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The ethics of manipulating ROI and residual income big bath

Manipulating return on investment and residual income

The October 5, 1998, issue of Business Week includes the article "Who Can You Trust?" authored by Sarah Bartlett. Among other dubious accounting practices, the article describes a trick known as the "big bath," which occurs when a company makes huge unwarranted asset write-offs that drastically overstate expenses. Outside auditors (CPAs) permit companies to engage in the practice because the assets being written off are of questionable value. Because the true value of the assets cannot be validated, auditors have little recourse but to accept the valuations suggested by management. Recent examples of questionable write offs include Motorola's $1.8 billion restructuring charge and the multi-billion dollar write-offs "in-process" research taken by high-tech companies such as Compaq Computer Corp. and WorldCom, Inc.

Required

a. Why would managers want their companies to take a big bath? (Hint: Consider how a big bath affects return on investment and residual income in the years following the write-off.)

b. Annual reports are financial reports issued to the public. The reports are the responsibility of auditors who are CPAs who operate under the ethical standards promulgated by the American Institute of Certified Public Accountants. As a result, attempts to manipulate annual report data are not restricted by the Institute of Management Accountants Standards of Ethical Conduct (http://www.ima-pdx.org/ethics.htm). Do you agree or disagree with this conclusion? Explain your position.

Solution Preview

a. Why would managers want their companies to take a big bath? (Hint: Consider how a big bath affects return on investment and residual income in the years following the write-off.)

If a company is going to have a bad year, it is better to get all the bad news into one year rather than have a little bit of bad news in several years in a row. The market can forgive one problem year but if you have a problem every year for years in a row, they will cease to stick with you and your cost of capital will skyrocket. You are no longer a consistent performer with just one bad break; you are poorly managed and seem to have issue after issue. Think about a report card in school. You can have one F and four A's and the parent will probably let it go, especially if you have A's for the next three years, right? What about bringing home three Cs every semester. That's a bit different, isn't it? If you can get all the write-downs in one year, and ...

Solution Summary

Your tutorial is 439 words plus a reference. The discussion explains why the big bath is an attractive technique and then explains how the IMA Code of Ethics does not permit the taking of a "big bath" ethically. The response includes a four-year profit trend line to show the difference between consistent earnings and a "big bath."

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