Creative Accounting and Deceptive Practices
Over the past decade companies, investment banking advisors, accountants and other consultants have all contributed to distorting the traditional accounting concept of cash flow most commonly referred to as Earnings Before Depreciation and Amortization or EBITDA by adding back adjustments.
EBITDA is a standard measure used for company valuation and thus stock value as well as for bank covenants in loan agreements. While selected adjustments can be justified, many of those being made in recent years have been used simply to deceive investors and creditors leading to higher stock valuations and in my view fraudulent accounting or just outright fraud.
Companies argue that these non-GAAP adjustments are important as they help to provide a clearer picture of a company’s underlying cash flow by removing extraordinary events. However, if these events are recurring for at least several quarters then I believe the adjustments are deceptive to investors. The latest adjustment likely to become more prevalent will be the use of EBITDAC or EBITDA excluding Corona virus impacts. As we are unaware of the full impact and duration of COVID-19, I do not believe it’s prudent for a company to add back all the expenses related to Covid such as business disruption, layoffs, furloughs, etc., especially if the business impact will be over several quarters. Regulators and investors need to be especially vigilant in analyzing company’s quarterly earning and financial reports in these unprecedented times.