Warranty Reserve: Contingent Liability, Information Signal, or Earnings Management Tool?

49 Pages Posted: 30 Jan 2008 Last revised: 3 Sep 2010

See all articles by Daniel A. Cohen

Daniel A. Cohen

Vanderbilt University - Owen Graduate School of Management

Masako N. Darrough

Baruch College - CUNY

Rong Huang

Department of Accounting, School of Management, Fudan University

Tzachi Zach

Ohio State University (OSU) - Department of Accounting & Management Information Systems

Date Written: August 31, 2010

Abstract

We examine the information role of accounting disclosures on warranties, utilizing a database that became available due to the requirements of FIN 45. First, because firms use warranty policies as a business strategy to promote their products, a warranty reserve can serve two roles: an information signal regarding product quality as well as a contingent liability. Consistent with this view, we find that the stock market recognizes that: (1) the warranty reserve contains information about firms’ future performance, and (2) the reserve is a liability. Second, because warranty accruals require estimation of future claims, they can be used as a tool of earnings management. Our evidence indicates that managers use warranty accruals to manage earnings opportunistically to meet earnings targets. Finally, we find that the stock market recognizes the understatement of warranty liabilities of firms that managed earnings.

Keywords: Warranty, Contigent Liaiblity, Signaling, Earnings Management

JEL Classification: M41, M44, M43

Suggested Citation

Cohen, Daniel A. and Darrough, Masako N. and Huang, Rong and Zach, Tzachi, Warranty Reserve: Contingent Liability, Information Signal, or Earnings Management Tool? (August 31, 2010). Accounting Review, 2011, Available at SSRN: https://ssrn.com/abstract=1087808 or http://dx.doi.org/10.2139/ssrn.1087808

Daniel A. Cohen

Vanderbilt University - Owen Graduate School of Management ( email )

401 21st Avenue South
Nashville, TN 37203
United States

Masako N. Darrough

Baruch College - CUNY ( email )

One Bernard Baruch Way
New York, NY 10010
United States
646 312 3183 (Phone)
646 312 3161 (Fax)

Rong Huang

Department of Accounting, School of Management, Fudan University ( email )

670 Guoshun Rd.,
Shanghai, Shanghai
China

Tzachi Zach (Contact Author)

Ohio State University (OSU) - Department of Accounting & Management Information Systems ( email )

2100 Neil Avenue
Columbus, OH 43210
United States
614-292-4101 (Phone)

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