Cohen%20Darrough%20Huang%20Zach

Cohen%20Darrough%20Huang%20Zach - Warranty Reserve:...

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Electronic copy available at: http://ssrn.com/abstract=1087808 Warranty Reserve: Contingent Liability, Information Signal, or Earnings Management Tool? * Daniel Cohen a , Masako Darrough b , Rong Huang c , Tzachi Zach d a School of Management, University of Texas at Dallas dcohen@utdallas.edu b Zicklin School of Business, Baruch College Masako.Darrough@baruch.cuny.edu c Zicklin School of Business, Baruch College Rong.Huang@baruch.cuny.edu d Fisher College of Business, The Ohio State University zach_7@fisher.osu.edu First Draft: November 2007 This Draft: August 2010 * We thank Steve Kachelmeier, Wayne Thomas, and two anonymous referees for helpful comments and suggestions. We also thank Patricia Dechow (AAA Discussant), Nicole Heron, participants at the 2009 AAA meetings and seminar participants at Fordham University, George Washington University, INSEAD, Massachusetts Institute of Technology, Tel Aviv University, Temple University, University of Rochester, Washington University in Saint Louis, the 2008 Four-School conference at Baruch College, and the 2008 Burton workshop at Columbia University. Finally, we thank Eric Arnum for his help with warranty data.
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Electronic copy available at: http://ssrn.com/abstract=1087808 Warranty Reserve: Contingent Liability, Information Signal, or Earnings Management Tool? 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: Warranties, Contingent Liability, Product Quality, Signaling, Earnings Management
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Electronic copy available at: http://ssrn.com/abstract=1087808 1 I. INTRODUCTION Most durable products are sold with warranties. A product warranty is “an obligation incurred in connection with the sale of goods or services that may require further performance by the seller after the sale has taken place” (SFAS No. 5, Accounting for Contingencies). 1
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Cohen%20Darrough%20Huang%20Zach - Warranty Reserve:...

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