The accounting trick that's killing WorldCom.

The accounting trick that's killing WorldCom.

The accounting trick that's killing WorldCom.

Moneybox
Commentary about business and finance.
June 26 2002 7:56 PM

The Accounting Trick That's Killing WorldCom

The announcement yesterday that long-distance giant WorldCom had fudged its books by $3.8 billion has not only pushed the company to the brink of extinction and debunked the legend of former CEO Bernard Ebbers. It has also given the lie to another myth of the '90s bull market: the infallibility of the financial metric known as EBITDA, or earnings before interest, taxes, depreciation, and amortization.

During the Bubble, investors—professional and amateur alike—came to regard EBITDA as a more reliable indicator of a company's financial health than the old standard, net income. The biggest reason for EBITDA's ascendance was that it was considered the financial equivalent of a Yale lock: tamper-proof.

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The EBITDA boom had its origins in the '80s, when companies began to take on more debt to complete acquisitions. The debt meant higher interest payments, which reduced net income. And the acquisitions created an asset called "goodwill": the difference between the price paid and the book value of the assets acquired. (Buy a company for $2 billion while it has tangible assets of just $1 billion, and you create $1 billion in goodwill. That $1 billion becomes an asset whose value is written down, or amortized, over time, and is charged against earnings, even though it doesn't represent cash going out the door.) Depreciation represents the decline in value of physical property like factories. Intel builds a $2 billion microchip plant and charges off the value lost by that plant each year. That's another reduction in taxable income that doesn't involve new cash expenditure.

In the late 1980s and early 1990s, acquisitive cable and telecommunications companies— which carried lots of debt, regularly depreciated their physical plants, and piled up billions in goodwill—made a strategic choice to start reporting net losses and instead encourage investors and lenders to focus on EBITDA.

Wall Street loved the new formula. Investment bankers began to use EBITDA to determine the value of companies for acquisitions or IPOs. Lenders made EBITDA a yardstick for how much credit they would extend companies. Prodded by talking heads on CNBC, investors went along.

More recently, Internet companies hopped on the EBITDA bandwagon. Their problem wasn't interest or depreciation—they had little in the way of debt or depreciable assets. But since most had no net income to speak off, they wanted to change the conversation. And many of them had bought similarly asset-light companies with the incredibly inflated currency of their own stock and thus had tons of goodwill to be charged off. The 2000 merger of AOL Time Warner, which combined a debt-laden cable company and overpriced Internet firm, was a marriage made in EBITDA heaven. Its executives trumpeted that the combination would be a cash machine, throwing off untold billions in EBITDA while likely reporting net losses into the distant future. By the late 1990s, EBITDA emerged as the best and simplest way for investors to gauge whether a company was able to charge more for its goods and services than it cost to make and distribute them.

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Best of all, it was thought, companies couldn't mess with that number. Chief financial officers could routinely manage earnings by using the tremendous leeway that existed to account for certain items or take various charges. But EBITDA had far fewer moving parts, and there was far less discretion in accounting for items like operating expenses and revenues. And that's why investors continued to trust in the validity of EBITDA numbers put out by companies like WorldCom, Qwest, and Global Crossing, even as their debts mounted and sales didn't meet expectations.

In admitting that it had manipulated its EBITDA, WorldCom pinned the blame squarely on Chief Financial Officer Scott Sullivan, who was fired coincident with the company's confession. Here's how Sullivan is supposed to be responsible. In 2001 and part of 2002, the company, presumably under the direction of Sullivan, took $3.8 billion in costs related to building out its systems, which were usually filed as "line cost expenses," and treated them instead as capital expenses. Remember, something that's a capital expense—say the construction of a plant—creates an asset whose value can be depreciated over time. More significantly, it doesn't count in the figures used in calculating EBITDA. By improperly recharacterizing those expenses—the maneuvers were done contrary to accepted accounting practices—WorldCom made it seem as if its EBITDA was $3.8 billion greater than it really was. This charade went on for five quarters, apparently undetected by WorldCom's hapless accountant, Arthur Andersen.

WorldCom is not the only company now suspected of having tried to manipulate EBITDA. Fellow telcom ne'er-do-wells Global Crossing and Qwest are suspected of achieving a similar result through different means. They allegedly engineered transactions whereby they sold services or products to companies and booked revenues. They then turned around and bought an equivalent amount of assets from the same customers, essentially returning the cash. But instead of treating those purchases as operating expenses, they treated them as capital expenses. Voilà! Without any money really changing hands, they breathed life into the impossible-to-inflate EBITDA number.

So, what now? With net income passé and EBITDA suspect—one wag, Chris Edmonds of TheStreet.com, suggests it should stand for Earnings Before I Trick Dumb Auditors—investors must now look further up the line in financial statements, to simple but poorly understood measures like operating cash flow or free cash flow. But it's probably only a matter of time before desperate executives use their alchemy to debase those pure elements and once again turn losses into profits.