An empirical investigation of the effect of expensing stock options on earnings quality

This research examines whether the FASB's requirement that firms measure and disclose stock option expense in the financial statement notes improves earnings quality. Arguments have been made that discretionary accruals damage earnings quality. Although there is no consensus on how to define earnings quality, we define it herein as the degree of association between earnings and future net operating cash flows, a definition that has a reasonable degree of support in the literature. We utilize a multiple regression methodology. Total assets are employed to control for the effect firm size has on net operating cash flows. Pre-stock option expense earnings are used to explain variations in future net operating cash flows prior to considering the impact of stock option expense. Stock option expense is added to the regression to evaluate whether it provides incremental earnings quality in the explanation of future net operating cash flows. The stock option expense variable is found to be extremely statistically significant in explaining future net operating cash flows. Accordingly, we conclude that stock option expense provides incremental earnings quality. Keywords: Stock option expense, earnings quality, discretionary accruals, operating cash flows.
1. INTRODUCTION SFAS No. 123: Accounting for Stock-Based Compensation was issued in 1995 and became effective in 1996 (Financial Accounting Standards Board, 1995). This standard was the culmination of a [...]