Big Bath Earnings Management: The Case Of Goodwill Impairment Under SFAS No. 142

Abstract

<p class="MsoBodyText2" style="text-align: justify; margin: 0in 0.5in 0pt;"><span style="font-style: normal; mso-bidi-font-style: italic;"><span style="font-size: x-small;"><span style="font-family: Times New Roman;">The big bath theory of earnings management suggests that firms experiencing low earnings in a given year may take discretionary write downs to reduce even further the current period’s earnings.<span style="mso-spacerun: yes;">  </span>The notion is that the company and its management will not be punished proportionately more for the big hit it takes to its already depressed earnings.<span style="mso-spacerun: yes;">  </span>This “clearing of the decks” makes it easier to generate higher profits in later years.<span style="mso-spacerun: yes;">  </span>SFAS No. 142, with its new requirement to test goodwill annually for impairment, provided a unique opportunity to test this big bath theory.<span style="mso-spacerun: yes;">  </span>Examining Fortune 100 companies, this study presents compelling evidence that the big bath theory is more than just a theory but is instead a practiced method of managing earnings.</span></span></span></p>