The Effects of Directors’ and Officers’ Liability Insurance on Earnings Conservatism

Abstract

We show that firms with greater litigation risk are more likely to purchase directors’ and officers’ (D and O) insurance. The data do not support the hypothesis that D and O insurance complements the existing monitoring mechanism. Instead, we find strong evidence that the higher the D and O liability coverage, which reduces the expected legal liability of directors and officers, the less conservative the firm’s earnings. In addition, we find that firms that voluntarily choose to have a Certified Public Accountant (CPA) review tend to have fewer conservative earnings reports. Moreover, the demand for D and O insurance and the voluntary CPA review are complementary. Key words: Directors’ and officers’ liability insurance, voluntary accounting review, earnings conservatism, moral hazard