Libya and studied accounting hoax

Big bath accounting is accepted as a fact of life by most analysts. But what is it and how should it be treated?
Well travelled readers may be familiar with the ancient city of Leptis Magna (pronounced Lepcis Magna). It was located on the Mediterranean Sea near the modern Libyan city of Al Khums. Associated with the Roman empire for more than 600 years, Leptis Magna housed huge and elaborate Roman-style baths, the remains of which can still be viewed today. But, in this article, we'll be focusing on a different type of elaborate 'big bath'?a financial one.

www.investopedia.com explains the concept of a financial big bath nicely: 'The strategy of manipulating a company's income statement to make poor results look even worse. The big bath is often implemented in a bad year to enhance, artificially, next year's earnings. The big rise in earnings might result in a larger bonus for executives. New CEOs sometimes use the big bath so they can blame the company's poor performance on the previous CEO and take credit for the next year's improvements.'

Good summary

That's a pretty good summary of a practice that's been going on for decades. In the 1934 edition of Security Analysis, Ben Graham wrote: 'An examination of the wholesale charges made against surplus in 1932 by American Machine and Metals? suggests the possibility that excessive provision for losses may have been made in that year with the intention of benefiting future income accounts.'

Take a trip across the Pacific Ocean and fast forward 71 years to the 2003 financial accounts of AMP. In that year the financial services giant recorded a loss of more than $5.5bn. Buried in the footnotes of that gigantic sea of red ink (footnote 2 relating to note 5 to the accounts on page 35 of the full financial report) was the following disclosure: 'Operating expenses in 2003 includes (sic) $558m of restructuring and demerger costs. The costs comprise $197m of Staff and related expenses, $74m Information and communication, $112m Professional fees, $146m Occupancy and property maintenance, Advertising and marketing $21m and $8m Other operating expenses.'

That poorly-worded footnote begs the Goldilocks question; was $558m too much, too little or just the right amount to provision for these 'restructuring and demerger costs'?. It's a question that can't be answered definitively and, in a sense, it doesn't matter in any case.