Management Risk Incentives and the Readability of Corporate Annual Reports

• In Event: Disclosure and Financial Reporting

Abstract

Options compensation incentivizes managers to pursue riskier firm policies, but a growing body of research suggests that risk-incentivized managers tend to make excessively risky choices. Given that transparent disclosures of increases in firm-specific risk are potentially costly, we ask whether managers, incentivized to take more risk but obliged to periodically communicate their decisions to stakeholders, use more obfuscated annual reports to mask the increased risk. Our results show that Chief Executive Officers (CEOs) with higher options compensation to stock volatility sensitivity (options vega) are associated with riskier choices and more obfuscated annual reports. We do not find any such link between the options vega of the Chief Financial Officers (CFOs) and annual report obfuscation. The association between CEO vega and annual report obfuscation remains after controlling for the level of firm risk but gets modulated by higher institutional stock ownership and greater shareholder rights, highlighting the role of corporate governance in improving annual report readability. These findings, corroborated by a battery of robustness checks, document a new (and unintended) link between incentive compensation contracts and the readability of firms’ financial disclosures.

Authors

• Bidisha Chakrabarty, Saint Louis University

• Ananth Seetharaman, Saint Louis University

• Zane L Swanson, University of Central Oklahoma

• Xu Wang, Saint Louis University