Explain whether an “earnings bath” has implications for the value of a firm’s stock options.

You are a junior accountant with Factional Ltd, a large, publicly-listed company operating in the high-tech sector. Factional Ltd has recently appointed a new chief Executive Officer (CEO), Mr Magnus Bouche, who is due to take up his appointment very shortly. Last night, at the invitation of a friend, you attended a prestigious charity function which, coincidentally, was also attended by Mr Bouche. At one point during the night, you found yourself standing quite close to (but unobserved by) Mr Bouche and overheard a part of his conversation with friends, including his comment that the first thing he intended to do as CEO of Factional Ltd was to “take a bath”.

You are not sure of what it means to “take a bath”, but the conspiratorial tone of the conversation and the fact that one of Mr Bouche’s friends responded to the comment by asking about the likely impact on Factional Ltd’s share price, while another laughed and said something (which you couldn’t quite hear) about Mr Bouche’s put options in Factional Ltd shares, have aroused your suspicions.

This morning, you spoke confidentially to your supervisor in the accounting department of Factional Ltd, Ms Betta Golightly, telling her about the overheard conversation and asking her whether she knew what it meant to “take a bath”. She replied that she had heard of the Big Bath Hypothesis and knew that it related to earnings management, but confessed that she didn’t know about any likely capital markets impacts. She then asked you to conduct some research and prepare a report for her, outlining the following:

  1. Possible motivations for an “earnings bath”
  2. How an “earnings bath” may be achieved

iii. Whether an “earnings bath” has implications for a firm’s share price

  1. Whether an “earnings bath” has implications for the value of a firm’s stock options.

Your report will provide the basis for Ms Golightly’s decision on whether the matter should be brought to the attention of Factional Ltd’s audit committee (a sub-committee of Factional Ltd’s board of directors).

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