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It has become common practice for U.S companies to thumb their nose at accounting standards in their earnings reports. While GAAP—generally accepted accounting principles—earnings are required to be presented in quarterly reports, many firms now highlight non-GAAP figures such as EBITDA (earnings before interest, taxes, depreciation and amortization) as a better measure of results than net income. Some companies push the envelope even further, by supplanting EBITDA with an even looser calculation called “adjusted EBITDA.”
Practitioners of business valuation often tout EBITDA as a legitimate measure of a company’s earnings power that is useful when making an apples-to-apples comparison between companies. They argue items like interest, taxes and depreciation are figures that vary widely across companies and can distort GAAP net-income figures between companies in similar businesses. In addition, EBITDA is commonly used in Wall Street analyst reports and in private-equity acquisition valuations.
The fallacy with their argument is that interest, taxes and depreciation/amortization are real costs. The investor who ignores them is relying on a fantasy earnings figure. Ideally, a company will present EBIT (earnings before interest and taxes)—its revenue minus operating expenses, often called “operating earnings”—followed by line-item deductions for interest and taxes to arrive at net income.
But companies really go off the rails when they imply investors should ignore the expense inherent in depreciation (and amortization) figures. Managements that portray EBITDA figures as cash flow are misleading investors. In many businesses, depreciation is roughly equivalent to the capital expenditures a business must make on an ongoing basis just to maintain its operations. Capex is a real and recurring expense.
Worse, companies presenting adjusted EBITDA suggest that investors should disregard a litany of additional costs such as stock-based compensation, restructuring charges, impairment charges, litigation costs and other charges when appraising their results.
Last May, the Securities and Exchange Commission mandated new reporting guidelines in an attempt to slow the proliferation of non-GAAP numbers. A full 90 percent of S&P 500 companies reported non-GAAP numbers in 2015, up from about 70 percent in 2009. Non-GAAP earnings per share were higher than GAAP EPS by an average of 25 percent in 2015.
The fourth edition of Howard Schilit’s book “Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports” provides an array of maneuvers companies might use to overstate performance. Schilit demonstrates how companies might shift expenses to a later period; record revenue too soon; or inflate revenue, earnings and cash flow.
One method we use to uncover changes in company reporting is called a “Delta Report.” Software available through financial-data service providers allows comparisons across reporting periods and highlights changes in the accounting language and in the way results are presented over time.
It will be interesting to see if companies change their earnings methodology once the lower tax rates of the Tax Cuts and Jobs Act take effect. With corporate tax rates falling from 35 percent to 21 percent, GAAP earnings should show meaningful year-over-year gains. It would not be surprising to see managements revert toward GAAP accounting to spotlight this boost to earnings.
What investors want from corporate management is candid reporting, not deception. Results in business are always going to be uneven. Managers who emphasize GAAP accounting should be applauded.•
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 317-818-7827 or ken@aldebarancapital.com.
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