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Big bath is an accounting term that refers to the practice of a company making earnings seem less than they actually are in a particular year. By doing this in a year in which the company wasn't likely to meet earnings expectations anyway, the company can then inflate the earnings for the following year. To do this, the company takes on expenses, underreports earnings, and makes copious write-offs on income. Although big bath accounting can be achieved legitimately, it is often used as an attempt to mislead the public and investors about a company's actual financial situation.
It's somewhat counterintuitive to suppose that a company would ever want to present itself in anything but the best financial health to those outside the company. Yet there are cases when a company does just that, and that's when big bath accounting comes into play. By deferring income from one year to the next, it allows the company to appear as if it is recovering from a bad period or regaining its strength in the face of a downward trend.
There are several reasons why this kind of accounting practice might be undertaken. One of those might be the fact that the company has no chance of hitting its earning targets. In such a case, it might be advantageous for the company to take a big bath on that year, thereby increasing its chances of exceeding expectations in the next year. This can be particularly beneficial to company leaders who stand to receive big bonuses upon exceeding those expectations.
In the case of a regime change at a company, big bath accounting may come into play. A company's new CEO might want to pin the company's current struggles on the old boss. Piling on the losses in the year that the old CEO was in power would make it seem that the departed leadership was to blame for the financial struggles. It would also enhance the financial outlook for the first year that the new CEO was in power.
Determining where big bath accounting crosses the line from clever to fraudulent is a difficult task. Large, one-time expenses that are added to the books might be a sign that the company is exaggerating its losses for the year in question. While those charges could be legitimate, they would be even more suspicious if they appeared on the books of a company every other year, suggesting that the company was boosting earnings in the years between. For that reason, it's important to study the books of a company over a period of several years to get a better idea of whether the accounting is on the level.