Big Bath Accounting Fraud

By Ye Cheng Yuan, on December 11, 2008

One of the hardest accounting frauds to spot is big bath accounting. When a company is doing really bad and has no chance of meeting earning expectations, unscrupulous management would begin writing-off every expense and asset they could imagine. As a result, future expenses are reduced significantly and naturally earnings increase. In other words, the company is taking a big bath in the worst year so it can wipe its slate clean. This almost always guarantees record-breaking earnings in subsequent years, likewise performance bonuses.

Photo by arboresce via flickr

The reasoning behind taking a big bath is quite simple: We already look bad, so let’s make ourselves look as bad as we can. Needless to say, management wouldn’t take the blame for the fall. They would either blame it on previous management or the challenging economic conditions. The sweet-talking CEO never fails to wrap up with a personal assurance that the company is well poised to seize the opportunities when the market returns to more favorable conditions. (Learn how to distill management communication by reading Value Investing – Evaluating Management.)

The Usual Write-down / Write-off Suspects

In a big bath, management would write-down substantial assets, that don’t occur under normal operating conditions, in order to maximize future benefits. So, pay close attention to special one-time charges. Sale of discontinued operations, accelerated depreciation of inventory, plant and equipment, write-off of an investment gone south and restructuring charges are some of the most common one-time charges.

At one end of the spectrum, recording reasonable one-time charges before the end of the year for tax benefits is legal and could benefit shareholders. This is akin to investors selling our losers at the end of the year to lock in the tax benefits to offset profits next year. At the other end of the spectrum, writing off everything you can imagine with the goal of locking in huge performance bonuses in subsequent years is just plain evil.

In 2001, Cisco wrote off more than $2 billion in inventory even though some of the inventory was not worthless and would be sold in the future, thus resulting in pure profits from these future sales. [1]

Sniffing Out Accounting Smell

Because one-time charges could very well be valid, sniffing out the smell of big bath accounting is not easy. One thing to look out for is the frequency of big baths. If one-time charges begin to show up every other year, this becomes a worrisome pattern. It is, therefore, crucial for an investor to not just look at the current year financial reports. The company may have taken a big bath two years ago and is still basking in the glory attributed to their “turnaround” of the century.

Another thing to look for is when does the company typically incur one-time charges. Taking big baths during trough cycles in the industry or during economic recessions is hardly a coincidence. How convenient it is for management to only realize they had made huge, dumb mistakes during recessions? And yet, they are smart enough to earn huge bonuses when the tide rises.

There Is No Silver Bullet

Unfortunately, apart from spotting patterns of one-time charges, without adequate disclosure voluntarily offered by management, there is no sure way to determine whether or not management has taken a big bath. Sometimes, you can find more disclosures about these one-time charges in financial footnotes. (Be sure to check out my article Read Financial Footnotes, Invest Safely to learn how to decipher footnotes.)

Investors should focus on the management transparency. Is management open about what make up the one-time charges and how they can be justified? The Q & A session during earning calls could sometimes shed some light on management’s honesty.

The moral here is to take reported earnings with a grain of salt. If earnings seem to meet analyst expectations every quarter, it may just be too good to be true. Many respected money managers recommend investors to pay more attention to cash flow because this number is harder to manipulate. After all, cash flow is the basis for determining the intrinsic value of a business. To learn how Seth Klarman values a business, check out Valuing a Business – Seth Klarman’s 3 Methods.

References

[1] Pamela J. Black, Mind The GAAP, Registered Rep., September 1, 2002.

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Ye Cheng Yuan is a Principal of Qovax. Qovax is a small web development company based in sunny California. We build thoughtful web-based applications and beautiful websites. Learn more about how to invest safely at my Safe Investing Blog.

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