnings. Altria Group's $.49 average annual difference between adjusted EPS and reported EPS was the largest difference found in the sample. AmerisourceBergen's $.01 average annual difference was the smallest difference found in the sample. In percentage terms, when EPS statistics were adjusted for all stock purchases, the average annual adjusted EPS dollar amounts were lower the reported EPS dollar amounts by an average of 4.2% per year. The median 5

6 difference between the average adjusted EPS and average reported EPS was 3.5%. The data in Table 4 show that in only 11 of the 112 observations (9.8%) were the changes in EPS less.01%. Three observations were eliminated because the companies recorded losses during these years. Table 4 Basic EPS Percent Decreases When Adjusted for All Share Purchases For the Five-year Period Less.01% Greater 15% Totals*.01%- 5.0% 5.01%- 10.0% 10.01%- 15.0% Number of EPS changes Percent of EPS changes 9.8% 59.8% 22.3% 4.5% 3.6% 100% * Totals: 23 companies x 5 years of EPS data for each company = 115 observations, less three observations for which net losses were reported = 112 observations. Bank of America's 11.2% difference between adjusted EPS and reported EPS was the largest annual average difference. AmerisourceBergen's.2% average annual difference was the smallest difference found in the sample. All Common Stock Purchases Effects on EPS Growth In addition to discussing EPS dollar amounts in their annual reports and 10K s, it is common for companies to discuss growth in EPS. When EPS statistics were adjusted for all stock purchases, the growth in average annual adjusted EPS dollar amounts was lower the growth in reported EPS dollar amounts by an average of $.05 per year. The median difference between the growth in average adjusted EPS and growth in average reported EPS was $.04. The data in Table 5 show that in 70 of the 92 observations (76%) EPS growth decreased when adjusted for all stock purchases. Also of interest is the fact that the data show there were 14 observations in which EPS growth increased. This is possible because of the cumulative effect stock purchases can have on several years' EPS. Table 5 EPS Growth Changes When Adjusted for All Share Purchases For the 5-year Period EPS Decreased Less EPS More $.15 Totals* Increased $.01 $.01- $.05 $.05 - $.10 $.10 - $.15 Number of EPS changes Percent of EPS changes 15.2% 8.7% 44.6% 12.0% 6.5% 13.0% 100% * Totals: 23 companies x 4 years EPS growth data for each company = 92 observations. Bank of America's $.16 average annual difference between adjusted EPS growth and reported EPS growth was the largest decrease identified. Two companies, JP Morgan Chase and McKesson, showed no average annual differences between adjusted EPS growth and reported EPS growth. Reasons for Purchasing Common Shares The statistics reported in Table 1 show that 23 of the 25 companies examined purchased shares of their own stock during the five-year period , totaling over 6 billion shares repurchased. Table 2 shows that 11 of the 23 companies that purchased shares of their own stock purchased more shares they issued during the full fiveyear period. Twenty of the 23 companies purchased more shares they issued in at least one of the five years. A logical question is: Why did the companies purchase their own shares? Using stock shares distributed, as well as management s comments in 10K s, as evidence of motivation for stock repurchases, Table 6 shows that the two major reasons companies purchased their own shares were for use in employee benefit plans and business combinations. The most common reason companies issued their own shares was for use in employee benefit plans. One hundred percent of the companies actually issued shares for employee benefit plans during the five years 6

7 examined. Approximately 30% of the shares issued by the companies were for use in their employee benefit plans. General Electric issued the largest number of shares, approximately 700 million. Table 6 Uses of Repurchased Shares Employee Benefit Plans Business Combinations Stock Dividends Other Totals Percent of total shares distributed 30.5% 59.7% 8.8% 1.0% 100.0% Number of shares distributed (millions) 3,346 6, ,972 Number of companies Percent of companies 100.0% 52.2% 8.7% 39.1% The data in Table 6 show that twelve companies (52%) used their own shares to acquire other companies during the period examined. The largest use of shares in an acquisition was Pfizer's 1.8 billion shares used to acquire Pharmacia in JP Morgan Chase issued 1.5 billion shares to acquire BankOne in 2004, Bank of America issued 1.1 billion shares to acquire FleetBoston in 2004, and Hewlett-Packard issued 1.1 billion shares to acquire Compaq Computer in The Effects on EPS of Shares Repurchased in Excess of Shares Issued for Employee Benefit Plans Employee benefit plans were cited in the 10K s of our sample companies as the primary reason they repurchased stock. The logic behind purchasing shares during the same periods shares are issued for employee benefit plans is that the EPS-decreasing effects of issuing shares will be completely offset by the EPS-increasing effects of purchasing shares. While this in itself is a form of EPS management, an important question is: Are companies influencing EPS further by purchasing more shares they currently use in employee benefit programs? A review of the stock transactions of the 23 companies that purchased their own shares revealed that the vast majority of companies purchased more shares they issued for employee benefit plans in at least one of the five years examined. The data in Table 7, column 2, show that 17 of the 23 companies purchased more shares they issued for employee benefit plans over the five-year period. 7

8 (1) Table 7 Purchased Shares (P) Versus Issued Shares (I) (2) (3) (4) (5) (6) (7) (8) Ben. Plan. P>I for at least one year (9) Ben. Plan. No. of Years P>I Five years Company P>I P>I P>I P>I P>I P>I Altria Group YY NN YY YY YY YY Y 4 American Int'l NY YY YY YY YY NN Y 4 AmerisourceBergen NN YY NN NN NN NN Y 1 Bank of America NY YY YY YY YY YY Y 5 Boeing YY YY NN NN YY YY Y 3 Cardinal Health NY YY YY NN NN NN Y 2 ChevronTexaco YY YY NN NN NN YY Y 2 Citigroup NY NN NN YY NY YY Y 3 Dell YY YY YY YY NN NN Y 3 Exxon Mobil YY YY YY YY YY YY Y 5 General Electric NN NN NN NN YY NN Y 1 Hewlett-Packard NY YY YY NY YY YY Y 5 Home Depot YY YY YY YY NY NY Y 5 IBM YY YY YY NY YY YY Y 5 JP Morgan Chase NN NN NN NN NN NN N 0 Kroger YY YY YY YY YY YY Y 5 McKesson NN NN NN NN NN NN N 0 Pfizer NY YY NY YY YY NN Y 4 Procter & Gamble YY YY YY NN YY YY Y 4 Target YY YY NN NN NN YY Y 2 Valero Energy NN NY NN NN NN NN Y 1 Verizon Comm. NN NN NN NN NN YY Y 1 Wal-Mart YY YY YY YY YY NN Y 4 P>I total shares P>I benefits only Y indicates shares purchased exceeded shares issued. First letter indicates shares purchased exceeded shares issued for any reason. Second letter indicates shares purchased exceeded shares issued for benefit plans only. As shown in Table 7, column 8, 21 of the 23 companies (91%) purchased more shares they issued for employee benefit plans in at least one of the five years examined. Column 9 shows that on average, companies purchased more shares they issued in three of the five years examined (69 / 23 = 3). These data suggest that while the effects of stock purchases were modified when additional common shares were issued in the same period, the effects were not completely eliminated through stock issuances for employee benefit plans for most companies for most years examined. To determine the possible EPS effects of purchasing more shares needed to offset shares issued for current employee benefit plans, adjusted EPS statistics were calculated by eliminating from the adjusted EPS calculations the shares issued for employee benefit plans and an equal number of shares purchased. Any excess shares purchased were included in the adjusted EPS calculations. When EPS statistics were modified for stock purchases in excess of shares issued in employee benefit plans, the average annual adjusted EPS dollar amounts were lower the reported EPS dollar amounts by an average of $.06 per year. The median difference between the average EPS adjusted for excess stock purchases and the average reported EPS was $.03. The data in Table 8 show that in 69 of the 115 observations (60%) the reductions in EPS were $.01 or more. 8

9 Table 8 EPS Dollar Decreases When Adjusted for Share Purchases In Excess of Shares Issued for Employee Benefit Plans Less $.01 $.05 $.10 Greater $.15 Totals* $.01 $.05 $.10 $.15 Number of EPS changes Percent of EPS changes 40.0% 34.8% 7.0% 7.8% 10.4% 100% * Totals: 23 companies x 5 years of EPS data for each company = 115 observations. Altria Group's $.41 average annual difference between EPS adjusted for excess stock purchases and reported EPS was the largest difference. For six companies, there were no differences between their average annual EPS adjusted for excess stock purchases and reported EPS. In percentage terms, when EPS statistics were adjusted for stock purchases in excess of shares issued for benefit plans, the average annual adjusted EPS dollar amounts were lower the reported EPS dollar amounts by an average of 2.3% per year. The median difference between the average EPS adjusted for excess purchases and the average reported EPS was 1.0%. The data in Table 9 show that in 69 of the 113 observations (61%) the changes in EPS were.01% or greater. Table 9 EPS Percent Changes for Share Purchases in Excess of Shares Issued for Employee Benefit Plans Less.01%- 5.01% %- Greater 15% Totals*.01% 5.0% 10.0% 15.0% Number of EPS changes Percent of EPS changes 38.9% 45.2% 10.6% 5.3% 0% 100% * Totals: 23 companies x 5 years of EPS data for each company = 115 observations, less two observations for which net losses were reported = 113 observations. Three companies reported losses, but one of the three did not have a change in EPS, so it is included in the above table. Altria Group's 9.0% difference between average EPS adjusted for share purchases in excess of shares issued for employee benefit plans and reported EPS was the largest annual average difference. For four companies, there were no differences between their annual average EPS adjusted for excess stock purchases and reported EPS. The Effects on EPS Growth of Share Purchases in Excess of Shares Issued in Employee Benefit Plans When EPS statistics were adjusted for stock purchases in excess of shares issued in employee benefit plans, the growth in average annual adjusted EPS dollar amounts was lower the growth in reported EPS dollar amounts by an average of $.03 per year. The median difference between the growth in average EPS adjusted for excess share purchases and growth in average reported EPS was $.02. The data in Table 10 show that in 45 of the 92 observations (49%) EPS growth decreased by $.01 or more. Also of interest is the fact that the data show that there were 14 observations in which EPS growth increased. 9

10 Table 10 EPS Growth Changes for Share Purchases in Excess of Shares Issued for Employee Benefit Plans EPS Decreased EPS Increased Less $.01 $.01- $.05 $.05 - $.10 $.10 - $.15 More $.15 Totals* Number of EPS changes Percent of EPS changes 15.2% 35.9% 29.3% 6.5% 9.8% 3.3% 100% * Totals: 23 companies x 4 years of EPS data for each company = 92 observations. Altria Group's $.12 average annual difference between EPS growth when adjusted for employee benefit plans and reported EPS growth was the largest difference. Six companies showed no average annual differences between average adjusted EPS growth and reported EPS growth. Summary of Stock Purchases Effects on EPS Twenty-three of the 25 companies examined in this study purchased shares of their own stock during the time period. A total of approximately 6 billion shares were purchased by the 23 companies. Every one of the 25 companies had an adequate number of authorized and as yet unissued stock to meet its stock issuance needs during this time period. When adjusted for all stock purchases, the average annual adjusted EPS dollar amounts and growth in adjusted EPS were lower the reported EPS dollar amounts and growth. When EPS statistics were adjusted for stock purchases in excess of shares issued in employee benefit plans, the average annual adjusted EPS dollar amounts and growth in adjusted EPS were lower the reported EPS dollar amounts and growth. The results are summarized in Table 11. Table 11 Summary of EPS Changes for Share Purchases EPS Adjusted For All Stock Purchases EPS Adjusted for Purchases in Excess of Shares Issued for Benefit Plans Average $ Decrease in EPS $.11 $.06 Range of Average $ Decrease in EPS $.01-$.49 $.00-$.41 Average % Decrease in EPS 4.2% 2.3% Median $ Decrease in EPS $.06 $.03 Median % Decrease in EPS 3.5% 1.0% Average $ Decrease in EPS Growth $.05 $.03 Range of Average $ Decrease in EPS Growth $.00-$.16 -$.01-$.12 Median $ Decrease in EPS Growth $.04 $.02 The data in Table 11 clearly show that companies did affect their EPS by purchasing their own shares during the time period. Without such stock purchases, most companies would have reported lower EPS. The data also show that while companies may have purchased stock to offset the effects of employee benefit plans, stock purchases in excess of shares issued for employee benefit plans did affect their EPS. Without such excess stock purchases, most companies would have reported lower EPS. As a result, the data suggest that by buying shares of their own stock, companies did affect their EPS during the time period examined. Materiality is defined in FASB Statement of Financial Accounting Concepts No. 2 as "the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement" (1980, 10). Currently, there is no quantitative standard dictating whether an amount is material. As stated previously, even the 3% materiality rule used in EPS calculations was 10

11 eliminated in 1997 (FASB SFAS , 127). Quantitative guidance for determining materiality is also not provided by the SEC, even though it issued Staff Accounting Bulletin (SAB) 99 to clarify principles of materiality (1999). In fact, in SAB 99, the SEC states that registrants and auditors may not rely solely on quantitative criteria to evaluate an item's materiality. As a result of the lack of an existing quantitative measure of materiality, the significance of the differences in reported EPS and EPS adjusted for all stock purchases and adjusted for stock purchases in excess of stock issued for benefit plans, is not clear-cut. Using "greater 10%" as a measure of materiality, 8% of the differences between EPS adjusted for all stock purchases and reported EPS would be judged material. Using "greater 5%" as a measure of materiality, 30% of the differences between EPS adjusted for all stock purchases and reported EPS would be judged material (Table 4). Similarly, using "greater 10%" as a measure of materiality, 5% of the differences between EPS adjusted for stock purchases in excess of shares issued for employee benefit programs and reported EPS would be judged material. Using "greater 5%" as a measure of materiality, 16% of the differences between EPS adjusted for excess stock purchases and reported EPS would be judged material (Table 9). III. Summary and Recommendations During the five years , companies' purchases of their own stock affected their EPS by significantly reducing the number of shares in the denominator of the EPS formula. The resulting EPS were higher they would have been if shares had not been purchased. The most common reason cited for stock purchases was for employee benefit plans. Upon further examination, however, even after adjusting for shares used in benefit plans, companies' purchases of their own stock affected their EPS. The resulting EPS were higher they would have been if excess shares had not been purchased. If the differences in reported EPS and EPS adjusted for stock purchases are judged to be material by traditional definitions of materiality, there appear to be at least three possible actions for the Accounting profession to consider as alternatives to the current EPS reporting requirements. First, continue the current method of calculating EPS and recommend footnote disclosure of the impact of purchased shares. Second, recommend the addition of an EPS calculation that adjusts the EPS denominator by excluding any stock purchases. Third, consider the addition of an alternative EPS calculation that adjusts the EPS denominator by excluding stock purchases in excess of shares issued for employee benefit plans. Each of these alternatives is discussed in turn. Alternative 1: Continue the current method of calculating EPS and recommend footnote disclosure of the impact of purchased shares. The major advantage of continuing the current method of calculating EPS is that the financial public is familiar with it and it is consistent with past practice. The major disadvantages are that it allows EPS to be affected by stock purchases that are at the discretion of the companies and the footnote disclosure may not be adequately prominent. Alternative 2: Add an EPS calculation that adjusts the EPS denominator by excluding all stock purchases. The major advantages of this additional EPS calculation are that it exposes companies' ability to influence EPS by scheduling stock purchases and it emphasizes the importance of net income to EPS by reducing changes in the EPS denominator. The major disadvantages of this additional EPS measure are that it further complicates the calculation of EPS and it is unfamiliar to the financial public. Alternative 3: Add an additional EPS calculation that adjusts the EPS denominator by excluding stock purchases in excess of shares used for employee benefit programs. The major advantages of this additional EPS measure are that it exposes companies' ability to influence EPS by scheduling stock purchases, it allows the effects of issuing shares to employee benefit programs on the EPS denominator to be offset by shares purchased for such use in the current period, and it emphasizes the importance of net income to EPS by reducing changes in the EPS denominator. The major disadvantages of this additional EPS calculation are that it further complicates the calculation of EPS and is unfamiliar to the financial public. In summary, based on the data resulting from this study analyzing 25 companies for the time period, companies exercise earnings management through EPS by discretionary purchases of their own stock. If the effects are judged material, strategies to reduce, eliminate, or more clearly disclose the EPS effects should be explored. At a minimum, the Accounting profession should recommend EPS effects of stock purchases be reported in the financial statements through footnote disclosures. 11

12 References American Institute of Certified Public Accountants Earnings per Share, Accounting Research Bulletin No. 49. New York, NY: AICPA. American Institute of Certified Public Accountants Reporting the Results of Operations, APB Opinion 9. New York, NY: AICPA. American Institute of Certified Public Accountants Earnings Per Share, Accounting Principles Board Opinion 15. New York, NY: AICPA. Financial Accounting Standards Board Qualitative Characteristics of Accounting Information, Concepts Statement No. 2. Norwalk, CT: FASB. Financial Accounting Standards Board Earnings per Share, Statement of Financial Accounting Standards No Norwalk, CT: FASB. McVay, S. E Earnings Management Using Classification Shifting: An Examination of Core Earnings and Special Items. Accounting Review 81 (July): Securities and Exchange Commission Materiality, Staff Accounting Bulletin No. 99. Washington, D.C.: SEC. Xiong, Y Earnings Management and Its Measurement: A Theoretical Perspective. The Journal of American Academy of Business 9 (March): This article presents a recent summary of earnings management literature. 12