Internal Control and Warranty Reserves
Posted: 1 Feb 2013
Date Written: January 31, 2013
Prior studies indicate that warranty reserves present two major aspects: a contingent liability and an information signal about growth prospects. In addition, managers use warranty accounting as a tool of earnings management to meet or beat earnings targets. In this paper, we hypothesize that Section 404 internal control weakness disclosures can help isolate information signal role of warranty reserves. The results reveal that warranty reserves serve as a stronger information signal for firms with an effective system than those with internal control weaknesses (ICW firms). Specifically, we first find that internal control weaknesses have an adverse effect on the relation between abnormal warranty accruals and future firm performance. Second, we find that investors give a more positive valuation of warranty reserves for firms with effective system than ICW firms. Finally, we find that the negative effect on information signal is more pronounced for material weaknesses related to sales/cost of goods sold and accrual estimation than others. Overall, these findings suggest that internal control report can be used to discriminate between information signal role and other roles served by warranty accruals.
Keywords: warranty reserves, signaling, internal control weaknesses
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