EBITDA: Anatomy of an Accounting Gimmick

Updated from 3:17 p.m. EDT

If anything good can come out of the WorldCom (WCOM Quote - Cramer on WCOM - Stock Picks) accounting fraud, it's that investors may stop relying solely on financial metrics like EBITDA, or earnings before interest, taxes depreciation and amortization, to measure a company's performance.

WorldCom reported Tuesday night that it had inflated its EBITDA by $3.8 billion over five quarters by improperly identifying routine operating costs as long-term capital costs.

Simply put, the company shifted expenses out of its income statement and into its cash-flow statement -- a segment that far fewer investors actually scrutinize. Because the cost was recorded as a capital expenditure, it was simultaneously recorded as an asset on the balance sheet. As a result, both the company's income and assets were inflated.

Absent the misallocated costs, WorldCom said it would have lost money in 2001 rather than earning the $1.4 billion it reported. It also lost money in the first quarter of 2002, after earlier reporting $130 million of earnings. The amount of the mislabeled costs was $3.055 billion for 2001 and $797 million for the first quarter of 2002, the company said.

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Like other recent accounting blowups, this latest scandal has prompted serious questions about the way analysts and investors value stocks.

"Companies focus on EBITDA because it's more favorable; it's like pro forma earnings," said Mark Bradshaw, an accounting professor at Harvard Business School. "I like to look at all three statements -- cash flow, income and balance sheet -- you can't look at one without the other."

Although the term EBITDA is often used interchangeably with cash flow, the two aren't the same thing. To begin with, EBITDA doesn't recognize capital expenditures, which show up in the statement of cash flows.

EBITDA also excludes interest and taxes, even though these things can and do cost companies cash. In addition, EBITDA doesn't recognize changes to working capital, or current assets minus current liabilities, and their impact on cash flow.

This makes it far easier to manipulate EBITDA with aggressive accounting than to manipulate true cash flow, which measures the money a company has earned from operations when all costs have been subtracted.

The Reality

WorldCom's free cash flow stood at a paltry $108 million in 2001 as the company recorded $7.8 billion worth of capital expenditures. (Free cash flow is defined as operating cash flow minus capex.)

Jeff Brotman, adjunct professor of accounting at the University of Pennsylvania Law School, says investors should look at all financial metrics available. But in the case of WorldCom, he said, there was almost no way investors could have known about the misallocation of costs.

"This was a mammoth fraud," he said. "You have to have some belief that somebody in the company has a degree of integrity and that there are internal controls."

Brotman also added that EBITDA can be a valid measure, particularly when evaluating growth companies that spend a lot of money on building out their operations. "Capex is still something people care about," he said.

Still, the myopic focus on such things as pro forma earnings and EBITDA, which are open to so much chicanery, remains disconcerting.

"The company and its public relations and the analysts push you to look at the EBITDA and take you away from focusing on the negative issues which might be more prevalent by looking at the cash flow statement," said Richard Mole, CPA and partner at Weisberg Mole Krantz & Goldfarb.

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EBITDA: Anatomy of an Accounting Gimmick

Whether or not WorldCom's accounting techniques are pervasive within the telecom industry, or within other sectors, remains to be seen. But Mark Cheffers, CEO of AccountingMalpractise.com, said improperly capitalizing expenses is "fairly common" because it can have such a dramatic impact on the bottom line and at the same time, it can be a gray area of accounting. When companies record network maintenance costs, for example, they could simultaneously record that as an asset arguing that it is creating a future economic benefit.

"It's not cut and dry what constitutes an asset, it's subject to debate," noted Bradshaw.

That said, few accounting experts believe that WorldCom simply made a clerical error. Indeed, the SEC said in a statement that the disclosure confirms that "accounting improprieties of unprecedented magnitude have been committee in the financial markets."

The case that perhaps most closely resembles WorldCom is Waste Management, (WMI Quote - Cramer on WMI - Stock Picks)which was also audited by Arthur Andersen and recorded expenses as assets back in 1998. The company was fined $7 million by the SEC and paid $220 million to settle a shareholder lawsuit.

Worldcom, on the other hand, faces potential bankruptcy.

"Unless people were stupid or this company had the worst internal controls in the history of mankind, a lot of people had to know about [Worldcom's aggressive accounting]," Brotman said. "This had to be very well known within the company."