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Is the possible manipulation of depreciation and amortisation charges more susceptible to fraudulently misleading practice than level 3 fair value calculations are?
Depreciation & amortisation is one of the accounts that are highly susceptible to manipulation and fraudulently misleading practices in business (Jonada & Aliaj, 2014). The techniques used to manipulate depreciation and amortisation charges include charging less depreciation on assets, increasing the lifespan of assets, changing the method of calculation, keeping assets that are no longer in use on the balance sheet, and revaluing assets (Jonada & Aliaj, 2014). Another account that is susceptible to manipulation is the level 3 assets because it is not possible to determine their fair value using observable measures like market models or prices since they are very illiquid (Jonada & Aliaj, 2014). As such, calculation of their fair values can only be done using risk-adjusted value ranges or estimates.
However, while both accounts are susceptible to fraudulently misleading practices, level three assets are more susceptible when compared to depreciation and amortisation for a number of reasons. One is that it is easier to detect fraudulent practices in depreciation & amortisation charges than level 3 assets (Kenton, 2018). For example, it is easy to determine whether a company has fraudulently reduced the amount of depreciation and amortisation charges on its equipment. On the other hand, it is hard to determine whether a firm has underestimated or overestimated the value of its level three assets since the valuation is based on complex models and subjective judgement (Damodaran, 2012). Since the value of these assets can only be determined through subjective judgement, it makes them more susceptible to manipulation and fraudulently misleading practices.
Another reason level three assets are more susceptible to fraudulently misleading practices is because these assets are the least marked to market and are not actively traded (Kenton, 2018). Valuation of assets can be particularly challenging when the assets do no trade regularly. For assets that lack an observable market such as level three assets, there is normally discrepancies between the value a company places on them and the value that a third party valuation expert places on the assets. To deal with this challenge, a number of models are based on numerous assumptions and multiple data sets were developed.
However, these models are also susceptible to manipulation. For example, a company may decide to value its level 3 assets based on a model that assumes a certain earnings estimate or growth rate that is aimed to achieve a discounted cash flow (Damodaran, 2012). The inability to place a value on the assets through pricing as well as the susceptibility of the models makes level three assets to be more vulnerable to manipulation.
Lastly, since they are not actively traded, level three assets are not significantly scrutinised. Physical assets are constantly traded, for example, companies constantly sell their machinery in order to buy new ones, which expose them to scrutiny. On the other hand, level three assets are not sold (Kenton, 2018). This makes it hard to scrutinise them during the buying and selling process. In addition, even if it was possible to trade in these assets, the fact that their value can only be determined through subjective judgement increases their susceptibility to manipulation and fraudulently misleading practices.
“The very expenses that EBITDA ignores are in fact operational expenses required in the day to day operations of the company.”
This argument is true in the sense that most of the expenses are ignored in EBITDA have a huge effect on a company’s earnings. One of the expenses normally ignored in the determination of EBITDA is depreciation and amortisation. The reason they are ignored is that they are non-cash expenses (Kenton, 2018). It has been argued that since depreciation and amortisation are expenses related to already purchased assets, there is no movement of cash from one point to another where these expenses are involved. As such, they have no effect on the financial performance of a company. Another reason is that depreciation and amortisation expenses are subject to estimates or subjective judgements. Depreciation and amortisation charges are determined through projections of how long assets will last. These charges are adjusted based on new projections, experience and even fraud. It is considered that excluding depreciation and amortisation helps to paint a true picture of the operational performance of a company.
However, this is not always the case since firms in capital-intensive industries like the telecommunication sector, depreciation and amortisation are a major expense that cannot be ignored. Moreover, their capital expenditure is a significant part of the cash outflow (Jonada & Aliaj, 2014). Capital expenditure in the telecommunication industry is in form of network equipment and towers, which are real expenses, which makes it an intrinsically operating expense. Consequently, depreciation and amortisation charges become real expenses recorded on the income statements and make them to have a significant effect on the companies’ cash flow and financial performance (Jonada & Aliaj, 2014). This observation is also made by Professor Higson of London Business School who argues that depreciation is a real cost since it consumes the productive capacity of businesses. Higson also observes that depreciation in capital-intensive companies is one of the largest costs. Its omission creates an unrealistic picture of a company’s financial performance.
Another important expense ignored in EBITDA is the interest expense. The argument that is normally advanced for this omission is that it helps to provide a better operational profitability picture of a company (Ajekwe & Ibiamke, 2017). However, excluding the interest expense does not provide an accurate picture of operational performance of a company. It should be noted most companies, irrespective of their size, use debt financing to fund some of their operations, which implies that interest expense is part of their operation. In capital-intensive sectors that include oil and gas, steel and telecom, debt financing is normally very high, amounting to billions of dollars. Consequently, the interest expense for these companies is also very high. For example, in 2011, the EBITDA for US Steel, a leading steel producer in US, was 1 billion dollars while its operating cash flow was only 150 million dollars (Sibayan, 2016). The company’s depreciation and amortisation expenses amounted to 700 million dollars while the interest expense amounted to 200 million dollars. The reason for the high interest expense was that a significant part of the company’s 850 million dollars capital expenditure in 2011 was funded using debt. From this example, it can be seen that interest expense is a significant cost incurred by business and should thereby be considered as an operational expense that should be factored in EBITDA (Sibayan, 2016). Therefore, the argument that most of the expenses ignored in EBITDA are actually operational expenses that affect the daily operations of businesses is true.
Which of WorldCom, Qwest and Global Crossing is the most serious case of fraudulent capitalisation of expenses and why?
There are many cases of companies being involved in fraudulent capitalisation of expenses such as WorldCom, Qwest, and Global Crossing. WorldCom was a telecommunication company located in Clinton and had 80,000 employees and 200 million customers. However, in 2000, the telecommunication industry began to slow down. As a result, the company experienced credit rating downgrades and job cuts (Kennon, 2018), which caused a decline in the company’s stock values from 64 dollars to 2.65 dollars, which led to a significant revenue reduction. Due to the declining revenue and profitability, a number of officers in the company decided to use expense capitalisation, which involved recording expenses as revenue to overestimate revenue in order to paint a more appealing picture of the company’s financial performance. For example, in 2001, WorldCom’s cash flow was overstated by over 3.8 billion dollars. As a result, the company reported a profit of 1.4 billion dollars (Kennon, 2018). However, in reality, the company would have registered a loss if expenses had been recorded correctly.
Like WorldCom, Qwest was also a telecommunication company. It provided services to 14 US states. From 1999 to 2002, Qwest engaged in constant financial fraud that was designed to misinform investors about its revenue generation and growth (Ajekwe & Ibiamke, 2017). In this period, the company recognised about 3.8 billion dollars of spurious revenue while at the same time excluded 231 million dollars in expenses.
Global Crossing was also a telecommunications company that offered computer-networking services. The company accumulated 12.4 billion dollars in debt while building its fibre optic network (Gherai & Balaciu, 2011). In 2002, the company filed for bankruptcy amid allegations of fraud. Through extensive expense capitalisation, the company’s market capitalisation increased to over 40 billion dollars, which made the 12.4 billion dollars debt to look more manageable (Ajekwe & Ibiamke, 2017).
From the three companies, the most serious case of expense capitalisation was that of WorldCom because of the amount of money involved in the capitalisation. The company managed to spread a total of 3.8 billion dollars of expenses across different departments. The other two companies were involved in smaller amounts of expense capitalisation (Kennon, 2018). For example, Qwest excluded 231 million dollars while Global Crossing capitalised 150 million dollar worth of expenses. In addition, unlike Qwest that simply excluded the expenses, WorldCom turned the expenses into revenue (Ajekwe & Ibiamke, 2017). The fraud thereby did not only involve hiding expenses but also turning them into revenue.
Interest is an operating expense for businesses such as steel and other high leverage businesses. Does this mean interest should be included in the measure of earnings in these cases, in all cases or in no cases?
Interest expense should not be included in any of the cases because it will bring about discrepancies that would make it hard to compare companies. Companies are subject to different interest rates on their debts. As such, inclusion of interest in the measure of earnings does not paint an accurate picture of a company’s ability to generate revenue (Sibayan, 2016). In addition, interest is significantly high for steel and other high leverage businesses. Thus, including it in the measure of earnings would provide a poor picture of these companies’ ability to generate revenue.
It should be noted that measures of earnings such as EBITDA provide information about a company’s operational efficiency and not its cash flow. Those who criticise the exclusion of interest from EBITDA do so because they have substituted EBITDA for cash flow (Sibayan, 2016). They indicate that interest expense particularly for capital-intensive industries has a huge effect a company’s cash flow and should be included in the measure of earnings. While it is true that interest has a significant effect on the cash flow, it does not justify its inclusion in the measure of earnings since the measure of earnings is not concerned with cash flow.
However, excluding interest from EBITDA does not mean that investors should ignore it altogether in evaluating the profitability of a company (Owolabi & Obida, 2012). It should be remembered that investors, particularly shareholders, are paid dividends based on the amount of net profit that their company has made. Lower profitability means that shareholders get reduced dividends and vice versa. In addition, if a company becomes bankrupt because of its inability to be profitable, investors stand to lose their investments. Companies pay their expenses from the profits they have made. This implies that a firm with a high interest expense is less profitable. If the interest expense exceeds the gross profit, the company registers a net loss (Brigham & Houston, 2012). It is important for investors to consider such factors before investing in a company. However, for comparison purposes only, interest expense should be excluded.
Apple and Exxon are compared for 2012 for their gap between EBITDA and operating cash flows. How far has the picture changed from 2012 to 2017?
In 2012, Apple’s EBITDA was 58.518 billion US dollars while Exxon’s EBITDA was 94.941 billion dollars. Since then, the picture has changed significantly for the two companies (Macrotrends). Apple has experienced a mixed performance over the years, registering growth in its EBITDA in some years and a decline in other years. For example, in 2013, the company’s EBITDA reduced to 55.756 billion dollars. In 2014, the earnings went up to 60.449 billion dollars. In 2015, there was a further growth in the company’s EBITDA to 82.487 billion dollars (Macrotrends). However, in 2016, there was a drop in the earnings to 70.529 billion dollars. In 2017, Apple’s EBITDA increased slightly to 71.501 billion dollars.
On the other hand, Exxon experienced a decline in its EBITDA from 2012 to 2017. For instance, in 2013, the company’s EBITDA reduced to 74.902 billion dollars. In 2014, there was further reduction to 69.213 billion dollars (Macrotrends). In 2015, Exxon’s EBITDA reduced further to 40.325 billion dollars. In 2016, there was further reduction in the company’s EBITDA to 30.730 billion dollars. However, in 2017, the company experienced an increase in its EBITDA to 39.168 billion dollars (Macrotrends). In general, from 2012 to 2017, Exxon experienced a decline in its EBITDA.
There are a number of reasons for these varying trends between the two companies such as change in sales. Apple has experienced an increase in sales over the years. As a result, the company’s revenue has grown significantly thereby increasing its EBITDA (Macrotrends). On the other hand, Exxon has experienced a decline in its revenue through the years. For example, between 2013 and 2017, the company’s revenue declined by 263 billion dollars due to reduction of the company’s downstream operations (Macrotrends). During this period, Exxon aimed to increase its presence in the more profitable upstream business.
Another reason is change in prices, for example, there was reduction in oil prices between 2013 and 2016. On the other hand, there was an increase in production costs in the oil and gas industry. A combination of the two factors resulted in a significant decline in Exxon’s EBITDA in this period (Macrotrends). However, in 2017, market conditions improved and oil prices increased significantly, which resulted in an increase in Exxon’s EBITDA in 2017. The fluctuating product prices and increase in production cost is also the reason why Apple experienced fluctuations in its EBITDA over the period (Macrotrends).
Ajekwe, C.C. & Ibiamke, A. (2017). Accounting Frauds: A Review of Literature. IOSR Journal Of Humanities And Social Science (IOSR-JHSS) 22(4), 38-47.
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Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (Vol. 666). Hoboken: John Wiley & Sons.
Gherai, D. S., & Balaciu, D. E. (2011). From creative accounting practices and Enron phenomenon to the current financial crisis. Annales Universitatis Apulensis: Series Oeconomica, 13(1), 34.
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Kennon, J. (2018). The WorldCom scandal explained. Retrieved from https://www.thebalance.com/worldcom-s-magic-trick-356121
Kenton, W. (2018). Level 3 assets.Retrieved from https://www.investopedia.com/terms/l/level3_assets.asp
Macrotrends (n.d). Apple EBITDA 2006-2018. Retrieved from https://www.macrotrends.net/stocks/charts/AAPL/apple/ebitda
Macrotrends (n.d). Exxon EBITDA 2006-2018 | XOM. Retrieved from https://www.macrotrends.net/stocks/charts/XOM/exxon/ebitda
Owolabi, S. A., & Obida, S. S. (2012). Liquidity management and corporate profitability: Case study of selected manufacturing companies listed on the Nigerian stock exchange. Business Management Dynamics, 2(2), 10-25.
Sibayan, K. (2016). What is EBITDA, and why do investors care about it? Retrieved from https://www.axial.net/forum/what-is-ebitda-and-why-do-investors-care-about-it/