Review of Accounting Studies

, Volume 19, Issue 1, pp 1–42 | Cite as

Accounting and litigation risk: evidence from Directors’ and Officers’ insurance pricing

  • Zhiyan Cao
  • Ganapathi S. Narayanamoorthy


We study whether and how financial reporting concerns are priced by insurers that sell Directors’ and Officers’ (D&O) insurance to public firms. As D&O insurers typically assume the liabilities arising from shareholder litigation, the premiums they charge for D&O coverage reflect their assessment of a company’s litigation risk. Using a sample of public firms in the 2001–2004 Tillinghast D&O insurance surveys, we document that firms with lower earnings quality or prior accounting restatements pay higher premiums after controlling for other factors impacting litigation risk. In addition, insurers’ concerns about financial reporting are most evident for firms with restatements that are not revenue or expense related, are greater in the period following the passage of the Sarbanes–Oxley Act of 2002, and are greater for firms with financial reporting problems that linger. Our results are consistent with past restatements being viewed as evidence of chronic problems with a firm’s financial statements. By analyzing archival data, we can also quantify the effects of other determinants of D&O premiums (such as business risk, corporate governance, etc.) identified by Baker and Griffith (Univ Chic Law Rev 74(2):487–544, 2007a) through interviews regarding the D&O underwriting process.

JEL Classification

G22 G32 K22 K41 K42 M41 


Financial reporting quality Accounting restatements Directors’ and Officers’ insurance Litigation risk D&O Corporate governance 



We thank Tillinghast–Towers Perrin for providing the insurance data. We would like to thank several industry participants who have shared their valuable time with us. In particular, we thank Elissa Sirovatka of Tillinghast, David Allan of General Reinsurance Corporation, Dan Bailey of Bailey Cavalieri LLC, Michael Early and Frank Kastelic of the Chicago Underwriting Group, Lori Fuchs of Honeywell, Phil Norton of Arthur J. Gallagher and Co., and Paul Van Zuiden of Risk Management and Insurance Consulting LLC. We acknowledge helpful comments from Stephen Penman (Editor), two anonymous reviewers, Rashad Abdel-khalik, Tom Baker, Paul Beck, Andy Bauer, Michael Donahoe, Todd Green, Dongkuk Lim, Brian Mittendorf, Scott Richardson, Roberta Romano, Theo Sougiannis, Shyam Sunder, Jake Thomas, Anne Thomson, Albert Tsang, Peter Wysocki, Frank Zhang, and seminar and conference participants at the 2012 American Accounting Association Western Region Meeting, Yale School of Management, the University of Connecticut School of Law, the University of Illinois at Urbana-Champaign and the University of Washington Tacoma. Any errors are our own.


  1. Abbott, L. J., Parker, S. G., Peters, F., & Raghunandan, K. (2003). The association between audit committee characteristics and audit fees. Auditing: A Journal of Practice & Theory, 22(2), 17–32.CrossRefGoogle Scholar
  2. Aboody, D., Hughes, J., & Liu, J. (2005). Earnings quality, insider trading, and cost of capital. Journal of Accounting Research, 43(5), 651–673.CrossRefGoogle Scholar
  3. Agrawal, A., & Chadha, S. (2005). Corporate governance and accounting scandals. Journal of Law and Economics, 48(2), 371–406.CrossRefGoogle Scholar
  4. Ashbaugh-Skaife, H., Collins, D. W., Kinney, W. R., Jr, & LaFond, R. (2008). The effect of SOX internal control deficiencies and their remediation on accrual quality. The Accounting Review, 83(1), 217–250.CrossRefGoogle Scholar
  5. Baginski, S. P., Hassell, J. M., & Kimbrough, M. D. (2002). The effect of legal environment on voluntary disclosure: Evidence from management earnings forecasts issued in U.S. and Canadian markets. The Accounting Review, 77(1), 25–50.CrossRefGoogle Scholar
  6. Bailey, D. A. (2002). Size of D&O settlements exploding. Available at
  7. Bailey, D. A. (2005). D&O liability in post-Enron era. International Journal of Disclosure and Governance, 2(2), 159–176.CrossRefGoogle Scholar
  8. Baker, T., & Griffith, S. J. (2007a). Predicting corporate governance risk: Evidence from the Directors’ & Officers’ liability insurance market. The University of Chicago Law Review, 74(2), 487–544.Google Scholar
  9. Baker, T., & Griffith, S. J. (2007b). The missing monitor in corporate governance: The Directors’ & Officers’ liability insurer. Georgetown Law Journal, 95(6), 1795–1842.Google Scholar
  10. Black, B., Cheffins, B., & Klausner, M. (2003). Outside director liability. SSRN working paper. Available at
  11. Boyer, M. (2004). Is the demand for corporate insurance a habit? Evidence from Directors’ and Officers’ insurance. HEC Montreal CIRANO working paper. Available at
  12. Boyer, M. (2005). Directors’ and Officers’ insurance and shareholder protection. HEC Montreal CIRANO working paper. Available at
  13. Brown, S., Hillegeist, S. A., & Lo, K. (2005). Management forecasts and litigation risk. SSRN working paper. Available at
  14. Burks, J. J. (2011). Are investors confused by restatements after Sarbanes–Oxley? The Accounting Review, 86(2), 507–539.CrossRefGoogle Scholar
  15. Cao, Z., & Narayanamoorthy, G. (2011). The effect of litigation risk on management earnings forecasts. Contemporary Accounting Research, 28(1), 125–173.CrossRefGoogle Scholar
  16. Carcello, J. V., Neal, T. L., Palmrose, Z.-V., & Scholz, S. (2011). CEO involvement in selecting board members, audit committee effectiveness, and restatements. Contemporary Accounting Research, 28(2), 396–430.CrossRefGoogle Scholar
  17. Chalmers, J. M. R., Dann, L. Y., & Harford, J. (2002). Managerial opportunism? Evidence from Directors’ and Officers’ insurance purchases. Journal of Finance, 57(2), 609–636.CrossRefGoogle Scholar
  18. Chen, X., Cheng, Q., & Lo, A. K. (2012). Is the decline in the information content of earnings following restatements temporary? Working paper, 2012 American Accounting Association Annual Meeting. Available at
  19. Chung, H. H., & Wynn, J. P. (2008). Managerial legal liability coverage and earnings conservatism. Journal of Accounting and Economics, 46(1), 135–153.CrossRefGoogle Scholar
  20. Chung, H. H., Wynn, J. P., & Yi, H. (2008). Managerial opportunism, legal liability rule, and audit pricing. Working paper, Arizona State University. Available at
  21. Core, J. E. (1997). On the corporate demand for Directors’ and Officers’ insurance. The Journal of Risk and Insurance, 64(1), 63–87.CrossRefGoogle Scholar
  22. Core, J. E. (2000). The Directors’ and Officers’ insurance premium: An outside assessment of the quality of corporate governance. Journal of Law Economics and Organization, 16(2), 449–477.CrossRefGoogle Scholar
  23. DeAngelo, L. (1981). Auditor size and audit quality. Journal of Accounting and Economics, 3(3), 183–199.CrossRefGoogle Scholar
  24. Dechow, P., & Dichev, I. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(Supplement), 35–59.CrossRefGoogle Scholar
  25. Dechow, P. M., Ge, W., & Schrand, C. (2010). Understanding earnings quality: A review of the proxies, their determinants and their consequences. Journal of Accounting and Economics, 50(2–3), 344–401.CrossRefGoogle Scholar
  26. Dechow, P. M., Sloan, R. G., & Sweeney, A. P. (1996). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research, 13(1), 1–36.CrossRefGoogle Scholar
  27. DeFond, M. L., & Jiambalvo, J. (1991). Incidence and circumstances of accounting errors. The Accounting Review, 66(3), 643–655.Google Scholar
  28. Desai, H., Hogan, C., & Wilkins, M. (2006). The reputational penalty for aggressive accounting: Earnings restatements and management turnover. The Accounting Review, 81(1), 83–112.CrossRefGoogle Scholar
  29. Dopuch, N., & Simunic, D. (1980). The nature of competition in the auditing profession: A descriptive and normative view. In Regulation and the accounting profession, 34(2): 283–289. Belmont, CA: Lifetime Learning Publications.Google Scholar
  30. Dye, R. (1993). Auditing standards, legal liability, and auditor wealth. Journal of Political Economy, 101(5), 887–914.CrossRefGoogle Scholar
  31. Early, M., & Kastelic, F. (2004). What’s really going on in D&O insurance: Taking a look at capacity, claims and carriers. Tillinghast executive D&O seminar: D&O liability—What’s wrong with this picture? New York.Google Scholar
  32. Ettredge, M., Huang, Y., & Zhang, W. (2011). Restatement disclosures and management earnings forecasts. SSRN working paper. Available at
  33. Fama, E. F., & French, K. R. (1997). Industry costs of equity. Journal of Financial Economics, 43(2), 153–193.CrossRefGoogle Scholar
  34. Farber, D. (2005). Restoring trust after fraud: Does corporate governance matter? The Accounting Review, 80(2), 539–561.CrossRefGoogle Scholar
  35. Field, L., Lowry, M., & Shu, S. (2005). Does disclosure deter or trigger litigation? Journal of Accounting & Economics, 39(3), 487–507.CrossRefGoogle Scholar
  36. Files, R., Sharp, N. Y., & Thompson, A. (2011). Why do firms restate repeatedly? SSRN working paper. Available at
  37. Francis, J., LaFond, R., Olsson, P., & Schipper, K. (2004). Costs of equity and earnings attributes. The Accounting Review, 79(4), 967–1010.CrossRefGoogle Scholar
  38. Francis, J., LaFond, R., Olsson, P., & Schipper, K. (2005). The market pricing of earnings quality. Journal of Accounting and Economics, 39(2), 295–327.CrossRefGoogle Scholar
  39. Francis, J., Philbrick, D., & Schipper, K. (1994). Shareholder litigation and corporate disclosures. Journal of Accounting Research, 32(2), 137–164.CrossRefGoogle Scholar
  40. Jensen, M. C. (1993). Modern industrial revolution, exit, and the failure of internal control systems. Journal of Finance, 48(3), 831–880.CrossRefGoogle Scholar
  41. Johnson, M. F., Kasznik, R., & Nelson, K. K. (2001). The impact of securities litigation reform on the disclosure of forward-looking information by high technology firms. Journal of Accounting Research, 39(2), 297–326.CrossRefGoogle Scholar
  42. Johnson, M. F., Nelson, K. K., & Pritchard, A. C. (2007). Do the merits matter more? The impact of the Private Securities Litigation Reform Act. Journal of Law Economics and Organization, 23(3), 627–652.CrossRefGoogle Scholar
  43. Jones, C. L. (1998). The association of earnings management with current returns, current market values, future returns, executive compensation and the likelihood of being a target of 10b-5 litigation. Dissertation, Stanford University.Google Scholar
  44. Kaltchev, G. D. (2006). Dynamic panel models with directors’ and officers’ liability insurance data. Panel Data Econometrics, 274, 351–360.Google Scholar
  45. Karpoff, J., Lee, D., & Martin, G. (2008). The costs to firms of cooking the books. Journal of Financial and Quantitative Analysis, 43(3), 581–612.CrossRefGoogle Scholar
  46. Kim, I. Y. (2006). Directors’ and Officers’ insurance and opportunism in accounting choice. Working paper, Duke University. Available at
  47. Kinney, W. R., Jr, & McDaniel, L. S. (1989). Characteristics of firms correcting previously reported quarterly earnings. Journal of Accounting and Economics, 11(1), 71–93.CrossRefGoogle Scholar
  48. Knepper, W. E., & Bailey, D. A. (1998). Liability of corporate Officers & Directors (6th ed.). Charlottesville, VA: Lexis Law Pub.Google Scholar
  49. Kothari, S. P., Leone, A. J., & Wasley, C. E. (2005). Performance matched discretionary accrual measures. Journal of Accounting and Economics, 39(1), 163–197.CrossRefGoogle Scholar
  50. Lazer, R., Livnat, J., & Tan, C. E. L. 2004. Restatements and accruals after auditor changes. Working paper, New York University.Google Scholar
  51. Lys, T., & Watts, R. (1994). Lawsuits against auditors under the Security Acts. Journal of Accounting Research, 32(Supplement), 65–93.CrossRefGoogle Scholar
  52. Mathias, J. H., Neumeier, M. M., & Burgdoerfer, J. J. (2000). Directors and officers liability: Prevention, insurance, and indemnification. New York: American Lawyer Media Law Journal Press.Google Scholar
  53. O’Sullivan, N. (1997). Insuring the agents: The role of Directors’ and Officers’ insurance in corporate governance. Journal of Risk and Insurance, 64(3), 545–556.CrossRefGoogle Scholar
  54. Palmrose, Z.-V. (1988). An analysis of auditor litigation and audit service quality. The Accounting Review, 63(1), 55–73.Google Scholar
  55. Palmrose, Z.-V., Richardson, V. J., & Scholz, S. (2004). Determinants of market reactions to restatement announcements. Journal of Accounting and Economics, 37(1), 1–32.CrossRefGoogle Scholar
  56. Palmrose, Z.-V., & Scholz, S. (2004). The circumstances and legal consequences of non-GAAP reporting: Evidence from restatements. Contemporary Accounting Research, 21(1), 139–180.CrossRefGoogle Scholar
  57. PricewaterhouseCoopers. (2002). PricewaterhouseCoopers LLP 2002 securities litigation study. Available at
  58. PricewaterhouseCoopers. (2003). PricewaterhouseCoopers LLP 2003 securities litigation study. Available at
  59. Rogers, J. L., & Stocken, P. C. (2005). Credibility of management forecasts. The Accounting Review, 80(4), 1233–1260.CrossRefGoogle Scholar
  60. Romano, R. (1991). The shareholder suit: Litigation without foundation? Journal of Law Economics and Organization, 7(1), 55–87.Google Scholar
  61. Romano, R. (2001). Less is more: Making institutional investor activism a valuable mechanism of corporate governance. Yale Journal on Regulation, 18(2), 174–251.Google Scholar
  62. Ronen, J. (2002). Post-Enron reform: Financial statement insurance, and GAAP re-visited. Stanford Journal of Law, Business and Finance, 8(1), 1–30.Google Scholar
  63. Scholz, S. (2008). The changing nature and consequences of public company financial restatements. The Department of Treasury, April, 1–54.Google Scholar
  64. Sennetti, J. T., & Turner, J. L. 1999. Post-audit restatement risk and brand-name audits. Working paper, Nova Southeastern University.Google Scholar
  65. Shumway, T. (2001). Forecasting bankruptcy more accurately: A simple hazard model. Journal of Business, 74(1), 101–124.CrossRefGoogle Scholar
  66. Skinner, D. J. (1996). Why is stockholder litigation tied to accounting and disclosure problems? Unpublished manuscript, University of Michigan.Google Scholar
  67. Skinner, D. J. (1997). Earnings disclosures and stockholder lawsuits. Journal of Accounting and Economics, 23(3), 249–282.CrossRefGoogle Scholar
  68. Srinivasan, S. (2005). Consequences of financial reporting failure for outside directors: Evidence from accounting restatements and audit committee members. Journal of Accounting Research, 43(2), 291–334.CrossRefGoogle Scholar
  69. Tillinghast. (2002). Directors and Officers liability survey. Available at
  70. Tillinghast. (2005). Directors and Officers liability survey. Available at
  71. Wahlen, J. M. (2004). Discussion of “The circumstances and legal consequences of non-GAAP reporting: Evidence from restatements”. Contemporary Accounting Research, 21(1), 181–190.CrossRefGoogle Scholar
  72. Wilson, W. M. (2008). An empirical analysis of the decline in the information content of earnings following restatements. The Accounting Review, 83(2), 519–548.CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media New York 2013

Authors and Affiliations

  1. 1.Milgard School of BusinessUniversity of Washington TacomaTacomaUSA
  2. 2.College of BusinessUniversity of Illinois at Urbana-ChampaignChampaignUSA

Personalised recommendations