Manipulating return on investment and residual income

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.

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