Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is a common metric used by private equity fund managers to value investments made in portfolio companies. The advantage of EBITDA 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 EBITDA is that the effect of upcoming accounting standards may make comparisons to prior periods difficult and could cause valuation and performance metrics to move in an unexpected manner. Three of the largest impacts may be in changes to the accounting for revenue recognition, leases, and cloud computing arrangements.
The new revenue recognition guidance in ASC Topic 606, Revenue from Contracts with Customers, 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 contractors when performance bonuses are contained in their contracts. If a 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.
The headline news on changes coming upon adoption of ASC Topic 842, Leases, is that operating leases will be put on the balance sheet, but can ASC Topic 842 impact the measurement of EBITDA?
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 EBITDA. 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 EBITDA.
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).
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, may also have implications for EBITDA 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 EBITDA. 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 valuation or performance measurement, the upcoming changes in accounting standards may have a significant impact on the trend rate for performance or the valuation of investments held. Fund managers working alongside portfolio company management teams should assess the impact of the accounting change before adoption to be able to adjust the metrics to appropriately consider the effect of the accounting change on both the performance measurement and valuation process. The impending accounting changes also allow for an opportunity to consider other metrics, such as operating cash flows, in the valuation and performance management cycles.
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, please contact us.
Published on April 12, 2019