Investors and lenders frequently use Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) to establish covenants and make investment decisions. Companies may also use EBITDA to measure performance and assist with internal reporting and employee compensation arrangements.
Three significant accounting changes on the horizon could impact EBITDA, and the business processes that rely on it. Investors and lenders should prepare for how the following affects companies’ EBITDA calculations and be prepared to reposition financial arrangements if the need arises.
Non-public entities are required to adopt the new revenue recognition guidance in Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606) for annual periods beginning after Dec. 15, 2018 (calendar year end 2019). Several provisions in Topic 606 could affect a company’s EBITDA.
Performance bonuses and other forms of variable consideration may need to be recognized earlier than under previous guidance. Take the following example: A construction contractor has a two-year contract that contains a bonus if safety metrics are met at the end of the project. Under previous guidance, the bonus would have been recognized at the project’s end. Under Topic 606, the contractor concludes that the estimated performance bonus amount should be recognized, and pulls forward recognition of a portion of that bonus to year one of the contract. All other things being equal, this would be increase net income and EBITDA in the first year and decrease it in the second year.
Also changing is the guidance around commission expenses. Commissions may be capitalized on the balance sheet as an asset and amortized over the term of the contract with the customer, or even longer. The effect of the change would cause deferrals of expenses, increasing EBITDA in earlier periods as compared to prior guidance.
In February 2016, the Financial Accounting Standards Board (FASB) issued ASU 2016 02, Leases (Topic 842) which also may have an impact on EBITDA. A lessee with a treatedas- finance lease under Topic 842 would recognize interest expense (similar to a capital lease under prior guidance), and for an operating lease, recognize a lease expense. Changes in lease classification or lease structure (now that all leases will be required to be presented on the balance sheet) could have a significant impact on EBTIDA. Other changes, such as the accounting for initial costs and the allocation decision between lease and non-lease components could have longterm ramifications for EBTIDA as well.
Topic 842 is effective for annual periods beginning after Dec. 15, 2019 for non-public business entities (calendar year end 2020).
A recent change to accounting for cloud computing arrangements implementation costs requires certain costs to be capitalized beginning in 2021 for nonpublic business entities. Historically, companies have expensed the implementation costs when incurred, resulting in a direct decrease to EBITDA in the year the cloud computing arrangement commenced. Some companies would pre-negotiate an adjustment to their covenant compliance when they planned to incur large implementation costs in a particular year. Under the new guidance, the implementation costs are deferred and amortized over several years. The amortization is recognized in the same line item as the service fee for the cloud computing arrangement, which may mean that the amortization of the capitalized implementation cost may not qualify as amortization for EBITDA computations.
Investors and lenders may need to work with companies to review existing covenant calculations and definitions and determine the appropriate treatment of the amortization when using EBITDA as a metric.
PLANNING FOR CHANGES
Investors and lenders may find it helpful to plan ahead for the changes that could impact EBITDA. In some cases, it may be worthwhile to use operating cash flows as an additional metric to EBITDA to track performance and aid in decision making. Existing covenant agreements may also need to be renegotiated before a compliance issue arises.
Kelly O’Neil is a Lead Managing Director for CBIZ MHM, LLC, an accounting and financial services provider and the Attest Practice Leader for the Southern California practice of MHM, a national CPA firm that provides audit and attest services. Kelly specializes in complex accounting issues.