The financial numbers game detecting creative accounting practices phần 9 doc

CHAPTER TEN Getting Creative with the Income Statement: Pro-Forma Measures of Earnings Pro forma information is a tool that companies have invented to disseminate an idealized version of

CHAPTER TEN Getting Creative with the Income

Statement: Pro-Forma Measures

of Earnings

Pro forma information is a tool that companies have invented to

disseminate an idealized version of their performance It may exclude

any cost or expense the company wants, yet it is presented in a form

that suggests reliability and soundness 1

Cash flow, by the way, is not EBITDA EBITDA is the biggest joke of

the 1990s 2

Are GAAP net earnings on the endangered species list? Pro forma

per-share figures in earnings announcements, a number derived after

removing an expanding list of items and sometimes real cash

expenses, seem to be crowding out traditional net earnings in many

industries 3

Operating income is often more important to investors than net

income, and widely regarded as an indicator of how well management

is running the shop 4

The previous chapter laid out the GAAP requirements surrounding the income statementand also outlined how the financial numbers game could be played by creative classifi-cations within the GAAP-basis income statement Pro-forma creativity develops mea-sures of financial performance that employ GAAP information, but they are decidedlynon-GAAP measures A common justification for one such pro-forma measure (sustain-able or core earnings) is illustrated by this statement from the Corning, Inc annual report:Corning believes comparing its operating results excluding non-recurring items, a measurethat is not in accordance with generally accepted accounting principles (GAAP) and may

not be consistent with measures used by other companies, provides a better understanding

of the changes in its operating results.5

Corning’s pro-forma measure is GAAP net income adjusted for the effects of a ber of charges and gains that it judged to be nonrecurring In practice, it is common to dis-cuss results after the exclusion of selected nonrecurring items Corning simply refers tothis pro-forma measure as “operating results excluding non-recurring items.” By adjust-ing only for nonrecurring items, the scope of Corning’s restatement is rather limited Therange of adjustments made to GAAP net income is greater in the case of some of the otherpro-forma measures of performance These measures often adjust GAAP earnings fornoncash items as well as selected recurring and nonrecurring items of revenue, gain,expense, and loss However, they all share a common feature: They employ GAAP-basedinformation in the creation of alternative, non-GAAP measures of performance

num-The first two of the chapter-opening quotes are clearly critical of pro-forma measures

of financial performance Lynn Turner, chief accountant of the Corporation FinanceDivision of the SEC, has characterized some of these measures by referring to them asEBBS, or “earnings before the bad stuff.”6Such criticisms have led the Financial Exec-utives International (FEI), an organization made up mainly of company financial offi-cers, and The National Investor Relations (NIRI) Institute to release “best practice”guidelines for firms that release pro-forma measures of financial performance in earn-ings press releases.7A key feature of these recommendations is found in the following:GAAP results provide a critical framework for pro-forma results, although the pro-formaresults may be more analytically useful The order in which reported or pro-forma resultsare presented in the release is not as important as their context Pro-forma results shouldalways be accompanied by a clearly described reconciliation to GAAP results; this recon-ciliation is often provided in tabular form.8

The FEI/NIRI guidelines do not explicitly criticize pro-forma measures of financialperformance However, the absence of their recommended reconciliation of the pro-forma to GAAP numbers represents a clear weakness in most of the current presentations

of pro-forma data

This chapter builds on the discussion in Chapter 9 and presents a review and analysis

of pro-forma measures of financial performance The computation of these pro-formameasures is considered along with their motivation, characterization, and disclosure.Their role in the financial numbers game is also explored

RECASTING THE BOTTOM LINE: PRO-FORMA EARNINGS MEASURES

Adaptations of net income are generically referred to as pro-forma earnings.9 Otherlabels include EBITDA (earnings before interest, taxes, depreciation, and amortization),sustainable earnings, core earnings, and operating earnings.10 The Random House Unabridged Dictionary of the English Language provides an accounting-oriented defi-

nition of “pro-forma”:

def-It is less true in cases where adjustments to reported net income are designed to derive ajoint cash flow and sustainable earnings measure Pro-forma earnings typically involveadjustments to net income for items that are either noncash or nonrecurring or both.The two most common pro-forma numbers, which fall within the spirit of incomestatement creativity, are (1) earnings before interest, taxes, depreciation, and amortiza-tion (EBITDA) and (2) adjusted or sustainable earnings EBITDA is well known andwidely used in the business and financial community It is also common for sustainableearnings to be labeled adjusted earnings Whether called adjusted or sustainable earn-ings, the exclusion of nonrecurring items is the key feature of these measures.

Earnings before Interest, Taxes, Depreciation, and Amortization

EBITDA represents part of a movement up the income statement from the bottom line.EBITDA is predated by and probably evolved from earnings before interest and taxes(EBIT) EBIT is positioned farther down the income statement, below the point at whichdepreciation and amortization would have been deducted EBIT is one of the earlyincome statement adaptations It is designed mainly to gauge the extent to which fixedcharges are covered by earnings.12EBIT has been a common financial covenant in debtand other credit agreements for decades

EBITDA has a shorter history, with its widespread use extending back only into theearly 1980s EBITDA was used early on in leveraged buyouts (LBOs) on the premisethat there would be no replacement of fixed assets until later while the LBO companywas run and debt was serviced It has long been common to require firms to maintain aspecified minimum EBIT coverage ratio as part of a debt or credit agreement As inter-est is deductible before the computation of income taxes, it is logical to add back bothincome taxes as well as interest In more recent years, it has become even more commonfor fixed-charge and debt-limit covenants to be based on EBITDA.13While the mea-surement of EBITDA would seem to be dictated by the underlying words, in practice themeasurement of EBITDA is often more extensive Frequently a variety of adjustmentsare made beyond simply those for interest, taxes, depreciation, and amortization

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

The process of moving up from the bottom line of the income statement and tively jettisoning items of revenue, gain, expense, and loss is an exercise in incomestatement creativity Exhibit 10.1 contains examples of some of the additional adjust-ments made to arrive at EBITDA It is far more common to observe items of loss or

selec-Exhibit 10.1 EBITDA Adjustment Items

ACG Holdings, Inc (1998) EBITDA is defined as earnings before interest

expense, income taxes, depreciation,amortization, other special charges related toasset write-offs and write-downs, other income(expense), discontinued operations andextraordinary items

Boca Resorts, Inc (1998) Adjusted EBITDA represents EBITDA plus the

annual change in Premier Club net deferredincome

The Carbide/Graphite Group, Inc EBITDA is defined as operating income before

retirement/severance charges, and other expense.Coast Resorts, Inc (1999) EBITDA means earnings before interest, taxes,

depreciation, amortization, deferred (noncash)rent expense and certain nonrecurring items,including preopening expenses

Lifestyle Furnishings International, Adjusted EBITDA for 1998 excludes transition

reengineering initiative costs related to thedevelopment and implementation of year 2000compliance costs related to computer systemimplementation

News Communications, Inc (1999) EBITDA, excluding three one-time expenses:

hiring costs associated with a new president, anincrease in the reserve for uncollected

receivables, and an adjustment to the accrual forunpaid commissions

Sunrise Medical, Inc (1998) EBITDA excludes reengineering expenses,

merger costs, and unusual items

Teletouch Communications, Inc EBITDA for fiscal 1998 excludes the gain on

Sources: Companies’ annual reports The year following each company name designates the annual

report from which each example was drawn Information obtained from Disclosure, Inc., Compact

D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD:

Disclosure, Inc., June 2000).

expense as opposed to revenue or gain being adjusted from net income to arrive atEBITDA This may simply reflect the fact that the former items tend to be more numer-ous Beyond this, one or more of three characteristics are typically associated with theadditional adjustments: (1) nonrecurring, (2) noncash, and (3) nonoperating

An examination of the entries in the exhibit reveals a mix of adjustments that reflectone or more of the above characteristics The motivation for adding back depreciationand amortization is usually its noncash character Alternatively, it sometimes reflects thesentiment that depreciation and the amortization of intangibles are not real expenses.That is, in spite of the traditional GAAP requirement to depreciate fixed assets and toamortize intangibles, many feel that these assets often do not decline in value and thatover time they actually may appreciate in value

An example of the rejection of depreciation is found in the measure used to judge thefinancial performance of real estate firms, especially real estate investment trusts(REITs) Depreciation is added back to net income, along with adjustments for other

selected nonrecurring items, to arrive at a pro-forma measure termed funds from tions (FFO) The case for rejecting depreciation in measuring financial performance is

opera-illustrated by the next excerpt from a document that supports adding real estate ation back to the earnings of REITs:

depreci-GAAP historical cost depreciation of real estate assets is generally not correlated withchanges in the value of those assets, whose value does not diminish predictably over time,

as historical cost depreciation implies For this reason, comparisons of the operating results

of REITs that rely on net income have been less than satisfactory.14

Similar arguments have been made in the case of some intangible assets Goodwill is

a common example Interestingly, a new standard issued by the Financial AccountingStandards Board no longer requires the routine amortization of goodwill Rather, good-will will be written down only if it is judged to be impaired.14a

Interest and taxes are the standard add-backs to develop measures for determining thecoverage of fixed charges Additional adjustments for the growth in deferred income byBoca Resorts, Inc., and of deferred rent by Coast Resorts, Inc., reflect the cash-flowdimension of EBITDA That is, the growth in these balances represents an inflow of cashthat has not yet been included in net income (Boca Resorts) and an expense that has notyet required a cash outflow (Coast Resorts) Hence, these increases are added to netincome in order to produce a measure that is closer to cash flow

The adjustments for write-offs (ACG Holdings, Inc.), severance charges (The Carbide/Graphite Group, Inc.), certain nonrecurring items (Coast Resorts), transition costs(Lifestyle Furnishings International, Inc.), adjustments to the accrual for commissions(News Communications, Inc.), and gain on sale of assets (Teletouch Communications,Inc.), are all consistent with developing a measure of sustainable financial performance.The adjustments for some of the nonrecurring items, for example, other income andother expenses, reflects the effort to develop a measure that is based on operating items.The determination of what items should be adjusted out of EBITDA, where the keyconsideration is their nonrecurring character, is difficult Nonrecurring items are notspecifically defined under GAAP

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

It is common for EBITDA measures to be developed with additional adjustments fornonrecurring and nonoperating revenue, gains, expenses, and losses These all entail theexercise of considerable judgment A strict version of EBITDA requires the exercise oflittle or no judgment However, the dominance of adjusted EBITDA measures meansthat there is abundant room for the exercise of creativity This also means that it is verydifficult to compare EBITDA performance among different firms Doing so is somewhatakin to trying to compare the weights of different people when they all make a number

of unique adjustments to their scales There is a clear problem with the comparability ofEBITDA measures among firms

Comparability of EBITDA among Firms

EBITDA combines adjustments for noncash, nonrecurring, and nonoperating items in aneffort to create a revised measure that is a combined operating cash flow and sustainableearnings statistic The adjustments that are prompted by the noncash feature are reason-ably nonjudgmental.15However, the specification of nonrecurring items for adjustmentintroduces the potential for the creation of EBITDA measures that are not comparablebetween different firms This potential for a lack of comparability among firms is citedfrequently in discussions of EBITDA disclosures The following commentary is typical:All companies do not calculate EBITDA in the same manner As a result, EBITDA as pre-sented here may not be comparable to the similarly titled measure presented by other com-panies.16

Our calculation of EBITDA may be different from the calculation used by other panies and, therefore, comparability may be limited.17

com-It is worth noting that the lack of comparability introduced by adjusted EBITDAmeasures simply adds to the lack of comparability that already exists due to differencesamong firms in accounting policies followed as well as variations in accounting esti-mates Also, the judgments that go into the computation of EBITDA affect both interyearand interfirm comparability That is, EBITDA may be measured differently among firms

as well as differently by individual firms across different years

Company Characterizations of EBITDA

The characterizations of EBITDA provided by companies help to clarify some of themotivations for the creation of this measure Some examples of EBITDA characteriza-tions are provided in Exhibit 10.2 The information in the exhibit as well as the results

of a review of about 200 companies was used to identify a number of recurring themes

in these EBITDA characterizations EBITDA is held to be:

• Useful in evaluating operating performance

• Helpful in judging the ability to meet future cash requirements

• Useful as a measure of operating cash flow

• Helpful in evaluating financial condition, results of operations, and cash flow

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

Exhibit 10.2 Characterizations of EBITDA

Ameriking, Inc (1999) EBITDA is included to provide additional

information with respect to the ability of theCompany to meet its future debt service, capitalexpenditure and working capital requirements.The Carbide/Graphite Group, Inc Management believes that EBITDA is an

service its cash requirements EBITDA is animportant measure in assessing the performance ofthe business segments

Lightbridge, Inc (1999) Lightbridge considers EBITDA to be meaningful

given the impact on operating income from

non-cash expenses.

Metro Goldwyn Mayer, Inc (1999) Management considers EBITDA to be an

important measure of comparative operatingperformance It should be considered in addition

to, but not as a substitute for or superior to,operating income, net earnings, cash flow andother GAAP measures The items excluded fromEBITDA are significant components in assessingfinancial performance

News Communications, Inc (1999) EBITDA is used in this report because

management believes that it is an effective way ofmonitoring our operating performance and iswidely used among media related businesses.Niagara Mohawk, Inc (1999) EBITDA is a non-GAAP measure of cash flows

and is presented to provide additional informationabout Niagara Mohawks’ ability to meet its futurerequirements for debt service

Stimsonite Corp (1998) EBITDA, a measure of operating cash flow,

increased to $16.1 million from $14.3 million in1997

Note: The above entries are abridgements of the actual language used by the listed companies Sources: Companies’ annual reports The year following each company name designates the annual

report from which each example was drawn Information obtained from Disclosure, Inc., Compact

D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD:

Disclosure, Inc., June 2000).

• Widely accepted as an indicator of funds available to service debt

• Useful in measuring operating performance, liquidity, and leverage

EBITDA as a measure of cash flow is one of the more common themes It is obviouslynot a GAAP measure of cash flow, and companies often make this point as part of aneffort to distinguish EBITDA from GAAP cash-flow measures Yet, companies repeat-edly refer to EBITDA as a measure of cash flow, often presenting any qualifying lan-guage at some other location in the financial statements or notes

The evaluation of operating performance is another common EBITDA application.This is clearly facilitated by the adjustments that remove nonrecurring or nonoperatingrevenue, gains, expenses, and losses These adjustments provide better indicators of sus-tainable performance and better predictors of future results.18

Because of its prevalence and its representation as a measure of cash flow and ating performance, it is not surprising to observe EBITDA being employed in financialcovenants found in debit and credit agreements The problem of comparability can bedealt with in this setting because the credit agreement can include the specific definition

oper-of EBITDA to be used in measuring compliance with the EBITDA covenant

Use of EBITDA in Financial Covenants

Financial covenants are used so that lenders and other creditors will have more controlover the likelihood of their ultimate repayment Financial covenants provide somecapacity to monitor and influence the behavior of the debtor Exhibit 10.3 provides somerepresentative uses of EBITDA in financial covenants The EBITDA-based covenantsare of three types:

1 Coverage covenant: requires a minimum ratio of EBITDA to fixed charges

2 Leverage covenant: permits a maximum ratio of debt to EBITDA

3 Level covenant: requires maintenance of a minimum level of EBITDA

The common use of EBITDA by lenders in financial covenants is evidence that theyfind it to be a useful device in helping to monitor their borrowers and to ensure the even-tual repayment of their funds.19

While based on GAAP-based income statement data, EBITDA rearranges andremoves certain income statement data in the creative effort to develop alternative mea-sures of financial performance and cash flows As a cautionary measure, and with anudge from the Securities and Exchange Commission, some companies that includeEBITDA information in their annual reports highlight its non-GAAP character

Cautionary Comments about Non-GAAP EBITDA Information

EBITDA incorporates only information that is present in the GAAP-basis income ment Providing cautionary or qualifying commentary in conjunction with EBITDA data

state-is consstate-istent with SEC guidance.20Examples of cautionary or qualifying language arefound in Exhibit 10.4

Despite the many cautionary notes provided about EBITDA, the manner in which it

is presented and characterized implies, contrary to SEC guidance, its superiority toGAAP-based earnings and cash-flow data

EBITDA as Income Statement Creativity

EBITDA involves a creative rearrangement of selected income statement data While theEBITDA acronym suggests a simple alternative measure developed in a quite mechani-cal manner, this is usually not the case Rather, most measures of EBITDA go beyondthe acronym and involve the selective exclusion of GAAP-basis income statement data

Terms like special charges and nonrecurring items are common labels applied to these

exclusions However, as noted earlier, these terms are not well defined in practice or inGAAP Their identification entails a good deal of judgment, and this results in muchflexibility in developing EBITDA measures EBITDA is truly a creative income state-ment-based measure However, this effort to develop an alternative measure of cash flowand financial performance brings with it some new problems and continues some old

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

Exhibit 10.3 EBITDA-Based Financial Covenants

ABR Information Services, Inc (1998) Requires a funded debt-to-EBITDA ratio

maximum of 2.5 to 1Abercrombie & Fitch Co (1999) A financial covenant requires a minimum

EBITDAR to interest expense and minimumrent

Foodarama Supermarkets, Inc (1999) Requires the maintenance of certain levels of

EBITDAMarine Drilling Companies, Inc (1999) Calls for a maximum ratio of debt to EBITDA

of 4 to 1Packaging Corp of America (1999) Must not exceed a leverage ratio (indebtedness

divided by EBITDA) of 6.75 at December 31,

1999, decreasing per the guidelines set forth inthe Credit Agreement to 4.00 as of March 31,2006

Roanoke Electric Steel (1999) Funded debt cannot be greater than 3 times

consolidated EBITDA, and the ratio ofEBITDA to the sum of current maturities oflong-term debt and consolidated interestexpense must equal at least 1.5

Sources: Companies’ annual reports The year following each company name designates the annual

report from which each example was drawn Information obtained from Disclosure, Inc., Compact

D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD:

Disclosure, Inc., June 2000).

Interfirm Comparability The flexibility associated with the development of EBITDAresults in a lack of interfirm comparability It is common for EBITDA firms to point outthe comparability issue as part of their EBITDA disclosures.21For example, Lightbridge,Inc., takes the position that EBITDA enhances comparability because it eliminates the

Exhibit 10.4 Qualifying EBITDA

Browning Ferris Industries, Inc (1997) EBITDA, which is not a measure of financial

performance under generally acceptedaccounting principles, is included because thecompany understands that such information isused by certain investors when analyzing thecompany’s financial condition and

performance

Lifestyle Furnishings, Ltd (1997) Adjusted EBITDA should not be considered as

an alternative to net income, cash flow fromoperations or operating profit as determined bygenerally accepted accounting principles, anddoes not necessarily indicate that cash flowwill be sufficient to meet cash requirements

St Mary Land & Exploration EBITDA is a financial measure commonly

considered in isolation or as a substitute for netincome, cash flow provided by operatingactivities or other income or cash flow dataprepared in accordance with generally acceptedaccounting principles or as a measure of acompany’s profitability or liquidity BecauseEBITDA excludes some, but not all, items thataffect net income and may vary amongcompanies, the EBITDA presented above maynot be comparable to similarly titled measures

of other companies

Unidigital, Inc (1999) EBITDA does not represent and should not be

considered as an alternative to net income oroperating income as determined by generallyaccepted accounting principles

Sources: Companies’ annual reports The year following each company name designates the annual

report from which each example was drawn Information obtained from Disclosure, Inc., Compact

D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD:

Disclosure, Inc., June 2000) Information on St Mary Land and Exploration Co is from its annual report, December 2000, p 26.

A lack of comparability among firms is not a unique weakness of EBITDA It alsoafflicts GAAP-based measures of performance, notably net income However, the mea-sure of net income is laid out quite clearly in the income statement Moreover, theaccounting policies used to develop net income are disclosed There is usually no com-parable presentation of the development of EBITDA Rather, one must simply rely onstatements concerning the measurement or definition of EBITDA, such as those pre-sented in Exhibit 10.1 Efforts to reproduce disclosed EBITDA numbers from the com-bination of company definitions and their financial statements can be difficult.

If EBITDA is going to compete with net income, then in the interests of clarity andtransparency a schedule that details the computation of EBITDA should be provided.Moreover, this information should be presented in the same location with any qualify-ing commentary or other key EBITDA disclosures

Pitting EBITDA against Net Income Occasionally the SEC has felt the need to ment on the use by firms of alternatives to GAAP net income and GAAP cash flow fromoperating activities On the matter of earnings, the SEC has declared that “Such mea-sures [alternatives to GAAP net income] should not be presented in a manner that givesthem greater authority or prominence than conventionally computed earnings.”24

com-A review of EBITDcom-A disclosures would suggest that the SEC’s guidance is ignored

on occasion A study of the presentation of information on EBITDA reveals that it isoften reported ahead of net income This appears to be most common in the case of theEBITDA references in the president’s letter to shareholders.25A sampling of EBITDAdisclosures in the president’s letter revealed the following average order of presentation

of sales (or revenue), net income, and EBITDA: Revenue, 1.20; EBITDA, 2.20; and NetIncome, 2.30.26EBITDA and Net Income are basically tied for being the second measure

of financial performance presented in the president’s letter However, EBITDA either ispresented before earnings or is presented in cases where earnings are not presented at all

in 25 out of the 40 cases examined That is, by being presented first, EBITDA is givengreater prominence than earnings, something that the SEC advised against

The Grubb & Ellis Company’s annual report states:

Fiscal 1998 revenue grew 24 percent to $282.8 million, exceeding our goal of 20 percent

revenue growth EBITDA, before non-recurring items for fiscal 1998, totaled $19.1 million,

compared with $17.6 million in 1997 Net income was $21.5 million, or $0.98 per share, anincrease over $19.0 million, or $.97 per share, last year.27

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

The Mindspring Enterprises, Inc., annual report says:

Our revenue increased by 118% to $114,673,000 Our customer base grew by 149% to693,000 EBITDA increased 365% to $23,013,000 Earnings per share increased 328%from a loss of $(0.18) per share in 1997 to a profit of $0.41 per diluted share in 1998.28Beyond the issue of order of presentation, a further questionable practice involvesreporting EBITDA margins The most common margin disclosures are of gross mar-gin—gross profit divided by sales—and net margin—net income divided by sales Pre-sentation of EBITDA margins implies that EBITDA is a measure of profitability It is not

a GAAP profitability measure, and its use in place of GAAP-basis margins would alsoseem to be inconsistent with SEC guidance

EBITDA as Cash Flow It is common for company disclosures to characterize EBITDA

as cash flow As discussed earlier, EBITDA has aspects of both a cash flow and tainable earnings measure Noncash items are added back to earnings, but nonrecurringitems of revenue, gain, expense, and loss are also typical adjustments Some representa-tions of EBITDA as cash flow are provided in Exhibit 10.5

sus-EBITDA is clearly not operating cash flow as it is defined under GAAP Firms quently make this point in their EBITDA disclosures The following is a typical disclo-sure of the non-GAAP character of EBITDA as a cash-flow measure:

fre-Exhibit 10.5 EBITDA as a Cash Flow Measure

Aztar Corp (1999) In 1999, our consolidated operating cash flow,

as measured by earnings before interest, taxes,depreciation, amortization and rent

(EBITDAR), grew to $160.6 million

Brown-Forman Corp (2000) EBITDA represents a measure of the

company’s cash flow

Dole Foods Company, Inc (1999) Cash flow from operations (EBITDA) grew to

$372 million, an increase of 10% over prioryears

Mandalay Resort Group (1999) Companies frequently refer to operating cash

flow, or EBITDA, as a benchmark of earningpower

SI Technologies, Inc (1999) Sales and cash flow, as measured by EBITDA,

increased to record levels

Sources: Companies’ annual reports The year following each company name designates the annual

report from which each example was drawn Information obtained from Disclosure, Inc., Compact

D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD:

Disclosure, Inc., June 2000).

EBITDA does not represent net income or cash flows from operations as those terms aredefined by generally accepted accounting principles and does not necessarily indicatewhether cash flows will be sufficient to fund cash needs.29

The addition of depreciation and amortization to net income in computing EBITDA

is typically based on their noncash character However, in some cases their additionreflects the view that the underlying assets being depreciated or amortized either will notrequire replacement or are not declining in value

The failure to include working capital requirements and the adding back of both est expense and taxes are the key differences between EBITDA and cash flow from oper-ating activities under GAAP.30

inter-As should be clear by now, EBITDA is a non-GAAP measure, but it is derived fromthe GAAP-basis income statement and associated GAAP data It involves a creativerearrangement of income statement data It has become a very popular measure by whichmanagement represents its financial performance Moreover, it is widely used bybankers and other providers of debt capital to gauge and monitor the ongoing ability toservice debt

As financial statistics go, EBITDA is neither fish nor fowl Rather, it is a blend ofadjustments to GAAP income statement data that produce a blended measure of cashflow and sustainable earnings As a measure of cash flow it is incomplete, mainlybecause of the failure to include working capital requirements Moreover, in the typicalcase, the adjustments for nonrecurring items are also selective Comparability becomes

a key weakness of EBITDA as a result of the variability in the adjustments made to netincome in arriving at EBITDA

A related pro-forma measure, which also employs considerable income statementcreativity, is sustainable earnings This measure is also referred to as core or adjustedearnings

Adjusted or Sustainable Earnings

EBITDA is a non-GAAP, pro-forma financial measure that begins with net income orloss and then recasts earnings in order to develop an alternative measure of performance.The adjustments to net income or loss are of three basic types: (1) noncash, (2) nonre-curring, and (3) nonoperating Sustainable earnings is an additional pro-forma measure,which also begins with net income or loss, but it makes adjustments only for nonrecur-ring items of revenue, gain, expense, and loss The goal is to develop a measure offinancial performance that complies with investors’ need for “information about thatportion of a company’s reported earnings that is stable or recurring and that provides abasis for estimating sustainable earnings.”31In the spirit of this quote, Harbinger Corpo-ration states that the adjusted earnings are provided “In order to facilitate comparison ofoperating results year over year.”32

Developing a measure of sustainable earnings is not required by GAAP Moreover, asustainable earnings series, developed by performing a comprehensive restatement ofreported earnings, is not provided by most companies However, it is common for firms

to provide some information on the effects of selected nonrecurring items and to indicate

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

what results would have been in the absence of these items In addition to being part ofearnings releases, such information sometimes is provided in Management’s Discussionand Analysis of Financial Condition and Results of Operations (MD&A) and in selectednotes to the financial statements A SEC disclosure requirement that relates specifically

to the disclosure of nonrecurring (unusual or infrequent) items is found in this passage:Describe any unusual or infrequent events or transactions or any significant economicchanges that materially affected the amount of reported income from continuing operationsand, in each case, indicate the extent to which income was so affected In addition, describeany other significant components of revenues and expenses that, in the registrant’s judgment,should be described in order to understand the registrant’s results of operations.33

Disclosures of Nonrecurring Items and Adjusted Earnings

A sampling of disclosures of nonrecurring items and their effects on adjusted earnings isprovided in Exhibit 10.6 These disclosures are from both the MD&A and notes to thefinancial statements These pro-forma data are an additional form of income statementcreativity They involve the recasting of information that is already a part of the GAAP-based income statement Providing information on earnings, after the exclusion of non-recurring items of revenue, gain, expense and loss, should result in an earnings series that

is both more stable and of greater value in making estimates of sustainable earnings.34However, this creativity could be used somewhat selectively so as to play the finan-cial numbers game As with EBITDA, these pro-forma summaries are not GAAP state-ments Nonrecurring is the key quality of adjustment items that are added to or deductedfrom GAAP net income However, the precise meaning of nonrecurring is not welldefined Companies have considerable capacity to be opportunistic in making decisionsabout what items are adjusted out of reported earnings in arriving at adjusted earnings.This is a common characteristic of pro-forma measures, as was also pointed out in thecase of EBITDA

Notice that some of the exhibit disclosures enumerate the specific nonrecurring items(C.R Bard, Inc and Cisco Systems, Inc.) that have been adjusted out of earnings, whileothers simply characterize the nature of the adjustment items (Vishay Intertechnology,Inc.) However, elsewhere in its annual report Vishay does detail its nonrecurring items.The disclosures in the exhibit are fairly typical That is, where the effects on earningsare enumerated, it is usually in a textual format and not in a schedule More frequently,nonrecurring items are disclosed without summarizing their effects on earnings This isthe least effective approach to dealing with nonrecurring items A more effective pre-sentation provides a detailed statement that summarizes the effect of nonrecurring items

on adjusted earnings

Summary Disclosures of Nonrecurring Items The least helpful disclosures of curring items simply enumerate their amount and presence, usually in the MD&A sec-tion, but do not summarize their effects on net income The disclosures in Exhibit 10.6are an improvement on this practice because they do indicate the effect of the nonrecur-ring items on net income However, a potential limitation of these disclosures, especially

when the nonrecurring items are not listed separately, is that they may not be hensive That is, some items that are arguably nonrecurring may not have been removedfrom net income in arriving at adjusted earnings

compre-The disclosures of nonrecurring items by Mason Dixon Bancshares, Inc., in Exhibit10.7 are both comprehensive and presented in a user-friendly schedule, as opposed tobeing embedded in textual material

The term core net income is common among financial firms The report by the

Spe-cial Committee on FinanSpe-cial Reporting of the American Institute of Certified PublicAccountants recommended that core earnings be presented in income statements It pro-vided the following description of core earnings:

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

Exhibit 10.6 Adjusting Earnings for the Effects of Nonrecurring Items

C R Bard, Inc (1999) In 1999, Bard reported net income of $118.1

million, or diluted earnings per share of $2.28.Excluding the impact of the after-tax gain on thesale of the cardiopulmonary business of $0.12 andthe after-tax impact of the fourth quarter write-down of impaired assets of ($0.11), dilutedearnings per share was $2.27

Cisco Systems, Inc (1999) Net income and net income per share include

purchased research and development expenses of

$471 million and acquisition-related costs of $16million Pro-forma net income and diluted netincome per share, excluding these nonrecurringitems net of tax, would have been $2,548 millionand $0.75, respectively

Phillips Petroleum Co (1999) Phillips’ net income was $609 million in 1999, up

157 percent from net income of $237 million in

1998 Special items benefited 1999 net income by

$61 million, while reducing net income in 1998

by $138 million After excluding these items, netoperating income for 1999 was $548 million, a 46percent increase over $375 million in 1998

Vishay Intertechnology, Inc (1999) Net earnings, before special charges, for the year

ended December 31, 1999 were $97,799,000 or

$1.14 per share After special charges of

$14,562,000 or $0.17 per share, net earnings were

$0.97 per share

Sources: Companies’ annual reports The year following each company name designates the annual

report from which each example was drawn.

A company’s core activities are usual or recurring activities, transactions, and events Usualmeans the activity is ordinary and typical for a particular company Recurring means theactivity, transaction, or event is expected to occur again after an interval Core activitiesinclude usual or recurring operations and recurring non-operating gains and losses Con-versely, non-core activities, transactions, and events are unusual (not typical for a particu-lar company) or non-recurring (not expected to occur again in the foreseeable future orbefore a specified interval).35

Mason Dixon’s earnings revision is quite comprehensive However, two items remain

in core (adjusted) net income that could be candidates for adjustment: gain on sale ofsecurities of $792,000 and gain on sale of mortgage loans of $2,140,000 Such transac-tions no doubt fit within the concept of Mason Dixon’s core earnings In a nonfinancialfirm, the gain on the sale of securities would be a prime candidate for exclusion in mov-ing toward adjusted net income However, another financial firm, Emerald FinancialCorporation, excluded gains on the sale of loans in a comparable revision of earnings.36

As with EBITDA, comparability of adjusted earnings must be considered a potentialweakness of this pro-forma information

In Exhibit 10.8, the income statement of Cooper Industries, Inc., displays information

on nonrecurring items within the body of the GAAP-basis income statement Doing thishas the virtue of not requiring the reader to look to some other location for information

on the presence of nonrecurring items and their effects on earnings

The presentation of nonrecurring items within the body of the Cooper income ment is generally consistent with the recommendation of the Special Committee on

state-Exhibit 10.7 Comprehensive Revision of Earnings: Mason Dixon

Bancshares, Inc., Consolidated Income Statement, Year Ending December

31, 1998 (thousands of dollars)

Adjustments, add (deduct), for nonrecurring items:

Special loan provision for change in charge-off policy 2,000

———–

———–

Source: Mason Dixon Bancshares, Inc., Annual Report, December 1998 Information obtained from

Disclosure, Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC

(Bethesda, MD: Disclosure, Inc., June 2000).

Financial Reporting of the AICPA.37 The other major nonrecurring item in Cooper’sincome statement, Discontinued Operations, is placed below Operating earnings afternonrecurring items A fully adjusted net income measure also would require the deduc-tion of the income from discontinued operations However, this is easy to accomplishwith the information as presented

Notice the difference between the trend in Cooper’s performance as represented bythe income series that excludes the nonrecurring items Only modest growth is sug-gested by Operating earnings after nonrecurring items for the period 1998 to 2000 How-ever, substantial earnings growth is indicated for the same period by Operating earningsbefore nonrecurring items Getting a reliable reading on trends, if any, in underlyingoperating performance is a key benefit of the income statement creativity represented bythe development of adjusted earnings

In addition to the summary income statement disclosures of nonrecurring items,Cooper provided detailed notes on nonrecurring and unusual items Some of these itemsare quite small: a $2.8 million gain on a litigation settlement and a $0.8 million insurance

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

Exhibit 10.8 Adjusted Earnings within the Income Statement: Cooper

Industries, Inc., Consolidated Income Statements, Year Ending December 31, 1998–2000 (millions of dollars)

Income from discontinued operations, net of

recovery based upon an unsuccessful offer for another company in 1999 Nonrecurringitems in 1998 included charges of $5.8 million for a voluntary severance program and

$1.5 for other severance and closure costs Others are very large: a $132.7 million gain

on an exchange of securities and a $53.6 million restructuring charge, both in 1998.The presentation of adjusted or pro-forma earnings numbers within the GAAP incomestatement is uncommon Supplemental disclosures of this information are the norm.However, even with the absence of detail on the nonrecurring items on the face of theincome statement, Cooper’s disclosures provide an opportunity to present an alternativemeasure of operating performance within the framework of the GAAP-basis incomestatement It is decidedly user friendly

The reliability of alternative measures of financial performance, such as that sented by Cooper Industries, turns on the classification of items of revenue, gain,expense, and loss as recurring versus nonrecurring The treatment of individually smallnonrecurring items also could have a significant influence on the message conveyed bythe adjusted earnings Some attention was given to the issue of materiality in Chapter 9.Some examples of the classification of items as nonrecurring are presented in the nextsection

pre-Nonrecurring Classification Decision

The classification of items as nonrecurring is the key to developing adjusted earnings

No definition can remove the need for judgment in identifying nonrecurring items ever, some further insight into this classification decision can be gained by reviewing therange of items removed from net income in arriving at the pro-forma earnings A sam-pling of these items is presented in Exhibit 10.9

How-Some of the labels applied to these pro-forma earnings numbers by the companieswere: underlying results (Johns Manville Corp and Phillip Morris Cos.), core operatingresults (Area Bancshares Corp.), pro-forma results (Schnitzer Steel Industries, Inc.),adjusted net income (Beringer Wine Estates, Inc and Air Canada), and normalized netearnings (Curtiss-Wright Corp)

The listing in the exhibit includes more nonrecurring charges than gains This simplyreflects the typical excess of nonrecurring charges over nonrecurring gains A review of1,100 third-quarter earnings reports for 2000 showed 18 nonrecurring charges per 100companies against only eight nonrecurring gains per 100 companies.38

Pro-forma, or adjusted, income measures are presented by many firms, but these sentations are found most frequently among firms with numerous nonrecurring items.With the growth in the frequency of nonrecurring items, adjusted earnings are essential

pre-in order to determpre-ine the trends, if any, pre-in basic operatpre-ing profitability The presence ofnumerous nonrecurring items may mask developing profitability trends There is someevidence that earnings purged of nonrecurring items have more predictive value andinformation content, and are more closely associated with firm value than as-reportedearnings.39

However, adjusted earnings are not developed with the level of formal guidance ciated with GAAP net income The limited number of adjustments reported withadjusted net earnings and the absence of detailed summaries of the nonrecurring items

Getting Creative with the Income Statement: Pro-Forma Measures of Earnings

Exhibit 10.9 Adjustments for Pro-Forma Earnings

Nonrecurring Losses or Expenses

American Standard Cos., Inc (1999) Asset impairment charges

ATI Technologies, Inc (1999) Purchased in-process research and

developmentBEA Systems, Inc (2000) Payroll taxes on gains from employee

optionsBeringer Wine Estates, Inc (1999) Charge from inventory step-up

Compaq Computer Corp (1999) Restructuring and related charges

Cone Mills Corp (1999) Operating losses of businesses exitedCrown Cork & Seal Co., Inc (1999) Charges due to an earthquake in TurkeyFederal Mogul Corp (1999) Reengineering and integration costsJohns Manville Corp (1999) Shutdown, demolition and site restorationMicron Electronics, Inc (2000) e-commerce infrastructure developmentNova Chemicals Corp (1999) Loss on hedges of currency exposures

reservePhillip Morris Cos, Inc (1999) Beer asset write-downs

Schnitzer Steel Industries, Inc (2000) Inventory write-down

Stewart & Stevenson Services, Inc (1999) Change in estimated profit on a contractToys “R” Us, Inc (1999) Costs to establish internet subsidiary

Nonrecurring Gains or Revenues

Airtran Holdings, Inc (1999) Gain on litigation settlement

Area Bancshares Corp (1999) Securities gains

C R Bard, Inc (1999) Gain on settlement of patent infringement

claims

Cisco Systems, Inc (2000) Sale of minority stock investment

Curtiss-Wright Corp (1999) Environmental insurance settlementsFederal Mogul, Inc (1999) Gain on currency option

Phillips Petroleum Co (1999) Kenai tax settlement benefit

Quaker Chemical Corp (1999) Reversal of repositioning and integration

chargesSupervalue, Inc (2000) Sale of Hazelwood Farms Bakeries

Sources: Companies’ annual reports The year following each company name designates the annual

report from which each example was drawn.

make it unclear how comprehensively earnings have been adjusted Ample roomremains for firms to be creative with the income statement data that are the grist foradjusted earnings A process that should be prompted by the desire to reveal what mightotherwise be obscured could, instead, be used to do the opposite.

Interim Pro-forma Earnings Releases

The examples of adjusted earnings are drawn mainly from information found in formalfinancial statement disclosures in company annual reports However, the initialannouncements of interim and annual earnings usually include relatively limited disclo-sures More complete information often is available only later, when the more formalinterim reports on Form 10-Q or the annual report on Form 10-K are filed or the annualreports to shareholders are released In the case of interim reports on Form 10-Q, notedisclosures are far less extensive than in the annual report It is quite common for lim-ited-disclosure earnings releases to include pro-forma measures of earnings, with theirprominence often greater than that accorded to GAAP-based net income or loss Thedegree to which these pro-forma measures are explained varies

The earnings release of Amazon.Com, Inc., for its 2001 first-quarter results is moredetailed than the earnings releases of many other companies.40The release provides auseful example of the adjustments made to arrive at pro-forma results and includes dis-closures that reconcile actual results under GAAP to the pro-forma results

In its release, Amazon initially presents information on sales and gross profit growth,and then follows immediately with a disclosure of a pro-forma operating loss of $49 Apro-forma net loss of $76 million is presented next The pro-forma net loss makes addi-tional adjustments for the effects of noncash gains and losses, equity in losses of equitymethod investees, and cumulative effect of a change in accounting principle The net loss

on a GAAP basis of $234 million is presented last

The Amazon earnings release includes comments on both the nature and role of thepro-forma information:

Pro-forma information regarding Amazon.com’s results from operations is provided as acomplement to results provided in accordance with accounting principles generally

accepted in the United States (GAAP) Pro-forma operating loss excludes stock-based

compensation costs, amortization of goodwill and other intangibles, and related and other costs (including restructuring and other charges) Management measuresthe progress of the business using this pro-forma information

impairment-Pro-forma net loss excludes stock-based compensation costs, amortization of goodwill

and other intangibles, impairment-related and other costs (including restructuring and othercharges), non-cash gains and losses, equity in losses of equity-method investees, and thecumulative effect of change in accounting principle.41

Amazon.Com places an emphasis on pro-forma as opposed to GAAP numbers when

it comes to judging their financial performance This is consistent with the declarationthat “Management measures the progress of the business using this pro-forma informa-tion.” In a listing of “Highlights of First Quarter Results,” seven items are listed, begin-ning with the growth in sales, gross profit, and customers These three disclosures are