Peeling away financial reporting issues one layer at a time

The EBITDA Epidemic Takes Its Cue from Standard Setters

On October 4th, Jon Weil published “An Accounting Lesson for Twitter.”  Here’s how it starts:

Whether he prevails at his insider-trading trial or winds up paying a fine to the Securities and Exchange Commission, Mark Cuban, owner of the Dallas Mavericks, performed a mitzvah during his testimony this week when he plainly described to the jury what “Ebitda” is.

“It’s a term companies use when they want to make it seem like they’re doing better than they are,” he said of the oft-cited financial metric, which stands for earnings before interest, taxes, depreciation and amortization. Nice timing, too. Cuban said it right before Twitter Inc. filed the registration statement for its initial public offering.

To the best of my limited understanding, the SEC has accused Mr. Cuban, the multi-billionaire owner of the Dallas Mavericks, of avoiding the loss of a few hundred thousand dollars by selling stock before the company, in which he owned 6.3% of the outstanding shares, announced material negative information to the public.

The outcome of this case may hinge on whether the SEC can prove that Cuban knew that he was provided with confidential information; but whether he is technically guilty or not, some of the reports I have read indicate that Mr. Cuban allegedly capitalized on his access to nonpublic information to trade against innocent investors.  I’d love to know if some of those investors (direct or indirect, e.g., a pension plan) are Dallas Mavericks fans.    (Full disclosure — I’m a Phoenix Suns fan.)

But, I digress.  What I really want to discuss is the use of Ebitda, which brings me to Jon’s concluding paragraph:

I have never understood why companies believe it’s a good idea to do this. Highlighting pretend earnings figures shouldn’t add a dime to the company’s market value. Sophisticated investors see right through the nonsense. Unsophisticated investors probably won’t read the financials anyway. Nobody is deciding to buy Twitter’s stock because of its recent bottom line. They will buy it because Twitter is a global phenomenon with great potential. [italics supplied]

Jon, Jon, Jon.  Surely you realize that all measures of earnings are “pretend,” don’t you?  The “income statement” is the classic example of false advertising by accounting standard setters.  What we actually produce is a “statement of recognized revenues, expenses, gains and losses” – nothing more and nothing less.  Rarely does it come anywhere near to measuring “income,” as any self-respecting economist would regard that term.

My point is that Ebitda-like numbers and reported earnings are different sides of the same coin.  For reported earnings, standard setters decide what is left out, and for Ebitda, issuers are just picking up at a point where the standard setters left off.

Also, just like Ebitda, many of the things that are being left off net income by the standard setters are as equally obvious and transparent. Here’s just a quick-and-dirty list of the items that are reported as “other comprehensive income” instead of “net income”:

The effect on equity of “translating” (another false advertisement) financial statements of foreign operations to the reporting currency.

Unrealized holding gains and losses on marketable securities (i.e., assets just as good as cash) classified by management as “available for sale.”

Gains and losses (both realized and unrealized) on derivatives designated as “cash flow” hedges.

Certain components of pension expense.

I should also point out that the IASB’s list of OCI items is longer than the FASB’s, and the permitted machinations between OCI and net income is much more, shall we say, liberal.  Yet, the IASB chair has announced that his organization will soon publish a discussion paper setting forth its views on the measurement and use of OCI.  Good luck to them, I say, because these disparate things that are classified as OCI have only thing in common: they were inserted into the rules at the behest of managers – most definitely not investors – to help them make their bonuses more predictable.

To paraphrase Mr. Cuban, OCI is “…a term companies use when they want to make it seem like they’re doing better than they are.”  The justifications that managers conjure up to exclude, say, depreciation and amortization from the “non-GAAP” measure of “earnings” they want to showcase is not any better or any worse than the standard setters’  reasoning that went into any of the items in OCI.

The only distinction to be made between net income and Ebitda-like measures is that the former involves creative application of uniform rules. (I wonder if Emerson was thinking of accounting standard setters when he wrote, “A foolish consistency is the hobgoblin of little minds”?)  The latter is merely unbridled creativity – subject to finding a justification that will pass muster with an understaffed SEC.

4 Comments

  1. Reply Johnny October 14, 2013

    We call OCI “the third way.”

  2. Reply Joel Ungar October 14, 2013

    That Jon Weil called it a mitzvah qualifies the event as a machiyah. But I digress.

    Have never liked EBITDA. Don’t understand the thought that the cost of using up your long-term assets isn’t relevant.

    • Reply Tom Selling October 14, 2013

      He lives in NYC. Everybody there knows what a mitzvah is — more or less. 🙂

  3. Reply Tony Frank November 25, 2013

    The accountants, banksters and analysts game the system for their own personal interest.

Leave a Comment