What Is a Big Bath?
A "big bath" is an accounting term that is defined by a company's management team knowingly manipulating its income statement to make poor results look even worse in order to make future results appear better. It is often implemented in a relatively bad year so that a company can enhance the next year's earnings in an artificial manner.
- A big bath is an unethical accounting tactic whereby income in a bad year is made to look even worse than actual.
- Often undertaken in a bad earnings year, this tactic is intended to artificially inflate future earnings figures.
- Various techniques can be employed to carry out a big bath without breaking the law, where it can enrich corporate managers in the following years as bonuses are often tied to earnings performance.
How a Big Bath Works
A big bath is so named because it is like wiping the slate clean. A big bath accounting maneuver can result in a big rise in apparent future earnings, which might result in a larger bonus for executives, giving them the incentive to pursue a big bath accounting maneuver. New CEOs sometimes use the big bath so they can blame the company's poor performance on the previous CEO and take credit for the next year's improvements.
Because stocks trade on earnings, an adverse earnings report may cause significant depreciation in a stock with a few cents less in earnings per share (EPS); a big bath does not affect the stock price as much. When earnings are positively affected by the big bath in the future, the stock price can recover and trade even higher than it otherwise would have without the accounting manipulation. A big bath is not necessarily illegal because it can be done effectively within the boundaries of current accounting rules; however, it is seen as unethical.
Example of a Big Bath
If a CEO concludes the minimum earnings targets cannot be made in a given year, he has an incentive to move earnings from the present to the future because the CEO's compensation does not change regardless if he misses the targets by a little or a lot. The CEO can shift profits forward in several ways: by prepaying expenses, taking write-offs, or delaying the realization of revenues. By taking on these measures in a big bath maneuver, the CEO increases the chances of getting a large bonus the following year. Prepaying expenses and taking write-offs are particularly useful in a big bath scenario.
Banks typically face rising delinquency and default rates on loans when the economy goes into recession and unemployment rises. These banks often write off the loans beforehand in anticipation of the losses and create a loan loss reserve. A bank can effectively create a big bath and be liberal with the loan loss provision as its earnings are hurt by tough economic times.
When the economy recovers and loan payments are paid on time and in greater numbers, the bank can reverse the losses in the loan loss reserve that were not realized and boost earnings in future quarters. Management can benefit with higher compensation, and the bank's share price can recover from a fall during tougher financial times.