Big BathDefined along with Examples

Written By:
Adiste Mae

What is a Big Bath?

Big Bath is a type of accounting manipulation where the poor results of an accounting period are made to look even worse so that the next accounting period will show better results.

This practice is done by companies in order to artificially improve the earnings for the next year and make it look attractive. 

Understanding a Big Bath

Big Bath is the name given to this method because the management literally cleans the Balance Sheet of the company – a clean slate.

This technique is practiced by companies because it allows them to make a settlement for all of their losses in one accounting period and gives them an opportunity for more bonuses to executives. 

There are methods in using Big Bath in accounting without it being illegal.

But even when it is completely legal, it is still considered unethical. 

For example, a company’s stock price is affected by the reported earnings of a company.

When it reports a loss, the value of the stock depreciates but when the effect of the Big Bath results in a positive result, the stocks of the company will be able to recover, or even more. 

How Firms Can Conduct a Big Bath

There are several ways for companies to conduct a Big Bath – move the income to the next accounting period, increase expenses for the current accounting period or both.

CEOs of companies can decide to do the following: delay the realization of sales, prepay expenses or record write-offs.

By doing this, a CEO of a company is able to ensure a higher possibility of bonuses getting paid for the following year.  

In an economic situation where there is a recession and rise of unemployment, banks face a series of delinquency and defaults on loans.

When this happens, banks write off the loans in advance in anticipation of what could happen by creating a reserve for loan losses. 

When the economy recovers and banks are able to recover their losses, all they have to do is reverse the amount of the loss recovered from the reserve.

This reversal will result in an increase in the bank’s future earnings. 

Criticisms in Conducting a Big Bath

Conducting a Big Bath may be complicated to implement because firms need to adhere to the guidelines set by the Generally Accepted Accounting Principles (GAAP).

If not, the firm will be believed to be conducting fraudulent practices. 

A company that continually practices this may lead investors and creditors to believe that the firm practices too much financial dressing of their data.

This could impact their reputation and make investors become suspicious of the entire firm. 

When companies report improved profits after every accounting period and fails to deliver in the year that investors expect it to, this might cause them to withdraw their investments and back out.