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

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

Daniel A. Cohen

University of Texas at Dallas - Naveen Jindal School of Management

Masako N. Darrough

City University of New York - Baruch College - Stan Ross Department of Accountancy

Rong Huang

City University of New York (CUNY) - Stan Ross Department of Accountancy

Tzachi Zach

Ohio State University (OSU) - Fisher College of Business

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

University of Texas at Dallas - Naveen Jindal School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States
972-883-4772 (Phone)
972-883-6811 (Fax)

Masako N. Darrough

City University of New York - Baruch College - Stan Ross Department of Accountancy ( email )

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

Rong Huang

City University of New York (CUNY) - Stan Ross Department of Accountancy ( email )

One Bernard Baruch Way, Box B12-225
New York, NY 10010
United States
(646)312-3204 (Phone)

Tzachi Zach (Contact Author)

Ohio State University (OSU) - Fisher College of Business ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-4101 (Phone)

Paper statistics

Downloads
828
Rank
22,266
Abstract Views
4,482