Accountants have a theory which they call the big bath, not the hot shower. Naturally, it has nothing to do with water, bathing or the size of the bathtub. Big in this context means ‘exaggerated’ and bath means losses. It isn’t even a theory, it’s a practice. The big bath theory then is the practice of exaggerating losses. Some accountants even call it the ‘big bath accounting behaviour’. The behaviour that some accountants have, in certain circumstances, of exaggerating losses. Others reject behaviour and give it initials BBEM: Big Bath Earnings Management. The choice of such a name reflects a tendency to drown the true meaning in the bath water.
Management and their accountants seem to prefer big losses followed by big profits instead of average profits over the same period. Research suggests that new CEOs wipe the slate clean in their first year, perhaps with the water from the bath, with exaggerated adjustments such as goodwill impairment to enable better earnings in the future. An inaugural big bath. Covid was another trigger to exaggerate losses for some companies. A crisis big bath. Research also suggests that exaggerated adjustments arise when the IFRS change their accounting standards and management takes a regulatory big bath, or when a major reorganisation occurs: a restructuring big bath.
Auditors generally follow management into the bath, blaming uncertainty. They find it difficult to increase earnings against management’s wishes keeping their role as the bath attendant. They never, though, allow management to record too much profit, insisting they siphon bathwater out to the correct level taking the role of the plumber.
The baths however may become shallower with new detection models, using artificial intelligence and NLP: Natural Language Processing, to detect exaggerated write-offs. Accountants may have to change its name to Foot Bath Theory in a few years.