SMALL PROFITS AND BIG BATHS
Certainly, financial statement analysts do not have to fight the battle singlehandedly. The Securities and Exchange Commission and the Financial Accounting Standards Board prohibit corporations from going too far in prettifying their profits to pump up their share prices.
These regulators refrain from indicating exactly how far is too far, however. Inevitably, corporations hold diverse opinions on matters such as the extent to which they must divulge bad news that might harm their stock market valuations. For some, the standard of disclosure appears to be that if nobody happens to ask about a specific event, then declining to volunteer the information does not constitute a lie.The picture is not quite that bleak in every case, but the bleakness extends pretty far. A research team led by Harvard economist Richard Zeck- hauser has compiled evidence that lack of perfect candor is widespread.16 Zeckhauser et al. focus on instances in which a corporation reports quarterly earnings that are only slightly higher or slightly lower than its earnings in the corresponding quarter of the preceding year.
Suppose that corporate financial reporting followed the accountants’ idealized objective of depicting performance accurately. By the laws of probability, corporations’ quarterly reports would include about as many cases of earnings that barely exceed year-earlier results as cases of earnings that fall just shy of year-earlier profits. Instead, Zeckhauser et al. find that corporations post small increases far more frequently than they post small declines. The strong implication is that when companies are in danger of showing slightly negative earnings comparisons, they locate enough discretionary items to squeeze out marginally improved results.
On the other hand, suppose a corporation suffers a quarterly profit decline too large to erase through discretionary items.
Such circumstances create an incentive to “take a big bath” by maximizing the reported setback. The reasoning is that investors will not be much more disturbed by a 30% drop in earnings than by a 20% drop. Therefore, management may find it expedient to accelerate certain future expenses into the current quarter, thereby ensuring positive reported earnings in the following period. It may also be a convenient time to recognize long-run losses in the value of assets such as outmoded production facilities and goodwill created in unsuccessful acquisitions of the past. In fact, the corporation may take a larger write-off on those assets than the principle of accurate representation would dictate. Reversals of the excess write-offs offer an artificial means of stabilizing reported earnings in subsequent periods.Zeckhauser and his associates corroborate the big bath hypothesis by showing that large earnings declines are more common than large increases. By implication, managers do not passively record the combined results of their own skill and business factors beyond their control, but intervene in the calculation of earnings by exploiting the latitude in accounting rules. The researchers’ overall impression is that corporations regard financial reporting as a technique for propping up stock prices, rather than a means of disseminating objective information.17
If corporations’ gambits escape detection by investors and lenders, the rewards can be vast. For example, an interest-cost savings of one-half of a percentage point on $1 billion of borrowings equates to $5 million (pretax) per year. If the corporation is in a 34% tax bracket and its stock trades at 15 times earnings, the payoff for risk-concealing financial statements is $49.5 million in the cumulative value of its shares.
Among the popular methods for pursuing such opportunities for wealth enhancement, aside from the big bath technique studied by Zeckhauser, are:
■ Maximizing growth expectations.
■ Downplaying contingencies.