What does “Big Bath” Mean?
The accounting term “big bath” refers to a company’s habit of making its earnings appear lower than they actually are for a given year. This allows the corporation to exaggerate earnings for the following year in a year in which it was unlikely to exceed earnings forecasts otherwise.
In order to accomplish this, the corporation incurs costs, under-reports income, and writes off a substantial amount of money. Big bath accounting can be done lawfully, but it is frequently used to deceive the public and investors about a company’s true financial status.
It is quite illogical to believe that a firm would ever show itself to the outside world in anything but the highest financial shape. However, there are instances in which a corporation does just that, and in such scenarios, large bath accounting comes into play.
By delaying profits from one year to the next, a corporation might appear to be rebounding from a difficult time or rebuilding strength in the face of a declining trend.
Reasons Why “Big Bath” Might Be Undertaken
There are a number of reasons why this type of accounting practice might be pursued. The fact that the corporation has little possibility of reaching its profit goals might be one of them.
In such a scenario, it may be profitable for the firm to incur a large loss, improving its chances of exceeding expectations the next year. This may be especially advantageous for corporate executives who stand to collect substantial incentives for surpassing expectations.
Big bath accounting may come into play in the event of a regime transition at a corporation. The new CEO of a corporation may wish to blame the previous leader for the organization’s present difficulties.
It would appear that the former leadership was responsible for the company’s financial difficulties if more losses were incurred during the year that the previous CEO was in charge. It would also improve the company’s financial forecast for the first year under the new CEO.
It is difficult to determine the point at which creative accounting practices become dishonest. Large, one-time charges that are added to the books may indicate that the firm is misrepresenting its losses for the relevant fiscal year.
While these costs might be legal, they would be considerably more suspect if they appeared on a firm’s records every other year, indicating that the corporation was artificially inflating its earnings in the between years.
Determining if a company’s accounting is accurate requires a multi-year examination of its financial records.
Understanding a Big Bath
A large bath is so termed because it is comparable to wiping a clean slate. A big bath accounting trick can result in a significant increase in apparent future earnings, which may result in a bigger bonus for executives, incentivizing them to undertake a big bath accounting move.
New CEOs may sometimes use the large bath to criticize the prior CEO for the company’s bad performance and claim credit for the next year’s improvements.
Due to the fact that equities are traded based on earnings, a negative earnings report may cause a company to decline significantly.
When future earnings are favourably impacted by the huge bath, the stock price can rebound and trade much higher than it would have without the accounting fraud. It is not technically unlawful to take a large bath because it is possible to do so within the parameters of existing accounting standards; yet, it is considered immoral.
How Does a Big Bath Work?
The primary objective of this strategy is to suffer a more substantial hit to current earnings. In the future, the earnings can be shown in the books as accounts that are more aesthetically pleasant and of greater scale.
This method is permissible and involves the business’s reputation in the form of the size of the company’s manipulation of the books of accounts and the extent or value of the income statement’s financial dressing.
An investor should maintain vigilance or be slightly cautious of firms that have regularly employed the large bath approach and, as a result, reported improved profitability in successive periods.
This method is typically implemented when a company is aware that it is experiencing a loss-making period and believes that a future loss of a greater magnitude would not have a significant impact on its investors.
When a company wishes to write off assets that have been overvalued or whose valuations are suspect, it will sometimes take a large write-down.
Additionally, it may be used if the company intends to deliver or earn an excessive bonus in the forthcoming term. They will adopt this technique in the first year without offering a bonus, citing poor earnings. The next year, they will report an abundance of money and award bonuses in accordance.
Big Bath Examples
A company denies its employees a bonus, citing the fact that they are a loss-making operation. They will report larger earnings the next year and increase their bonus proportionately.
The company may manufacture fictitious sales records, which need that a corresponding account receivable be associated with it. These anticipated receivables may be written off in whole.
If top-level executives of a company believe that the objective cannot be met in the current fiscal year, they might move the little amount of profit they anticipate earning in a variety of ways, such as through write-offs, prepayment of costs, and writing off receivables.
Consequently, they report an exaggerated profit the next year, claiming that they have performed very well, and receive a larger bonus.
Assumptions of Big Bath
- When there is a loss recorded in a particular event or a decline in sales owing to unforeseeable reasons, a huge bath is usually implemented.
- Generally, it is done to clean up the balance sheet, and companies normally wait for a loss-making year to use this technique.
- This approach is employed to settle all losses in a single transaction so that the future appears promising.
- This method is sometimes employed to capture the attention of creditors or investors by depicting a promising future.
- Typically, this tactic is observed either just before or after a management transition.
Criticism of Big Bath
It typically decreases the level of optimization of the market’s available resources. Investors tend to become more distrustful of a business unit if it adheres to this approach excessively. This may have a negative effect on the company’s image.
The corporation that manipulates its earnings may tend to report a higher profit every year, and if this does not occur, investors may withdraw their support.
When profit is manipulated to a greater extent, the firm may lose credibility and relevance as a result of excessive data manipulation.
It is difficult to use this strategy because corporations must adhere to GAAP, and any substantial modification that is not in accordance with GAAP may lead the company to engage in fraudulent behavior.
Advantages of Big Bath
The advantages include the following:
- A large bath is a source of bonus and profit increases in the next year.
They may be utilized to entice investors and creditors based on the tale of a promising profit-earning potential in the near future.
- It is a proactive tactic to accept all losses simultaneously.
- Big Bath is a method for cleaning the balance sheet, and companies often wait for a losing year to do it.
How Firms Can Conduct a Big Bath
If a CEO determines that the minimum earnings objectives cannot be met in a particular year, he has an incentive to shift earnings from the present to the future because his remuneration is unaffected by whether he misses the minimum earnings targets by a little or large amount.
The CEO can advance earnings in a number of methods, including by prepaying expenditures, incurring write-offs, and delaying revenue recognition.
By implementing these procedures as part of a huge bath move, the CEO enhances the likelihood of receiving a substantial bonus the next year. In a case involving a large bath, prepayment of expenditures and obtaining write-offs are particularly advantageous.
Banks may also take a large bath. When the economy enters a recession and the unemployment rate rises, delinquency and default rates on loans often increase.
Frequently, these banks write off loans in advance in anticipation of losses and establish a loan loss reserve. In difficult economic conditions, a bank can efficiently establish a large loan loss reserve and be lenient with its loan loss provision.
When the economy rebounds and loan payments are made on schedule and in greater quantities, the bank can reverse the unrealized losses in the loan loss reserve and increase quarterly profitability.
The management can gain from a raise in salary, and the bank’s share price can recover from a decline in difficult economic circumstances.
A large bath is an unethical accounting technique whereby the revenue of a poor year is made to appear substantially worse than it actually is.
This method is meant to artificially increase future profits figures. It is frequently employed during a poor earnings year.
It is possible to conduct a large-scale laundering operation without breaching the law using a variety of strategies, which can reward business management in subsequent years due to the fact that incentives are frequently related to profit performance.