Warranty Reserve: Contingent Liability, Strategic Signal, or Earnings Management Tool

Abstract

Utilizing a database that recently became available due to the requirements of FIN 45, we examine the information content of accounting disclosures on warranties from two perspectives. First, since a warranty policy is a business strategy through which firms choose to promote their products, a warranty reserve serves two roles: a signal of product quality as well as a contingent liability to be honored in the future. Consistent with this view, we find that the stock market recognizes the warranty reserve as both a signal of firms’ future performance as well as a liability. Second, since warranty accruals require estimation of future claims, any discretion in this context can also be used as a tool of earnings management. Consistent with this expectation, our evidence indicates that managers use warranty accruals to manage earnings opportunistically to meet their earnings targets.