Shedding light on income adjustments
As the financial impact of COVID-19 unfolds, many businesses are grappling with sudden and dramatic shifts in business demand. For some, extended home orders mean a significant reduction in income, higher costs due to supply chain disruption and other issues, and lower levels of profit before interest, taxes, depreciation. and amortization. Companies that do not face business closures may still incur additional costs to keep their workforce safe.
While the severity and duration of the pandemic remains uncertain, and the long-term repercussions are unclear, many companies are closely monitoring the effects of the pandemic on EBITDA, a key metric often used in financing agreements. and in the valuation of a company. Indeed, we are seeing that some companies are adjusting EBITDA for the impact of COVID-19 and have coined the term “EBITDAC”, to represent EBITDA before the coronavirus.
What other types of EBITDA adjustments are we seeing and how will COVID-19 continue to affect accounting and valuations?
EBITDA and adjusted EBITDA
EBITDA is a common component of financial covenants in credit agreements. Credit agreements generally allow for various adjustments, including extraordinary, unusual or one-time charges (see Table 1 below). The intent of Adjusted EBITDA, which includes additions and deductions, is to present a standardized view of ongoing financial performance. However, the types of adjustments allowed are largely determined by judgment and negotiation and may be subject to accounting interpretation.
While the types of adjustments allowed differ by credit agreement, in general, the ability to maximize add-ons provides increased capacity for additional debt, dividends, and investments. For businesses stressed by COVID-19, additional additions may mean avoiding default on their credit agreements.
As companies assess the financial impact of COVID-19, we see that some are starting to quantify the effects in the calculation of Adjusted EBITDA. While some adjustments are likely to be considered extraordinary, non-recurring or unusual, others are more subjective and will likely need to be negotiated (see Table 2 below).
We anticipate that cash expenses that can be clearly identified and that are directly attributable to COVID-19 will be fairly common additions. These types of adjustments are consistent with the SEC’s recently released COVID-19 impact disclosure guidance, which we believe highlights that EBITDA adjustments are both: (a) incremental by compared to the charges incurred before the epidemic and should not recur after the return operations. normal and (b) clearly separable from normal operations.
We also started to observe some more subjective adjustments such as those related to lost revenue or missing margin. These adjustments are inherently more controversial as the amounts are more difficult to isolate, quantify and substantiate factually. While it is clear that many businesses are affected by closures and home orders, it is difficult to quantify the effects on lost business and separate the effects from other factors. In addition, there may be significant uncertainty as to when activity will revert to pre-COVID-19 levels, if any, for the reporting entity.
As the SEC encourages disclosures about the effects of COVID-19, the SEC has also reinforced its view that estimates of lost revenue from the pandemic should not be included in the calculation of non-GAAP measures .
The subjectivity of certain adjustments results from the assumptions that must be made to quantify the amount of EBITDA to be added rather than the amount of EBITDA that has been lost. For example, a business may easily be able to quantify the impact on EBITDA of lost volumes from a contract that has been terminated or an event that has been canceled due to COVID-19. However, the amount to be added to EBITDA, if any, will likely be based on subjective assumptions made by management.
Adjusted EBITDA also plays an important role in merger and acquisition activity as it contributes to the valuation of a business. EBITDA adjustments for M&A purposes are often similar to those included in covenants calculations, but can include a host of other adjustments indicating long-term value.
Loans: forgiven but not forgotten
EBITDA and debt-based measures could also be impacted by participation in US government stimulus programs, such as those provided by the Coronavirus Aid, Relief, and Economic Securities Act (“CARES Act”). This program allows eligible businesses to receive forgivable loans through the Paycheck Protection Program (PPP), if certain conditions such as maintaining specific pay and employment levels are met.
The impact of these loans on key financial metrics could boil down to whether the business meets the criteria for loan eligibility and cancellation – and how the loan proceeds are accounted for. This is because there is no guidance in US GAAP that specifically addresses accounting by a business entity that obtains a forgiveness loan from a government entity.
We understand that the recent and emerging accounting interpretation suggests that PPP loans can be reported either as debt or as a government grant in substance, the recognition of which may differ and could impact EBITDA as well as on debt-based measures. Companies that recognize the loan proceeds as debt would earn interest over the life of the loan. If an amount is ultimately written off, the income from the extinguishment of the loan would be recognized as a gain in earnings. In contrast, companies that apply subsidy accounting would not record any debt. (See the summary in Table 3 below.) It will also be important to consider how businesses view adjustments for loan forgiveness gains as additions for other losses are made.
In practice, we expect that the alternatives, coupled with uncertainties about the criteria for loan forgiveness, could lead to some diversity in practice as to how and when to recognize.
A number of other accounting issues have arisen from COVID-19 that could impact EBITDA. These issues include rent concessions granted to tenants affected by the economic disruption as well as restructuring costs associated with lease terminations, severance pay and other divestiture activities. Since the accounting rules related to these matters can be difficult, it will be important to assess the extent to which these items affect Adjusted EBITDA. Beyond these issues, we expect other additional financial reporting challenges to emerge to the fore.
While there is a lot of attention on the types of adjustments included in EBITDA, it is also important to have a broader perspective on the impact of COVID-19 on operations, margins and flexibility. financial in the future. As businesses pivot towards recovery, there are still many unknowns about the magnitude and severity of the economic and health impacts – and when and if demand for businesses returns to pre-COVID 19 levels. These unknowns include the scope and effects of other government, regulatory, fiscal, monetary and public health responses. Ultimately, no number can represent a true representation of “normalized” performance, and it is incumbent on users of financial information to feel more comfortable with degrees of uncertainty.
We expect to see the manifestation of COVID-19 adjustments in financial markets for some time. Even if the recovery is rapid, financial covenants are generally tested on a “last 12 months” basis. Over time, adjustments will become more common and the types and amounts of adjustments will become more obvious.
Likewise, we expect to see the effects of COVID-19 adjustments incorporated into assessments as companies demonstrate operational capability in a post-COVID-19 world. While the assessment takes a longer-term view, we anticipate increased use of earn-outs in M&A transactions until uncertainty surrounding the impact of COVID-19 is reduced over time. .
Ultimately, Adjusted EBITDA is and always has been interpreted by users of this information, and we believe the effects of COVID-19 will be no different. In the near term, we expect significant diversity in the meaning of the term “adjusted EBITDA” as used in both financing and mergers and acquisitions. However, over time we would expect to see some convergence of views depending on what is accepted in the market.
Jonathan Nus and Michael Tamulis are Managing Directors in the Alvarez & Marsal transaction advisory group and co-lead the group’s capital markets and accounting advisory team.