Can 'Big Bath' and Earnings Smoothing Coexist as Equilibrium Financial Reporting Strategies?

Posted: 19 Feb 2002

See all articles by Michael Kirschenheiter

Michael Kirschenheiter

College of Business Administration University of Illinois at Chicago

Nahum D. Melumad

Columbia Business School - Accounting, Business Law & Taxation

Abstract

We study a model of financial reporting where investors infer the precision of reported earnings. Reporting a larger earnings surprise reduces the inferred earnings precision, dampening the impact on firm value of reporting higher earnings, and providing a natural demand for smoother earnings. We show that for sufficiently "bad" news, the manager under-reports earnings by the maximum, preferring to take a "big bath" in the current period in order to report higher future earnings. If the news is "good", the manager smoothes earnings, with the amount of smoothing depending on the level of cashflows observed. He either over-reports or partially under-reports for slightly good news, and gradually increases his under-reporting as the news gets better, until he is under-reporting the maximum amount for sufficiently good news. This result holds both when investors are "naive" and ignore management's ability to manipulate earnings, or "sophisticated" and correctly infer management's disclosure strategy.

Keywords: Earnings smoothing; Big bath; Reporting discretion and optimal credible reporting strategies

JEL Classification: M41, M43

Suggested Citation

Kirschenheiter, Michael and Melumad, Nahum D., Can 'Big Bath' and Earnings Smoothing Coexist as Equilibrium Financial Reporting Strategies?. Journal of Accounting Research, Vol. 40, June 2002, Available at SSRN: https://ssrn.com/abstract=300962

Michael Kirschenheiter (Contact Author)

College of Business Administration University of Illinois at Chicago ( email )

601 South Morgan Street
11th Floor
Chicago, IL 60607
United States
312.996-2284 (Phone)
312.996-4520 (Fax)

Nahum D. Melumad

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
611 Uris
New York, NY 10027
United States
212-854-2475 (Phone)

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