‘WorldCon': The Death of EBITDA?

In the wake of several high-profile scandals, analysts are looking for a better way to measure corporate performance. They may not find one.


Despite the public and political uproar over ‘WorldCon’ (WorldCom’s restatement and other recent high-profile accounting scandals), the death of EBITDA has been greatly exaggerated.

Or at least, that’s the opinion of some accounting experts. While it’s true that the WorldCom accounting scandal — a $3.8 billion overstatement of EBITDA (earnings before interest, tax, depreciation, and amortization) — has many CFOs and Wall Street analysts rethinking the value of the EBITDA metric, it would be rash for finance chiefs to shun the measure completely.

For starters, EBITDA gives analysts an apples-to-apples comparison of apples-to-oranges companies. “EBITDA is a way for analysts to measure the results of operations excluding the effect of interest costs and corporate income taxes, as well as the effects of depreciation and amortization of long-term assets,” notes Edward Radetich, CPA and executive partner of regional accounting firm Heffler, Radetich & Saitta LLP, in Philadelphia. He adds that in effect, “EBITDA provides a way to compare operating income among companies.”

In practical terms, says Radetich, EBITDA is used to isolate operating numbers from long-term costs — for example, goodwill resulting from a flurry of acquisitions.

Perhaps more important, the key to using EBITDA as a valuation tool is not to use it alone. A holistic picture of a company’s health requires a close look at net income, as well as information derived from a company’s cash flow statement and the balance sheet.

And why should investors compare all three? Because even a free cash flow statement can mislead investors — if company executives are fooling with revenues. That appears to have been the case with Qwest and Global Crossing.

Interestingly, some analysts say they read the footnotes in financial statements first. They note that footnotes often provide the most information about what a company is doing — and how it is performing.

If that’s the case, then the SEC needs to do a better job of making sure corporate filers bring material financial information into plain view for everyone — not just for the initiated.

Case in point: In its 10-K filed with the Securities and Exchange Commission in March, WorldCom explains — in a footnote — that certain line costs associated with fees it paid to its MCI subsidiary are recorded as a credit “to depreciation expense.”

While the footnote does not right the wrong of hiding line costs among capital expenditures, it does show how costs-in-question can be camouflaged by publicly traded companies.

From an accounting perspective, “these seem like simple operating expenses,” says Mark Nelson, an accounting professor at Cornell’s Johnson Graduate School of Management. Nelson concedes that some of the costs may be leasing arrangements that could be viewed as an installment sale to WorldCom.

But even in that case, says Nelson, the lease would give rise to what is called a capital lease, in which WorldCom would have to recognize an asset and an offsetting liability for the present value of all future lease payments. So WorldCom’s apparent cost-fudging still doesn’t wash.

What’s surprising, asserts Nelson, “is that this sort of thing — that any reasonable internal or external audit should be designed to pick up — was missed.”

So how long has this sort of questionable accounting been going on at WorldCom?

Well, a look at the financial filings of WorldCom since 1999 seems to indicate an alarming trend. Credit analyst Carol Levenson, head of research at Gimme Credit Publications, went back through three years of WorldCom filings and found that the company’s line costs as a percentage of sales had not changed materially, while capital spending as a percentage of sales was dwindling (the result, she says, of huge capital spending cutbacks).

The takeaway here: WorldCom may have been tarting up line costs as capital spending for far longer than the five quarters its management has admitted to.

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