Ernst & Young Speaker Series

Desautels Faculty of Management
Accounting Area
presents
Ernst & Young Speaker Series

Professor Daniel Cohen
New York University
Stern School of Business

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

Friday, 16 October 2009
688 Sherbrooke St
Room 1025
10h30 – 12h00

Everyone is cordially invited to attend.

Abstract: Utilizing a database that became available due to the requirements of FIN 45, we examine the informational role of accounting disclosures on warranties. First, since firms use warranty policies as a business strategy to promote their products, a warranty reserve may serve two roles: an informational 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, since warranty accruals require estimation of future claims, they can also be used as a tool of earnings management. Our evidence indicates that managers use warranty accruals to manage earnings opportunistically to meet their earnings targets. Finally, we find that the stock market recognizes that warranty liabilities of firms that managed earnings are underestimated.