As many companies deal with the aftermath of declining sales and reduced profit margins associated with the COVID-19 pandemic, management may be tempted to engage in an earnings management technique commonly termed “big bath” accounting. Using this approach, management intentionally overstates losses in order to present more favorable results moving forward. Given the increased risks over the past couple of years, all stakeholders should remain diligent and exercise professional skepticism when evaluating financial results. By closely examining the components and trends of common financial metrics for liquidity, leverage, efficiency, profitability, and market value, stakeholders can better gauge a company’s operating performance and financial condition while potentially detecting management manipulation through big bath accounting.
As most companies have now weathered the worst of the pandemic, many leaders are looking for ways to position their organizations for future sales growth and profit-ability in a novel landscape. One area most experts expect to see used (and abused) during the crucial reporting years bearing the brunt of the effects from the global pandemic is the concept called “big bath” accounting, where firms intentionally, and often creatively, inflate current expenses, thus lowering current profits, in order to report lower expenses and higher profits in the future (E. Bary, “How Companies are Becoming Creative with Accounting during the COVID-19 Pandemic,” https://on.mktw.net/3DDzNB4, May 28, 2020).
The concept of big bath accounting is nothing new. The practice was highlighted in a 1978 article that focused on big bath abuse in segment disposals (D. Rankin, “The Issue of ‘Big Bath’ Write-Offs,” New York Times, Jan. 31, 1978). The big bath concept is quite simple; if management knows that it will have an especially bad quarter (or year), it might be tempted to make that accounting period even worse through expense inflation, unnecessary write-downs, and unrealistic or overly conservative assumptions and estimates that result in additional costs and accruals.
History reveals that when tragedy strikes, there is a tendency to stretch any legitimate loss to include as many future expenses as possible in the current write-off amount (M. Kirschenheiter and N. Melumad, “Can Big Bath and Earnings Smoothing Co-Exist as Equilibrium Reporting Strategies?” Journal of Accounting Research, vol. 40, no. 3, pp. 761–796, 2002). That is not to say that all firms do this, of course; it is also not to say that there are not legitimate expenses that need to be accounted for even though they may be unusual in nature and not the norm for the firm. But human nature seems to be to give all the bad news at once, chalk it up to whatever perceived or actual issue may have caused the loss, and then paint a rosy picture of the future to placate customers, investors, employees, and other stakeholders (J. Ernstberger, “Six theses on the impact of COVID-19 on financial accounting and auditing,” Technical University of Munich, https://bit.ly/3RrZMB4, 2020).
Historically, big bath accounting has been a difficult practice to detect as management tends to blame the current market condition while presenting a positive future outlook. Common targets for big bath abuse in the past have included discontinued operations, depreciation charges, inventory write-offs, investment write-downs, and unusual one-time charges such as restructuring or reorganization costs (A. Tenton, “Big Bath Accounting Fraud,” https://bit.ly/3Rs0Tke, Dec. 11, 2008). This phenomenon is likely to be compounded by the pervasive and unprecedented nature of the operational and financial challenges that businesses faced during 2020 and 2021 due to the ongoing COVID-19 pandemic. Industries initially most affected by the fallout from COVID-19 included travel, hospitality, leisure, and retail. Sales and operations were negatively affected by a variety of mandatory closures, occupancy restrictions, and social distancing requirements (Deloitte, “Financial Reporting Considerations Related to COVID-19 and an Economic Downturn,” https://bit.ly/3HpepAy, July 8, 2020). As initial panic and restrictions subsided, many companies in these industries slowly started to make their way back to a new normal. However, other industries, including manufacturing and healthcare, quickly started to feel the pinch, including strains in supply chain management and the “great resignation” (Y.N. Lee, “Survey Finds Auto Industry Hit Hardest by Supply Chain Disruptions During Covid Pandemic,” CNBC Economy, https://cnb.cx/3X411rs, Aug. 25, 2021).
Expectations and Skepticism
Given the immense operational and financial challenges that most companies encountered in 2020 and 2021, financial statement users can expect to see some unusual results for the affected fiscal years. With users expecting to see major fluctuations and unusual trends, it becomes even easier for management to engage in big bath accounting without raising suspicion. The head of global financial reporting policy at the CFA Institute, Sandy Peters, warns that financial statement users should exercise significant skepticism of management’s methods, techniques, and potential creativity in reporting results, following COVID-19 (Bary, 2020).
Common targets for big bath accounting for 2020 and 2021 include:
- Inventory write-downs
- Overestimated bad debts
- Asset impairments (especially goodwill)
- Overestimated credit losses
- Investment write-downs
- Unusual costs (i.e., restructuring charges or reorganization costs)
- Losses from contracts and agreements
- Onboarding costs and employment related liabilities.
Inventory is a tricky area, and the trends here are likely to vary by industry. Companies will report their inventories based on the lower of cost or the net realizable value—that is, market value—of the goods. Due to market volatility, supply chain disruptions, and ongoing logistical challenges, the market value or replacement cost of inventory for many companies has seen rapid fluctuations over the past two years. As such, management must exercise professional judgment in estimating those net realizable values and comparing them against the costs carried on the balance sheet, which also depend on the company’s inventory costing methodology (H.B. Levy, “Financial Reporting and Auditing Implications of the COVID-19 Pandemic,” The CPA Journal,https://bit.ly/3DBSNzE, August 2020).
Overestimated bad debts.
Under U.S. GAAP, management must use the allowance method to estimate bad debts or uncollectible receivables. Such estimates are inherently subjective, but can typically be supported by prior experience and industry trends. During extraordinary times, the role of professional judgment and discretion becomes more pronounced, as management is forced to make projections with limited precedent. Therefore, some experts predict that management may be overly generous in their bad debt reserves (V. Burca, D. Mates, O. Bogdan, “Exemplifying the Effect of Big Bath Accounting in the Pandemic,” Ceccar Business Review, The Body of Expert and Licensed Accountants of Romania, https://doi.org/10.37945/cbr.2021.02.01, February 1, 2021). When the allowance account undergoes the annual true-up in years to come, any excessive accruals are reversed, as the company records small bad debt expenses, which leads to higher reported profits.
Although many of the initial business changes from the pandemic were arguably temporary such as mandatory lock-downs and full work stoppages, there are other changes that may be permanent, or at least linger for some time. Such changes bring into question whether long-term assets could be subject to other-than-temporary impairments. Although short-term disruptions would not signal an impairment, if such conditions were expected to persist, an impairment is merited (Levy, 2020). As new variants of the virus continue to emerge, it becomes increasingly difficult to project future cash flow trends and thus arrive at reasonable valuations for assets, especially goodwill (J. Litman, “The Next Big Bath: Wall Street is Blind to an Oncoming Earnings Disaster,” Forbes,https://bit.ly/3HSkAyp, May 27, 2020).
Overestimated credit losses.
Public companies are now relying primarily on the current expected credit loss (CECL) model under ASC Topic 326 to report their estimated credit losses, including some lease receivables depending on the financing arrangements (Levy, 2020). The estimated losses associated with lease receivables, specifically for leased real property, are difficult to assess at the moment. Even as many activities have started to return to normal, certain aspects of consumer behavior may have been forever changed. The pandemic accelerated the acceptance of online shopping, which likely leaves many retailers looking to change their business model. This could mean reducing their physical footprint and increasing their digital presence. For lessors of retail space, this means uncertainty of whether the lessee will continue to pay, whether they will elect to renew, and if they do not renew, whether the lessor can find another lessee or will face a loss on the property. Owners of large office buildings face similar questions. Many employees have embraced remote work and have no intention of ever permanently returning to the office. Thus, companies looking to lower overhead and administrative costs may be looking for smaller office buildings or locations where space sharing can be optimized.
Although fair value is generally easy to ascertain for investments in publicly traded securities, the valuation of minority interests in privately held companies poses a greater challenge. Many large organizations hold equity-method minority interests in non-public entities that are accounted for under ASC Topic 320. If the investment undergoes what is deemed to an other-than-temporary impairment, then management must write-down the value of that investment accordingly (Levy, 2020). Due to the unprecedented challenges, fluctuations, and permanent shifts due to the pandemic, subjectivity plays an even greater role in determining whether there is an other-than-temporary impairment and, if so, the amount of the write-down should be.
Although unusual items such as restructuring costs and reorganization costs are listed separately on the statement of earnings, they affect overall profitability and thus a variety of common financial indicators. As such, they are a tempting target for managers looking to engage in big bath accounting techniques (Litman, 2020).
Losses from contracts and agreements.
Many holders of lease agreements and long-term contracts will be looking to negotiate new terms, if they have not already. Because the market impact remains unclear, estimating losses with any degree of accuracy could prove challenging (Levy, 2020).
Onboarding costs and employment related liabilities.
One surprising result of the pandemic has been the “great resignation,” which colloquially refers to workers who left their positions in the wake of the pandemic. As a result, employers are facing mounting onboarding costs as they recruit and hire new workers (J. Mullins, “What the Great Resignation Means for your Accounting Team,” MIP Fund Accounting, https://bit.ly/3Rs76Nc, Feb. 15, 2022). Additionally, this trend has placed would-be workers in more favorable bargaining positions because they might be able to negotiate higher salaries and better benefits, which create additional employment costs.
Management, auditors, and financial statement users commonly use financial metrics to assess a company’s performance and evaluate earnings quality. Financial statement metrics are commonly grouped into the categories of liquidity, solvency, efficiency, profitability, and market ratios. These are summarized in the Exhibit and detailed below.
Impact of Big Bath Techniques of Key Metrics
Liquidity ratios indicate a company’s ability to pay their short-term debts as they become due. Liquidity ratios generally focus on the relationship between short-term or liquid assets and short-term liabilities.
- Current ratio = Current assets ÷ Current liabilities. Total current assets could be affected by a number of big bath–related accounting abuses, including inventory write-downs, overestimated bad debts, and overestimated credit losses. Depending upon how the company records the event, most likely, the transaction will likely result in a decrease to a current asset account. It is possible that restructuring charges or other unusual expenses could be recorded as an accrued expense (i.e., a liability) or a reserve. If a company engages in one of these techniques, the current ratio will most likely decline. As most users are expecting to see declines in liquidity indicators, inflated liabilities would be less likely to draw scrutiny at present.
- Quick ratio (a.k.a., Acid test) = Quick assets (cash and cash equivalents, accounts receivable, and marketable securities) ÷ Current liabilities. Although an inventory write-down would not affect the quick ratio, as inventory is specifically excluded from quick assets, overestimated bad debts or accrued expenses could result in a decrease in the quick ratio.
- Cash ratio = Cash ÷ Current liabilities. Interestingly, very few big bath accounting techniques affect cash. Thus, if a company accrues unusual expenses, the cash ratio may decrease, as cash would be unaffected by the techniques but current liabilities would increase.
Leverage or solvency ratios focus on a company’s ability to satisfy their interest and debt obligations on a long-term basis.
- Debt ratio = Total liabilities ÷ Total assets. Most common big bath techniques would result in an increase to the debt ratio, as liabilities would be likely to rise and assets would be likely to decline.
- Debt to equity ratio = Total liabilities ÷ Total equity. The debt-to-equity ratio would likely increase using big bath accounting techniques. By overstating expenses, net income will be understated, possibly to the point of a loss position, which would reduce equity. In addition, if a company uses accruals to record unusual charges, liabilities will increase. With a potential increase to the numerator and decrease to the denominator, the debt-to-equity ratio could rise substantially.
- Interest coverage ratio = Operating income ÷ Interest expense. Big bath accounting results in lower operating income, assuming that write-downs and costs are reported as part of continuing operations. Big bath accounting techniques are unlikely to affect interest expense. As such, the interest coverage ratio would likely decline.
Efficiency ratios provide insights into management’s use of key resources.
- Accounts receivable (A/R) turnover = Net sales ÷ Average A/R. Although it is possible that a company could accomplish a big bath effect through a combination of expense inflation and revenue deferral, the most commonly used methods are on the expense side. As such, this assumes that revenue, or net sales, would not be substantially misstated even if a company were using big bath techniques. If a company overestimates their bad debts, the average accounts receivable will fall, as ending accounts receivable will be understated. If management overestimates bad debts, A/R turnover will appear to increase.
- Inventory turnover = Cost of goods sold (COGS) ÷ Average inventories. If a company writes down their inventories, both the numerator and denominator of the inventory turnover ratio would be affected. If management runs the write-down through cost of goods sold, then cost of goods sold would be lower. If management records the loss as unusual and reports it separately from cost of goods sold, then cost of goods sold may be unaffected. Regardless of where management records the expense, the inventory write-down would most definitely reduce ending inventory on the balance sheet, thus lowering average inventory. Thus, if a company engages in excessive inventory write-downs, the inventory turnover will increase due to a reduction in the denominator, possibly combined with an increase in the numerator.
- Asset turnover = Revenue ÷ Total assets. Asset turnover should be substantially affected by big bath accounting techniques. Although revenue is likely to remain unaffected by most techniques, nearly all result in a reduction of total assets. Thus, asset turnover is likely to increase using most big bath techniques. But if revenues also substantially decrease, this ratio may not show a significant increase.
Profitability ratios focus on a company’s ability to generate earnings based on their use of assets and investments.
- Gross margin ratio = Gross margin ÷ Net sales. If a company records inventory write-downs through cost of goods sold, then the gross margin ratio will decline. Most other big bath techniques will not affect this ratio.
- Profit margin ratio = Net income ÷ Net sales. If big bath techniques are used, the profit margin ratio will most certainly decline.
- Return on assets (ROA) = Net income ÷ Total assets. Return on assets will likely decline through the use of big bath techniques. Although both net income and total assets would likely decrease, net income is likely to decrease at a more substantial rate.
- Return on equity (ROE) = Net income ÷ Total equity. Similar to return on assets, return on equity would also be likely to decline, as both net income and equity fall. But net income, inarguably, would decrease more substantially than total equity.
Market ratios focus on market expectations associated with a stock, specifically as those expectations compare with reported earnings and equity.
- Book value per share = (Shareholders’ equity less preferred equity) ÷ Common shares outstanding. In the event of a big bath, book value per share will likely fall in response to a decline in shareholders’ equity (assuming the big bath results in a loss rather than income).
- Dividend yield = Dividend per share ÷ Share price. Dividend yield will likely be unaffected by big bath techniques. Given potentially unfavorable financial results combined with the ongoing economic uncertainty, however, most charged with corporate governance would likely argue against the payment of a cash dividend.
- Earnings per share (EPS) = Net earnings ÷ Common shares outstanding. EPS will likely decline as income declines, whereas shares outstanding will likely remain largely unchanged.
- Price-to-earnings (P/E) ratio = Share price ÷ EPS. In the case of a big bath, P/E ratio may be unpredictable. Although the denominator, EPS, will probably decline, the share price is influenced by many external factors, including the market’s expectations for the future. Assuming no significant changes in share price, the P/E ratio would increase amid a big bath; however, this ratio may prove more difficult to interpret.
Ensuring Earnings Quality
In order for financial statements to be relevant, useful, and reliable, they must exhibit a reasonable degree of earnings quality. A company’s earnings quality is generally understood to be the extent to which such earnings are accurate and serve as a reasonable basis for projecting future results (Jodi L. Gissel, Don Giacomino, Michael D. Akers, “Earnings Quality: It’s Time to Measure and Report,” Accounting Faculty Research and Publications,https://epublications.marquette.edu/account_fac/12/, 2005). Big bath accounting techniques pose a substantial threat to earnings quality. In addition, because big bath accounting normally records expenses now that would have been recorded later, the practice also compromises the earnings quality of future periods where expenses may be understated and net income may be overstated. For example, asset impairment tests rely on cash flow projections that are subjective and may be unusually unreliable due to lingering uncertainties. Under U.S. GAAP, impairments cannot be reversed in a later period, even if estimates or assumptions change (Deloitte, 2020). Armed with such knowledge, management might be especially inclined to use unrealistically conservative assumptions in order to generate large impairments now, thus reducing future impairments or cost allocations against earnings.
Will analytical procedures, including the use of financial metrics, be enough to detect big bath accounting? Not even close. But they may serve as a starting point and give users an indication of areas that merit further review and analysis. The following are some other suggestions:
- Consider how the company’s metrics compare with others in the industry.
- Determine how the company compares to the industry average or industry trend.
- Evaluate estimates, assumptions, and projections, and consider how they compare with other companies in the same area or industry. This is especially important in evaluating long-term asset impairments that generally rely on future cash flow projections (Deloitte, 2020).
It seems inevitable that recent financial reports will reflect the ongoing uncertainty and volatility in the markets. Although it may not be ideal, much of a company’s reported earnings are based on the discretion and professional judgment of management. If history is any indicator, during turbulent times, management is prone to write off more, not less, in an effort to prepare for better days in the future. There are no easy answers, and ethics will play a significant role in terms of what gets reported during periods affected by the global pandemic.