The impact of directors’ and officers’ insurance on audit pricing: Evidence from UK companies

Abstract

This paper examines the impact of directors’ and officers’ (D&O) insurance on audit pricing in a large sample of UK companies. The existence of D&O insurance is expected to exert a dual impact on auditors’ pricing decisions. The presence of an additional source of funds to satisfy stakeholder claims in the event of audit client failure suggests that audit fees in insured companies should be lower. Alternatively, recent research has identified a positive link between the presence of D&O insurance and a number of characteristics traditionally associated with more expensive audits. The main objective of this study is to ascertain which of these influences pre-dominates. Analysing a sample of 753 UK listed companies in the early 1990s, when companies were obliged to disclose the presence of D&O insurance, this study shows that D&O insurance is associated with higher audit fees. It also confirms that insured companies are larger, more complex and present a greater audit risk (using a range of measures) than uninsured companies. Further analysis suggests that the impact of D&O insurance on audit fees may be influenced by company size, auditor size, and the extent of non-executive presence on the company’s board.

Keywords:

• D&O insurance
• Audit pricing
• Audit fees
• Liability
• Risk

Acknowledgements

This paper has benefited from the comments of two anonymous reviewers, and contributions from participants at presentations at the University of Sheffield and University College Cork. The research assistance of Kerry Musson and Carolynne Mason is also gratefully acknowledged.

Notes

1 Under sections 532–538 of the Companies Act 2006, auditors will be able to limit their liability by contract with the audited company provided that shareholder approval is obtained (see Financial Reporting Council, 2007 for a full discussion of this development).

2 Bush, Fearnley, and Sunder (2007) provide a comprehensive review of the reform of auditor liability in the UK.

3 The duty on UK companies to disclose the purchase of D&O insurance was repealed during 1996 so the 1995 annual reports were the final ones to contain such disclosures.

4 It should be noted that prior to the 1989 amendment it was possible for directors to purchase their own D&O insurance policy. I am grateful to one of the reviewers for pointing this out.

5 The specific catalyst for reform was the outcome of Smith v. Van Gorkam (1985) where the Delaware Supreme Court found nine directors and officers of the Trans Union Corporation personally liable for approving the sale of the company for less than its intrinsic value.

6 Swinson (1990) provides a useful guide to the 1989 amendment to the 1985 Companies Act. The specific enabling legislation for the aspects of the Act of relevance to this study is contained in Statutory Instrument 1990/335. The duty on companies to disclose the existence of D&O insurance was subsequently repealed by the Companies Act 1985 (Miscellaneous Accounting Requirements) Regulations. The relevant legislation was contained in Statutory Instrument 1996/189.

7 The presence of D&O insurance and the amount of non-audit services purchased are not significantly correlated so the reduced impact of D&O in years 1993–1995 does not appear due to the addition of the non-audit fee variable.

8 These results are not shown here due to space constraints but are available from the author on request.

9 Oxera (2006) make an interesting observation that, while in absolute terms audit fees have increased significantly in recent years, they have not increased as a proportion of company size (measured by turnover).