The recently announced performance measure, EBITDAC has been greeted with scepticism. Indeed, I’m yet to find a single investor that thinks it is useful. I’ve been wondering why until I considered the following analogy.
Like many in my profession, I awaited my professional exam results with a fair degree of trepidation. I’d not performed at my absolute best in the tax exam in particular, and the question on deferred taxes was based on a portion of the manuals that I just couldn’t read without my eyes glazing over. But what if I’d been able to mark my own exam papers and then adjust for the utter mess I made of that deferred tax question?
I could have assumed, instead of the disappointing reality, that I’d actually read the question properly, that I’d remembered the existence of critical exemptions, that I’d successfully multiplied the right timing difference by actual tax rate and I’d written something more enlightening than “Because” to answer the question “Give reasons why the company might not recognise the deferred tax asset that you calculated in the answer to part (a)”. In my hypothetical world, I, like many, would have scored full marks and I need not have worried. However, it would have been zero use in assessing how I had actually performed.
EBITDAC is, in essence, the same. In reporting financial performance, it represents a hypothetical reality that never happened. The impact of COVID-19 is pervasive. It has resulted in inefficiencies, increases in costs, the need to impair assets across the balance sheet and, perhaps the most pervasive impact of all, a loss of revenue. Given the likely duration of COVID-19’s impact, it’s hard to argue that EBITDAC is relevant.
Consider what adjustments should be made to reported results to report EBITDAC. A starting point might be pulling out incremental costs (for example, safety equipment). But where do you stop? How about adding back impairments (or those portions of impairments that arose solely due to COVID-19 and not due to other factors?) What about adding back portions of costs which were actually incurred but where production efficiency was impaired so there was little or no revenue to absorb the costs? What about adding additional hypothetical revenues and profits that you would have earned if the crisis had never happened? The problem with any adjustments is that no two entities will approach this the same way and the more you move from actual numbers to allocations, the more you move from real to hypothetical. What decision-useful information is contained in reporting what is, in effect, budgeted revenue and profit, in a world that has fundamentally and possibly irretrievably changed?
One argument that has been advanced in favour of EBITDAC is that such an adjusted profit measure is necessary to understand performance as defined in banking covenants. But, in many cases banking covenants are based on frozen GAAP (so not actually based on the reported numbers) and the permitted adjustments are defined in a different, often much more subjective way, than those in the financial statements in an era where APM’s have to be much more clearly and consistently defined. In this context, it is not clear why subjective COVID-19 adjustments should be excluded from an APM that is designed to inform all investors – this may be better dealt with in disclosures within the body of financial reports or within correspondence with the bank.
In 2008, I don’t recall seeing a rash of reporting of EBITDABC (Profits before banking crisis). We did see some adjusting or exceptional items – for example, impairments, but even there, the ‘underlying profits’ earned in 2007/8 were of little relevance to the long journey to recovery. I don’t see this time is any different. Meanwhile, regulators the world over are encouraging entities to disclose, in narrative form, the various impacts of the financial crisis but are actively discouraging management from devising new adjusted performance measures. Maybe they have a point – as following the logic of consistent application of adjusted measures – shouldn’t this year’s EBITDAC become next year’s comparator against which 2020 and onwards performance will be judged?
Reporting in a post-COVID-19 world is rightly focusing on how businesses will manage in the here and now in the immediate future. This explains the focus on liquidity and going concern disclosures and post balance sheet events trading updates. EBITDAC is attempting to report a version of the past assuming COVID-19 didn’t exist. But COVID-19 exists and will be with us for a prolonged period, so it’s not clear that EBITDAC is of any practical benefit to users of the financial statements.
This week's guest blogger is Dave Walters, Partner in UK Accounting Consulting Services. Connect with him on linkedIn here.
All views expressed are the authors
Partner, Accounting Consulting Services, PwC United Kingdom
Tel: +44 (0) 121 232 267