Big Baths and Earnings Manipulation

Abstract

Financial statement manipulation to increase net income often also increases net operating assets (NOA) and when NOA reach larger-than-normal levels future manipulation is constrained (Barton and Simko, 2002). We investigate a strategy available to manipulating firms when NOA grow conspicuously large: a "big bath" where a significant portion of NOA are written off. This has the effect of significantly decreasing net income in the bath year, generating accounting losses and significantly negative abnormal returns. But by reducing NOA a firm with prior history of manipulation can continue manipulating net income future years. This allows the firm to resume the "manipulation life cycle" proposed by Kim and Oler (2024).

Keywords: Big Bath, Financial Statement Manipulation

JEL Classification: M41