Increasing EBITDA – you’re doing it wrong

Part 1. Loose ends of accounting rules

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It’s been 25 years last summer – that I have been in the business of accounting, valuations and transaction services. A quarter of a century is really long! Over those years I have seen the ever increasing importance of EBITDA – the earnings figure which takes out depreciation and amortisation of the operating profit of a business.

It is a Holy Grail of valuations and deal making. Buyers quote in multiples of EBITDA and sellers know that to get what they want they need to show the right EBITDA. Managers know that in order to a get a bonus or keep their jobs in view of their venture capitalist investors review – they need to report EBITDA high enough so that those investors can show ever growing EBITDA based valuations.

For some of those investors it is no longer a business that matters, but EBITDA alone and they seem to even delegate responsibility for the reported EBITDA to finance department rather than to business and product development.

One single measure instead of all the complexity of enterprises, manufacturing, selling and market interactions. But Charles Goodhart rightly noticed many, many years ago, and even formulated it in the form of a law, a statement the simplified form of which goes: “WHEN A MEASURE BECOMES A TARGET – IT IS NO LONGER A GOOD MEASURE”.

The principle is simple – we notice something the reflects our reality the way we think is relevant (the measure). Then we set targets by saying what value that measure should have if the situation is to be considered healthy. And then… the measure starts living a life of its own – it is no longer impacted by the outside conditions that used to influence it when we noticed it. Now it is the product of the actions or inactions of people whose well being was made dependent on meeting the target.

So it happened to EBITDA as well. Every business wants it to grow. Even if the whole world around conspires to reduce it… Many managers do not allow the external environment to have an impact on the reported earnings. An when doing this – they often cross certain red lines.

In this article I describe some of the more common ways of manipulating EBITDA. This piece of text should not be treated as an accounting guide for desperate managers. It is more of a instructional cheat sheet for analysts and buyers to be able to know it when they see it.

1.?????? Acceleration of revenue

Especially with longer term contracts, the revenue recognition should progress with the fulfillment of the so called “performance obligations”. More often than we would like to see it however, companies recognise a disproportionate share of revenue early in the contract claiming (or more often silently assuming) that the majority of their performance obligations were fulfilled at the outset. Whether it? is true or not – is irrelevant (to them) or at best – subjective. Anyway – by accelerating the revenue recognition they accelerate profitability so the potential buyer may be left with “contract ends” which would be far less profitable than what was presented in the numbers during the due diligence.

Of course there may be cases when such a pace of revenue recognition is justified but my experience tells me that the internal debate: “I think our performance obligations are met early in the contract” usually only starts when the exit is on the horizon.

How to identify it? A proper due diligence should be enough. Analyse revenue recognition policies in detail, search of extra profitability on services which seem rather standard, ask for contract progress sheets.

2.?????? Capitalisation of expenses

This quite obviously is even required by accounting standards. But the magic phrase here is “when conditions are met”. And those conditions are pretty strict for the capitalisation of in-house development projects. This article is not about detailed discussions of accounting rules, but two major conditions here are: (1) technical feasibility of the outcome must be ensured, and (2) costs must be reliably measured.

The result is that costs may only be capitalised from a certain point in the life of many projects ie. from the moment we know the solution is technically possible and does not carry risks of doing more harm than benefit (as very often in case of medicines). Second point is the reliable measurement which means that a link between the expense and the development project must be documented, therefore saying something like: we capitalise 70% of salaries of our IT staff is unlikely to meet the condition.

What to look for? Well, any sort of capitalisation must draw attention – what is the policy, how are costs to be capitalised identified? And any retrospective adjustments there are also signs of manipulation ie. when a company retrospectively decides that more expenses should have been capitalised than actually were – it is a clear indicator of an attempt to make prior years (and consequently current year) EBITDA better in view of a sale.

And one more thing to be aware of: if a company has an aggressive policy of capitalisation, when the asset is finally ready to use – those capitalised costs would start to be amortised. And guess what? Amortisation is not part of EBITDA! So – capitalisation pays-off twice: whatever you manage to capitalise, will NEVER go through EBITDA.

3.?????? Capitalise all purchases of any sort of material

This is a variation of point 2 above. In the course of business we incur a lot of expenses which are operating in nature but relate the purchase of actual items with varying lives. Those entail laptops, tablets, phones, desk lamps, electric bulbs, scissors etc. So why don’t we consider everything we buy, that has some physical substance – a fixed asset? In the majority of cases we will prove its usability for more than 12 months (take the example of scissors – they will serve their purpose for years!), so they would easily qualify.

And then – because obviously we do not want the hassle of a fixed asset register, maintenance, stock take etc. – we will write them off immediately. In fact we will depreciate them at 100% rate. Where’s the magic? Well – this way all purchases of materials, which normally would be just part of opex, become depreciation – which… yes, you are right – is NOT included in EBITDA.

So beware when you see little or no costs of materials and depreciation charges which are unusually high compared to fixed asset purchases (indicating high depreciation rates).

4.?????? Government grants

Sometimes, especially in tech industry, companies enjoy a favourable government policies allowing them to apply for a wide range of grants related to purchases of assets or capitalisation of development costs. Once those assets are bought or developed, according to IAS 38, companies have an accounting policy choice of either reducing their purchase cost by the amount of the grant (and consequently their depreciation or amortisation) or to treat the grant as an item of deferred income on the liability side of the balance sheet (while showing the asset at its full cost) and write it off to profit and loss account gradually in line with the depreciation of the asset.

Some companies seem to forget however that the item is only an adjustment to the depreciation (a reduction of the depreciation resulting from the fact that the item of assets was not actually bought for its full cost – if was partly funded by the government) and have a notorious tendency to show it as an item of other operating income.

And then – when they calculate EBITDA – they adjust the operating profit by the full amount of depreciation (upwards) but “forget” to adjust it for the adjustment to that depreciation which would obviously make EBITDA lower.

Importantly – if EBITDA is to be an operating profit adjusted by key non-cash items – then definitely a write-off of government grant is one of them.

How to spot it? Again – a good DD should be enough – focus on large items in “Other operating” category – that is were it would be hiding.

5.?????? Leases

The change in the accounting for leases in 2018 was scary for most accountants. It was however much better received by CEOs, who quickly noticed that treating all leases as finance leases removes lease payments from operating expenses (where they reduced reported EBITDA) and transforms them into amortisation of the right of use (which we do not care about) and interest expense (which we care about even less).

But this is past. Or should be… Because you still have a number of similar contract that should be reported within EBITDA – those include: service contracts (of course), leases of small values or short term leases.

So if you see in the accounting policies of a target, that in the current or previous year they “reassessed certain contracts and decided that they met the definition of a lease contract” and by that they recognised a right of use asset and a liability – chances are the overall objective was to also release EBITDA of the burden of lease installments.

6.?????? Presentation of hedging instruments when hedge accounting is used

This might seem trivial and nor worth discussing but… even if you let it go – at least know that you did!

When entities hedge their operating transactions (revenues or expenses), they usually use derivatives. The valuation of those derivatives (in case of a currency risk hedges for instance) often goes to profit and loss account. Now – IAS 32 does not mandate any particular presentation of the hedging derivatives (or derivatives in general).

It would only be a common sense approach that effects of hedging revenues would adjust revenue line (and hedges related to expenses would adjust the opex). In fact – if the hedging strategy is appropriate (and this is a pre-condition for applying hedge accounting in the first place) – what companies achieve is – the revenues or expenses are presented in P&L account in the exact amounts that they wanted to hedge. So presenting them net of hedging makes a lot of sense.

However presenting the fair valuation of hedging instruments in financing section of the profit and loss account – takes them out of EBITDA which may be beneficial if their impact is negative. So – another item to monitor and know about – where are they really presented?

7.?????? Loss of control over a subsidiary

When a company looses control over a subsidiary, it recognises a profit or loss on the part disposed of and restates the retained interest to fair value through profit and loss.

Those items are usually shown separately or aggregated in “Other operating” but the question remains: should such items be part of EBITDA? Though there is no definite answer to this (EBITDA is the so called “non-gaap measure” ie. it is not defined in the accounting standards, so what is in or out must be derived from the abbreviation itself or, if not possible, from definitions adopted by parties to the contract), one thing is certain – even if included in EBITDA, remember – this is a non-recurring item, so should be eliminated from the application of any multiples since it is highly unlikely that the Group under review would have some subsidiaries for sale each year.

So those were the key tricky elements of calculating EBITDA. In this part of the article I only described those where the potential manipulation would still fall under the label of "aggresive accounting policies" but not yet "a fraud". In the following part - I will describe the other category.