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

Abstract

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.  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.  This “clearing of the decks” makes it easier to generate higher profits in later years.  SFAS No. 142, with its new requirement to test goodwill annually for impairment, provided a unique opportunity to test this big bath theory.  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.