What is Big Bath?
Big Bath is a kind of manipulative accounting in the books of accounts where the company manipulate the income in a bad year by degrading the income further thereby reporting even more loss than what it actually is so that the upcoming period or year looks better and make future results look attractive.
- It is a typical scenario of manipulation of books of accounts where accountants understate the current year’s income or loss to make the year look even worse so that they can enhance the future earning and show a better picture. It is an unethical accounting technique to make the current year look worse than what it is. This strategy is applied to artificially blow up future income potential.
- There can be several techniques to apply a big bath strategy without coming to legal trouble. In this process, it can enrich the managerial performance as a bonus is often looked in tandem with the company performance. When they show a picture where the company is in bad shape, the bonus level gets impacted, which in some form or the other is the right amount of savings for the company. This name means to wipe a slate clean. This strategy, on the other hand, may lead to substantial future earnings for the company where it can lead to high bonus amounts for the executives.
How Does it Work?
- The main intention of this strategy is to take a more significant blow to the earning in the current period so that in future, the earning can be made to dress more attractive or shown in the books as accounts to be more pleasing and of higher magnitude.
- This approach is legal but also has the reputation of the business involved in the form of to what magnitude the company is manipulating the books of accounts and what extent or value of the income statement is getting financially dressed. An investor should stay aware of a company or be a little suspicious about companies who have repeatedly applied the big bath strategy and thus shown better earnings reports in the consecutive period.
- This strategy is usually taken when the firm is aware of the financial condition that it is going through a loss-making phase and, thus, based on the belief that a more substantial loss in the future should not affect the investors to a great extent. A big bath at times is also implemented when the firm wants to write off their assets which are over-inflated or have suspicious values that are not correct.
- It may also be applied when the business wants to distribute or earn an excessive bonus in the upcoming period. In the initial year, they will implement this strategy and provide no bonus stating the earning are low, and immediately next year, they will report excessive income and distribute bonuses accordingly.
Big Bath Examples
- A business provides no bonus to its employees, stating they are a loss-making unit, and immediately the next year, they will show higher earnings reported and provide the bonus too accordingly.
- The business may create records of false sales, which demand that there should be a matching account receivable that also should be tagged to it. A big bath may be applied to write off these expected receivables.
- Top-level executives of a firm, if they feel that the target cannot be achieved in a current year, they can shift the little profit which they are expecting to earn in several ways, like making write-offs or prepaying expenses or writing of receivable, etc. Thus in the next year, they show an inflated number of the profit stating that they have done exceptionally well and bags the bonus to a greater magnitude.
Assumptions of Big Bath
- A big bath is generally brought into practice when there is a loss reported in a particular event, or there is a fall in the sales level due to some uncontrollable factors.
- It is generally done for a balance sheet cleansing, and firms typically wait for a loss-making year to apply this strategy.
- This strategy is applied to settle all losses at one shot and so that the future looks attractive.
- This strategy, at times, is applied to pull the interest of creditors or investors by portraying an attractive future.
- This strategy is generally seen to be in practice either before the management is getting changed or immediately after the management has been changed.
Criticism of Big Bath
- It generally reduces the optimization level of the resources available in the market.
- Too much adherence to this practice may impact the reputation of the business, also, as investors tend to become more suspicious of the business unit.
- The business using earning manipulation may tend to show an enhanced profit every following year, and if this doesn’t show the expected result, investors may back out from the firm.
- When the profit is manipulated to a higher degree, it may end up on the business losing its reliability and relevance due to too much financial dressing of its data.
- It is tough to apply this technique because companies have to work under the guidelines of GAAP, and any significant change which is not under GAAP guidelines may lead the firm to practice of fraudulent activity.
Some of the advantages are as follows:
- A big bath is a source to earn more bonuses and profit in the successive year.
- They may be used to attract investors and creditors based on the story of an attractive profit-earning capacity shortly.
- It is a proactive strategy to settle for all losses at one go.
- Big bath is a technique to clean the balance sheet, and firms typically wait for a loss-making year to do this.
A big bath though a manipulative accounting technique is legal if it is applied to a limited magnitude. Though it attracts a lot of criticism, the management with a fixed expectation in mind may use it for this. The different expectations may attract the practice of this strategy, and the business has to keep well in mind to manipulate their numbers only to a certain extent.
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This has been a guide to what is Big Bath and its definition. Here we discuss how does Big Bath works with examples, assumptions, and criticisms. You may learn more about financing from the following articles –