Managerial legal liability coverage and earnings conservatism

This paper examines the effect of managerial legal liability coverage on earnings conservatism. Using directors’ and officers’ (D&O) liability insurance coverage and cash for indemnification as a proxy for managerial legal liability coverage, we find that the higher the managerial liability coverage, which reduces the expected legal liability of managers, the less conservative the firm's earnings. We also find that managerial legal liability coverage has a stronger influence on earnings conservatism in a legal regime with higher litigation risk. Our results are consistent with the threat of litigation conditioning managers to practice conservative accounting.