EBITDA, the primary measure of public organizations’ reported profit, is an interesting topic. To the outsider, it might seem like it would be such an unexpected thing to play games with earnings and other financial figures.
But, for many organizations, this is how people keep their jobs- by “managing” and smoothing out earnings to match expectations and publicly expressed and communicated.
Officially, EBITDA stands for EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), but the number of games to play, levers to pull, and couch cushions to dig into to find the loose change is astounding. Oh, look, we found some change squirreled away in our Rainy Day Fund!
Unofficially, “Earnings Before I Tricked the Dumb Auditor” (EBITDA) is a humorous, sarcastic phrase used to mock the concept of EBITDA and highlight the potential for manipulation or misrepresentation of financial figures. It implies that EBITDA could be misleading because companies take advantage of the inherent limitations and challenges auditors face in detecting financial manipulations.
This phrase underscores the importance of conducting thorough due diligence and being cautious when analyzing financial metrics like EBITDA. Investors and other stakeholders should be aware of the potential for manipulation and consider using multiple financial metrics and qualitative factors to assess a company’s true financial health and performance.
From working in mainly public organizations for 10 years, I can tell you that playing with the numbers is “de rigueur” for finance teams and that some level of gamesmanship is always being played.
Knowing these tactics can help investors, regulators, and other stakeholders maintain vigilance and ensure the accuracy and reliability of financial information.
How EBITDA is manipulated
1. Inappropriate revenue recognition
Companies may recognize revenue prematurely or manipulate the timing of revenue to inflate EBITDA.
2. Capitalizing expenses
Companies might capitalize on certain operating expenses, converting them into assets and depreciating or amortizing them over time. This can lead to a higher EBITDA as expenses are deferred.
3. Manipulating non-recurring items
Companies may classify certain costs as non-recurring or one-time expenses, which are excluded from EBITDA calculations, even if they are actually recurring in nature.
4. Aggressive cost-cutting
Companies could slash operating expenses, such as R&D and marketing, to boost EBITDA in the short term, which could harm long-term growth prospects.
5. Changes in inventory accounting
By altering inventory valuation methods, companies can manipulate the cost of goods sold, affecting EBITDA.
6. Related-party transactions
Companies may engage with related entities to influence EBITDA. For example, a company might sell assets to a related party at inflated prices to boost EBITDA.
7. Mergers and acquisitions
Companies might acquire other businesses with a higher EBITDA multiple to boost their overall EBITDA figures.
8. Use of non-GAAP measures
Companies may use non-GAAP financial measures, such as adjusted EBITDA, to exclude items that could have a negative impact on the reported EBITDA.
9. Inflating assets
Companies might overstate the value of their assets, resulting in lower depreciation and amortization expenses and, consequently, a higher EBITDA.
10. Improper classification of expenses
Companies may classify certain expenses as interest- or tax-related to exclude them from the EBITDA calculation.
Investors and other stakeholders should exercise caution when analyzing EBITDA figures and always seek additional information to validate the accuracy and reliability of the reported numbers.
How can you play with EBITDA?
If you’re unfamiliar, an organization publicly releases earnings results and forecasts each quarter. And then, annually, these numbers and processes must be audited.
And when I say audited, I mean, typically, that a team of fresh-faced kids overseen by a manager with little practical experience in the industry will look over files and spreadsheets with compounding layers of complexity and pretend they know something about anything (hint: they usually don’t and are pressured by their management to cut corners on time spent everywhere).
While auditors play a role in examining and verifying the financial statements of public corporations, several factors can make it challenging for them to detect misrepresentations or manipulations related to EBITDA:
1. Complexity of financial transaction
Financial transactions can be complex and may involve multiple entities, making it difficult for auditors to trace and verify every aspect of the transactions. This complexity creates opportunities for companies to distort or manipulate EBITDA.
2. Management estimates and judgments
EBITDA calculations often involve management’s estimates and decisions, such as revenue recognition, capitalization of expenses, and asset valuation. These judgments can be subjective, providing room for manipulation. As so much work we do is in Excel, it is very easy and convincing to create and manage Excel workbooks that are cunningly deceptive.
3. Time and resource constraints
Auditors often face tight deadlines and limited resources, which can hinder their ability to thoroughly examine a company’s financial statements, including EBITDA calculations.
4. Inherent limitations of auditing
Auditing involves sampling and testing rather than an exhaustive review of all financial transactions. This means auditors may not always detect errors or misrepresentations, mainly if they are intentional and carefully concealed.
5. Reliance on management representations
Auditors often rely on company management representations when performing their audit. If management is engaged in misleading practices, they may provide false or incomplete information to auditors.
6. Collusion
In some cases, individuals within the company or external parties may collude to hide financial misrepresentations or manipulations, making it difficult for auditors to detect such issues.
7. Use of non-GAAP measures
Companies may use non-GAAP measures, such as adjusted EBITDA, which can involve excluding certain items or using alternative calculations. This makes it challenging for auditors to compare EBITDA across companies or industries.
8. Aggressive accounting policies
Companies may adopt aggressive accounting policies or frequently change accounting methods to distort their financial statements and mislead auditors.
9. Capitalizing expenses
Companies might capitalize on certain operating expenses, converting them into assets, which can be depreciated or amortized over time, to defer expenses and inflate financial results.
10. Auditor independence
In some instances, auditors may face conflicts of interest, such as when they provide non-audit services to the company they are auditing. This could compromise their objectivity and independence, affecting their ability to detect EBITDA manipulation. In many cases, the accounting team used to work at the auditor’s firm, and there are buddy-buddy sympathies.
11. Screw with the auditors
Give them incomplete files, the wrong files, and files that don’t tie. Tell them certain files don’t exist or that their understanding is incomplete. Or, better yet, give them too many files that are difficult to make sense of. Use nested formulas and multiple sheets that connect to each other that are all originally hand-keyed manually from some obscure data source.
Despite these challenges, the auditing profession continues to evolve and improve its processes and methodologies to better detect and prevent financial misrepresentations, including those related to EBITDA. Investors and other stakeholders should be aware of audit limitations and exercise their judgment when analyzing EBITDA and other financial metrics.
How long can companies play games with EBITDA before the truth comes out?
The duration for which a company can continue to manipulate or distort EBITDA before the truth comes out can vary significantly depending on several factors, including:
1. The sophistication of the manipulation
If the company employs complex and well-concealed methods to distort EBITDA, it may take longer to uncover the truth.
2. The vigilance of auditors and regulators
Effective auditing and regulatory oversight can help detect financial manipulation more quickly. However, as discussed earlier, auditors may face challenges in detecting misrepresentations due to various factors.
3. The involvement of whistleblowers
Whistleblowers within the company or those with knowledge of the manipulation can bring the truth to light faster, especially if they report their concerns to regulators or the media.
4. The scrutiny of investors and analysts
Investors and financial analysts may identify discrepancies or red flags in a company’s financial statements, prompting further investigation and potentially revealing EBITDA manipulation.
5. Changes in the company’s leadership or management
New leadership or management may uncover past manipulations and take corrective actions, which could lead to the truth being revealed.
6. Market or industry events
Economic downturns, industry disruptions, or other external factors may put financial pressure on companies, making it harder for them to maintain the appearance of strong financial performance and potentially exposing any EBITDA manipulation.
7. Legal actions or investigations
Lawsuits, investigations, or enforcement actions by regulators or law enforcement agencies can lead to the discovery of financial manipulation.
Eventually, if your business is struggling, you can play games for a few quarters. But, as the saying goes, “Cash is king.” Things start falling apart that can’t be fixed again, and the bottom eventually falls out.
Generally, you can hide 1, 2, or 3 bad quarters by borrowing from Paul to pay Peter.
But eventually, chaos ensues.
It is essential to note that when analyzing financial statements, including EBITDA, investors and other stakeholders should exercise caution and conduct thorough due diligence.
In my career, one of my favorite moments was witnessing my boss, the former CFO, get fired on the spot after it was realized that he had been misleading the entire leadership team by constantly shifting expenses around because he didn’t understand the business nor was he willing to invest in the proper analytical infrastructure.
So, take these words with caution. When it comes to EBITDA, understand the game, the players, and how it is played to wind up on the right side of things.
Earnings Before I Tricked the Dumb Auditor (EBITDA)- Recommended Reading
EBIT and EBITDA: Essential Metrics for Business Profitability
Updated: 2/17/2024
