How Does Fair Value Accounting Affect Risk Management for Directors and Officers?

Abstract

This study investigates the relationship between fair value accounting and the perceived litigation risk of directors and officers, particularly focusing on their demand for directors’ and officers’ liability insurance (D&O insurance). In the context of stringent legal frameworks and fiduciary responsibilities, directors and officers face significant personal liability risks, especially in financial reporting. While prior research suggests that fair value accounting may reduce actual litigation risk due to its complexity, our study explores how the perceived risk influences D&O insurance coverage decisions. Using data from Taiwan’s D&O insurance market, we find that firms with a higher proportion of financial instruments measured at fair value tend to maintain greater D&O insurance coverage, supporting the managerial risk-aversion hypothesis. Our results also show that this relationship is intensified in environments with higher firm-level litigation and financial distress risks, as well as in firms with high net income sensitivity to changes in fair value. These findings suggest that adopting fair value accounting may lead to increased demands for D&O insurance, potentially affecting the retention costs of top talent.

Keywords: managerial risk management, Fair value accounting, Directors' and Officers' liability insurance, Financial instruments