We analyze the link between financial reporting choices that affect accruals quality and firms' use of call options. We argue that call options used in compensation arrangements (employee stock options or ESOs) create countervailing incentives for managers to affect accruals quality. On the one hand, poorer accruals quality is associated with greater returns volatility (which leads to an increase in ESO value); on the other hand, better accruals quality is associated with a lower cost of capital (and, therefore, higher share price, which leads to an increase in ESO value). We confirm both effects on accruals quality, and we show that the net effect is for ESOs to worsen accruals quality. We provide additional evidence on this main result by showing that in two settings where the returns volatility incentive to worsen accruals quality is muted or absent (cases where managers hold employer shares and cases where the firm uses call options for financing purposes, such as preferred stock and convertible debt), the overall incentive is for managers to increase accruals quality.
