farah's blog: Big Bath Accounting Theory/ Earnings Management

Introduction and Origin of Big Bath

Earnings management is manipulation of earnings intentionally. The organizations performance normally judge by earnings. The earning elements consist of company’s cash flows and accruals.

The most common and largely used management techniques are classified into five main techniques big bath is one of them. Performance of a firm can be assessed on degree of its revenues; this makes earnings an important tool for measuring performance (Dechow, 1994)

Jay Patel of Boston University and Francois Degeorge of the HEC School of Management along with Harvard economist Richard Zeckhauser, in Paris ("Earnings Manipulation Exceeds Thresholds", Working Paper, 1997) found evidence of what they call the "Big Bath Theory".

Big Bath in accounting is an earnings management technique in which assets are over charged to reduce assets value which ultimately result in low expenses in future.

“Earnings management is actions and steps taken by the management to achieve certain earning objectives (Scott, 2009)

There are two perspective of earning management:

· By changing the accounting procedures make earnings favorable to the management.

· By manipulating accounting policies to control the loss.

Big Bath Accounting Theory is one of the subset of earnings management. For secure future earning commonly organizations will take large non-recurring loss one year for not to be suffered in future. Typically in the periods of profit depression, so that earnings in future are not charged. In view to protect firm or management market reputation make worst to already depressed earnings to wipe out all losses in once. The market typically punish organizations almost same for misses out its earning a bit or by a lot (Henry and Schmitt, 2001).

Definitions:

Ø “If you are going to take a bath, make it a big bath. Recall of every solid piece of bad news you can have” (Henry, 2008). There is always a possible way to get out no matter how much bad situation it is. That way, you get as much bad news as possible out of the way at the same time.

Ø ”The excess write off result in reduction in revenue by low collections and high accounts payments” (Healy, 1985, p.86).

Ø “By reporting high expense and increase in tax, interest and offsetting extraordinary expense in subsequent period” (Walsh et al., 1991)

Ø “Overstating losses in current period for creating high earning in subsequent future period” (Fiechter and Meyer, 2009)

All provided definitions states that big bath technique is used to decrease an organization’s revenue for the greater good in future. Because there is always a possible way to get out no matter how much bad situation it is.

Numerous earnings management techniques exist, the big bath is one of them. Consistent earning capacity and stability in capital market are essential for agreements with other organizations. When there is expectation of increase and decrease in earnings, management use different tactics to show low earning in recession period or may have idea of future affect by particular period performance. Management takes big bath to clear out its all losses in one particular period for profit maximization in future periods (Scott, 2009).

The big bath charge or off set expenses to current bad period to make it worse for taking advantage of high earning in future period (Itoh, 2007).When a change is took place in management probability of taken big bath increases. This is because organizations take it as a advantage to minimize elements that may put stress on future organization’s performance. Management changes can be sub divided into “amicable changes” and “hostile changes”

It is depend on the relationship between the successors and predecessors. When a management take big bath in its first fiscal year it is considered as hostile change. And when big bath is taken during the period of predecessor’s resignation it is called amicable change. These tactics strengthen the management for future earnings (Otomasa. 1998).

Case: Nissan Motor Company

In 2000 Nissan motor company changed its management and utilizes the tactic of big bath. In Japanese market Nissan stood second in automaker ranking. In April 2000 Mr. Carlos Ghosan entered as chief operating officer (COO) from Renault of France business partner and announced Nisan Revival Plan. Although a huge loss is recorded in march 2000 taken as big bath for the V shape revival of business in a particular period. Mr. Ghosan did that for placed the huge loss responsibility of his predecessor. Immediate V shape recovery is recorded after Mr. Ghosan joined as COO.

Assumptions of Big Bath Theory

· This technique is implemented when there is loss in a particular event or sale decline is recorded due to external factors.(fiechter et al., 2010)

· Big bath tactic is used to clean up the balance sheet and firms typically wait until a bad year to implement this tactic.(Ishak et al., 2013)

· Big bath is taken to adjust all losses at once and a positive impact on future earnings.

( Christensen et al., 2008)

· This technique is used to attract creditors and investors by portraying positive picture. (fiechter et. al., 2010)

· Big bath technique is commonly implemented in before and after management change. (fiechter et al., 2010)

· Managers use this technique in large organizations to manipulate reports in benefit of taking personal incentives and for the reputation of organization.(peek et al., 2004)

Criticism:

· It is very difficult to report big bath in financial statements because companies must report under the generally accepted accounting principles so any change in it may lead to fraud too. (peek et al., 2004)

· If earning management must be reported up to some specific level, if it goes beyond that it may lead to misleading financial statement and affect the reliability, comparability of the financial statements and can also effect the economic development.(walsh et al., 1991)

· When profits are changed beyond a reasonable degree, it may lead to the loss of relevance and reliability in financial data. .(Walsh et al., 1991)

· The companies, through earning management aim to increase the profits with every successive year and if it does not happen, the investors would feel reluctant and can back out. Moreover, there is a danger of decrease in company’s value in enterprise market. (Xiaohui et al., 2007)

· It reduces the market resource optimization. (Xiaohui et al., 2007)

Reporting Earnings Management:

It is very difficult to report earning management (Dechow and Skinner, 2002).Due to difficulty in reporting earnings management various models have been developed to report earnings management through accruals.(Dechow et. al, 1995). These models are as follows:

· Healy Model

· DeAnglo Model

· Jones Model

· Modified Jones Model

· Industry model.

All of the above models are doing reasonably good when dealing with entity’s years. In case of high financial performance all models lead to miss lead specifies tests. However after the researches it has been noticed that modified jones model is the strongest model among all and has been used by several researches to conduct test of earnings management. (Dechow and Skinner, 2002).

Incentives of Big Bath Accounting:

Bonus Plans:

Big bath accounting is beneficial when there involves an agency conflict.( Nieken et al., 2015). As shareholders often do contract with the managers in order to get the managers work for their interest and in return managers achieve high bonuses.(Ruch et al., 2014). So in order to achieve high bonuses, managers become self-interested and maximize the loss in order to get maximum profits in future.(Kent et al., 2008)

Debt Contracts:

With this big bath accounting, company tries to smooth its earnings by convincing the debt holders that profits do not have high volatility due to which risk is also low. This way the cost of debt becomes low and firm can earn smooth earnings through this cash flow. (Kirschenheiter et al., 2002)

CEO Change:

Researchers have shown that one big advantage of big bath is achieved by change in CEO. The new CEO applies a big bath in company and makes company’s earnings worse in his initial years and can blame this loss on the previous CEO.(Ramanna et al., 2007). In this way the new CEO can easily bear that loss in earnings and take the advantage of high earnings in future.(Habib et al., 2013),( Peasnell et al., 2005).

Meet Analysts’ Expectations:

Firms want to meet analysts’ expectations because it is the major pressure for a firm to meet analyst expectation.(Jordan et al., 2011). If firm is unable to meet these expectations they make as many losses as possible so that it will be easy for them to gain profits in following periods because stock market reacts strongly when firm is unable to meet analyst expectation.(Goldfrey et al., 2003).

Recent publications and their Findings (Tania)

Author	Year		Article name	Findings	Recommendations
Petra Nieken, Dirk Sliwka	2015	Management Changes, Reputation and Big Bath Earning Management		The research concentrated on the impacts of administrative turnover on profit administration exercises in a model in which chiefs think about their outside notoriety. We build up a covering eras display demonstrating that both active and approaching director’s inclination reported income with the end goal that ordinarily low returns are accounted for in the primary time frame after a supervisor has been supplanted. Active supervisors move income forward to their last period in office as they won't profit by profit acknowledged after that. Approaching supervisors can have a motivating force to move income to the second time frame in office as reported profit will, promptly after an administration change, just be mostly credited to their own particular capacity. Conceded pay can lessen motivations for income administration.
Ruch, George W Taylor, Gary K	2014	The Effects of Accounting Conservatism on Financial Statements and Financial Statement Users: A Review of the Literature		Conservatism would have a critical association with consider acquiring administration. because of the vulnerability of news occasions director are not ready to viably transfer on the bookkeeping acknowledgment of new occasions in a period to meet profit targets terrible news record might be utilized to oversee winning descending (big bath) yet we don't know about experimental confirmation supporting, for example, declaration.	Future research on the impact of conservatism on winning administration ought to look at whether restrictive conservatism in the shape auspicious misfortune acknowledgment has capacity to facilities procuring administration (big bath). Future research could inspect the nearness of order moving in auspicious compose downs.
Habib, Ahsan Uddin Bhuiyan, Borhan Islam, Ainul	2013	Financial distress, earnings management and market pricing of accruals during the global financial crisis		Observationally the administrative profit administration practices of fiscally upset firms, and to consider whether these practices changed amid the late worldwide money related emergency. Albeit corporate trouble has been a theme of research enthusiasm for a long time, income control by upset firms has gotten moderately little consideration.	Money related misery experienced by firms gives motivating forces to administrators to profit control. In any case, the course of the profit administration could be income‐increasing or income‐decreasing. The discoveries from this study will permit speculators to settle on better venture choices for firms that are encountering money related troubles.