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The Challenge with EBITDA

Sept. 25, 2018

Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) is a common metric used by companies to measure performance. It starts with net income and adds back interest, income taxes, depreciation, and amortization. For non-public businesses, it is often used for internal reporting and investment decisions, covenants with banks or investors, and employee compensation arrangements. Investors and lenders also frequently use it in establishing covenants and making investment decisions.

The advantage of EBTIDA compared to net income is that the metric allows investment decisions and evaluations to be made while excluding the effects of financing and certain significant accounting decisions. Some also use it as an approximation of operating cash flows. The challenge with EBTIDA is that the effect of upcoming accounting standards may make comparisons to prior periods difficult and could cause covenants and performance metrics to move to compliance or noncompliance. Three of the largest impacts may be in changes to the accounting for revenue recognition, leases, and cloud computing arrangements.

Revenue Recognition

The new revenue recognition guidance in ASC Topic 606, Revenue from Contracts with Customers (ASC Topic 606) can cause changes to the timing of revenue and expense recognition. The guidance is required to be adopted for non-public entities for annual periods beginning after Dec. 15, 2018 (calendar year end 2019).

One example where changes upon adoption of ASC Topic 606 may cause a change in EBITDA is the potential acceleration of revenue for construction contractors when performance bonuses are contained in their contracts. If a construction contractor has a two-year contract that contains a bonus if safety metrics are met at the end of the project, under prior guidance the bonus would have been recognized at the end of the two-year project. Under ASC Topic 606, the contractor may conclude that the estimated amount of the performance bonus (variable consideration) he or she will be entitled to at the end of the project should be recognized, and pull forward recognition of a portion of that bonus to year one of the contract. All other things being equal, the effect would be to increase net income and EBITDA in the first year and decrease it in the second year.

Also changing is guidance around certain costs associated with contracts with customers, such as commission expense. In some cases, commissions will now be capitalized on the balance sheet as an asset and amortized over the term of the contract with the customer, or even longer. The effect of the change could impact various common covenant measures such as working capital and other asset-based measures, but in particular, it would cause deferrals of expenses, increasing EBITDA in earlier periods when commission expense is increasing relative to the prior guidance.

Lease Accounting

The headline news on changes coming upon adoption of ASC Topic 842, Leases (ASC Topic 842) is that operating leases will be put on the balance sheet, but can ASC Topic 842 impact the measurement of EBTIDA?

In some instances it could impact EBITDA, because it eliminates the bright line classification guidance to distinguish between the two types of leases. For a lessee, a finance lease would result in the recognition of interest expense (similar to a capital lease under prior guidance), while an operating lease would result in lease expense. Changes in lease classification or the structure of leases (now that all leases will be required to be presented on the balance sheet) could have a significant impact on EBTIDA. Other changes, such as the accounting for initial costs and the allocation decision between lease and non-lease components could have long-term ramifications for EBTIDA.

The new guidance on lease accounting is effective for annual periods beginning after Dec. 15, 2019 for non-public business entities (calendar year end 2020).

Cloud Computing

A recent addition to new accounting standards, ASU 2018-15 Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract (ASU 2018-15), may also have implications for EBTIDA metrics. ASU 2018-15 requires that certain implementation costs related to obtaining cloud computing services will be capitalized beginning in 2021 for non-public business entities.

Historically, companies have expensed the implementation costs when incurred, resulting in a direct decrease to EBITDA in the year of adoption. Due to the potential size of the impact, some companies would pre-negotiate an adjustment to their covenant compliance when they planned on having large implementation costs incurred in a particular year.

Under the new guidance the implementation costs are deferred and amortized, resulting in a spreading out of the expense over multiple years. An additional complication is the amortization is to be recognized in the same line item as the service fee for the cloud computing arrangement. The presentation requirement may mean that the amortization of the capitalized implementation cost may not qualify as amortization for computations of EBTIDA. This is similar to how an operating lease involves the reduction of a lease asset and lease liability, which is then treated as a lease cost and not amortization and interest expense. Companies will need to review existing covenant calculation and definitions to determine the appropriate treatment of the amortization when using EBITDA as a metric.

Planning for Changes

When EBITDA is used as a metric for purposes of performance measurement or compliance with covenants, the upcoming changes in accounting standards may have a significant impact on the trend rate for performance or whether a covenant is met. Management teams that assess the impact of the accounting change before adoption will be able to adjust the metrics to appropriately consider the effect of the accounting change, negotiate covenants before a compliance issue arises, and avoid potentially costly disputes over how the new accounting standards should affect performance pay and covenant compliance.

Investors and lenders may also find it helpful to plan ahead for the changes that may impact EBITDA as the analysis of compliance or assessment of investment decisions. In some cases, it may be worthwhile to consider using operating cash flows as an additional metric to track performance and aid in decision making.

Ultimately, the challenge with EBITDA is the same as the challenge with all non-cash financial measures: significant changes to the classification and measurements within financial statements prepared under U.S. generally accepted account principles (U.S. GAAP) are soon to be adopted, and those that do not prepare may be caught flat footed.

For more information about how revenue recognition, leasing, and cloud computing could affect EBITDA, please contact Mark Winiarski of MHM's Professional Standards Group. Mark can be reached at mwiniarski@cbiz.com.

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