Call Options and Accruals Quality

Abstract

We investigate whether greater use of call options in compensation and financing arrangements is associated with financial reporting choices that affect accruals quality, which previous research has shown to be a priced measure of information risk. Consistent with prior research documenting an association between the use of call options in compensation arrangements (in the form of employee stock options or ESOs) and increased returns and/or income volatility, we find that ESOs are also associated with poorer accruals quality, which has been shown to be related to increased returns volatility. However, call options used in financing arrangements (in the form of convertible debt and convertible preferred stock) provide no post-issuance incentives to worsen accruals quality, and may encourage the opposite behavior. We predict and find that the use of these instruments is associated with better accruals quality.