More Onerous Accounting Games

Paul N. Jaber, Jr., CFA
Dec 15, 2003

Though I think the abuse of stock options is most galling, here are two more accounting conventions that raise the hair on the back of my neck.

EBITDA – or I just want to Exclude all Expenses from my Definition of my Company’ s Free Cash Flow Calculation, OK

In addition to the rampant abuse of options, the use of earnings before taxes, depreciation and amortization (EBITDA) as a gauge for FCF really irks me.  Until Wall Street stops using EBITDA to value stocks and confuse investors, the equity markets will be a dangerous and non-shareholder friendly place to invest.

Recently I have noticed many companies, with technology companies again leading the way, bringing back EBITDA on press releases as a way to measure results.  It is particularly unnerving because the use of EBITDA, as a measure of free cash flow totally ignores the strength or weakness (in most cases weakness) of a company’s balance sheet.  The beloved EBITDA excludes interest expense because supporters argue that it is not a measure of the ongoing business profitability.  I reject such arguments completely.  How a business funds itself is completely a fair measure of the strength of the business.  Most of the silly dot com companies of the late 1990’s only existed because they had unlimited access to the capital markets, once their funding sources dried up, they began to run out of money and go out of business.

The second glaring problem with EBITDA results is that they exclude ongoing capital expenditures, and to make matters worse they actually include an adjustment for depreciation and amortization expense.  To this day no one has told me how excluding ongoing capital expenditures (to maintain current business levels) is not important to a company’s operations.

The bottom line on EBITDA, if you read or hear a company touting EBITDA results, run for the hills.  There is no reason any responsible management team would bring up such a useless financial measure other than to confuse and deceive investors.

Pro Forma – How to Manipulate Results to Make them Stronger

Just like EBITDA, pro forma results are generally meaningless.  Companies release pro forma income statements in conjunction with generally accepted accounting principle (GAAP) income statements in an effort to show investors what results would have been if a number of things did not happen or were excluded from results.  Whereas EBITDA adds real expenses back to earnings, pro forma results generally exclude certain expenses or so-called one-time charges.  Only problem is that often the one-time charges repeat year after year.

Pro forma earnings releases came about in an effort to normalize results for investors. Management figured a little handholding could go a long way.  At PV I don’t need handholding, I need honest management teams.  Pointblank, the use of pro forma results is nonsense.

Just like in January 2000, use of pro forma results are on the rise again today.  Technology companies are once again by far the biggest abusers of pro forma, but all industries can be guilty.  My advice is to avoid companies that use pro forma reporting – they don’t want you to know the truth.

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