Potential Litigation Risks and Accounting Choice: Evidence from Korea

This paper examines whether potential litigation risks affect manager’s accounting choice in Korea. There are two opposing arguments on the role of D&O insurance; on one hand, it plays a governance role, which makes managers more conservative, alternatively, it is argued that it makes managers more opportunistic, that is less conservative. We examine manager’s behavior faced with increasing litigation risks in Korea with several alternative measures of conservatism. In particular, we consider an endogenous problem of purchasing additional D&O liability insurance. This study employs D&O insurance coverage as potential litigation risks, as well as D&O insurance premiums as potential litigation costs which are used in Korean study. The empirical result of this study suggests that firms carrying high D&O insurance coverage or premiums show more conservative attitudes towards their accounting choices. These imply that managers tend to carry more D&O coverage limit when their potential litigation risks are expected to be higher in the Korean market and it makes them more conservative in their accounting choices. Consistent with prior study (Choi and Lee 2008), it strongly supports the monitoring role of D&O insurance. However, our study differs from prior ones in that we identify potential litigation risks separately from potential litigation costs. We also try to employ several alternatives to measure conservatism in the empirical test, which were not employed by prior studies. We also consider exogenous issues on D&O purchase additionally. Those results have implications for Korean policy makers in that regulation makes firms more conservative. It would be interesting for academic researchers to follow up this issue to see whether managers exhibit opportunistic behaviors with D&O liability insurance, even though this practice is not observed in Korea yet.