Big Bath Accounting Following Natural Disasters

Abstract

Practitioners and academics widely suspect that managers engage in “big bath” reporting behavior as a form of earnings management, but conclusive evidence of this behavior has been difficult to document due to the inherently endogenous nature of reporting the large nonrecurring charges necessary to engage in a big bath. We introduce a novel dataset of natural disasters to address this problem and argue that natural disasters provide an ideal exogenous shock to examine big baths. Consistent with opportunistic reporting, we find that, relative to both matched firms unaffected by a natural disaster and matched firms affected by the same natural disaster that do not report large, negative special items, big bath firms experience greater improvements in post-disaster earnings for multiple years and higher future stock returns. We also find that CEOs of bath firms receive relatively larger increases in bonus and cash compensation in the years following the natural disaster. Overall, our evidence suggests that managers take advantage of the occurrence of natural disasters by engaging in opportunistic big bath reporting behavior.

Keywords: Natural disasters, big bath accounting, earnings management

JEL Classification: M41, G32