Hidden in the Woodshed: Big Bath Herding

• In Event: Earnings Management - II

Abstract

We investigate, both theoretically and empirically, whether the “big bath” strategy can arise as an optimal response to peer firms' disclosures following a negative shock with heterogeneous effects on firms in the economy. We demonstrate the existence of the “big bath herding” equilibrium strategy: after the firms most affected by the shock (Leaders) disclose bad news, it becomes optimal for their less affected peers (Followers) to also report bad news. Notably, Followers not only strategically time the release of bad news; they also undertake a “big bath” by reporting excessive amounts of bad news. We empirically test our model on the two major recessions of 2001 and 2008. Consistent with the “big bath herding” strategy, Followers demonstrate superior future performance as measured by accrual accounting earnings, but not by cash flows. In addition, Followers are more likely than Leaders to meet/beat analyst forecasts in the two-year period after their write-offs. Finally, our comprehensive hand-collected data shows that Followers reverse their restructuring charges more often than Leaders during the two years following write-offs.

Authors

• Natalya V. Khimich, Drexel University

• Tatiana Fedyk, University of San Francisco