Big bath

Big Bath in accounting is an earnings management technique whereby a one-time charge is taken against income in order to reduce assets, which results in lower expenses in the future. The write-off removes or reduces the asset from the financial books and results in lower net income for that year. The objective is to ‘take one big bath’ in a single year so future years will show increased net income.

This technique is often employed in a year when sales are down from other external factors and the company would report a loss in any event. For example, inventory valued on the books at $100 per item is written down to $50 per item resulting in a net loss of $50 per item in the current year. Note there is no cash impact to this write-down. When that same inventory is sold in later years for $75 per item, the company reports an income of $25 per item in the future period. This process takes an inventory loss and turns it into a ‘profit’. Corporations will often wait until a bad year to employ this ‘big bath’ technique to ‘clean up’ the balance sheet. Although the process is discouraged by auditors, it is still used. In recent times, General Motors and other US Corporations have taken huge write downs on balance sheet assets resulting in massive losses. The same result can be achieved by recording in one year the future cash costs of expected plant closing or employee layoffs. The objective is to take these loses all at once, so future periods can show positive net income.

The incentives behind this earnings management technique varies. A widespread belief of why companies utilize this technique is to improve external reputation and appeal to investors and creditors. In most large corporations, managers are in charge of financial reporting. This gives managers the incentive of bias reporting to increase the reputation of their company and to attribute those gains to their own ability. Other possible reasons why some managers have the incentive to tamper with their company financial reporting is for higher salary and recognition of their abilities to increase profit. It is often believed that earning management activities are common before and after management changes. Thus, other incentives may possibly be led by management turnovers.

Often time Managers use reporting strategies regardless if the external users are naive and ignore management's ability to manipulate earnings or if users are sophisticated and can accurately deduce the management's disclosure strategy. When times are bad for the corporations financially, as a financial reporting strategy, managers will under-report earnings by the maximum they can in the current period, in order to report higher future earnings. On the other hand, in both academic and business press, earnings management has negative connotations because it suggests the tampering of earnings by management at the disadvantage of investors and other external users. Furthermore, biased financial reporting goes against GAAP regulations.

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