Big Bath Defined
In the accounting context, a big bath is defined by a company's management team that consciously manipulates the income statement such that the poor results look worse in order to make the future results appear better. Such manipulations are carried out in a relatively bad year so that the following year's earnings look better in an artificial manner.
Understanding Big Bath
A big bath accounting technique results in a big rise in the apparent future earnings, which results in a larger bonus for executives. The incentive encourages the management to pursue big bath accounting maneuver. For example, a newly appointed CEO of a firm would use the big bath so that he can blame the previous CEO for poor performance and show that his work has increased the company's performance in the following year.
A big bath is not illegal because it can be done within the accounting rules, but it is unethical. Reporting adverse earnings by a company can cause significant depreciation in stock earnings. Later, when the earnings see a positive growth due to the big bath, the stock price can recover and trade at even higher prices than that could have happened without manipulation.
How Does it Work at Banks?
Banks usually face a rise in delinquency and default rates on loans when the economy falls into recession state, and the unemployment increases. In such situations, banks anticipate losses, write-off loans beforehand, and create a loan loss reserve. The bank may create a big bath and stay liberal about the loan losses as its earnings are hurt by the economy. When the economy recovers, the banks receive loan repayments on time. Then, the banks reverse the losses from the loans and boost earnings in the upcoming quarters.
