Question

Depreciation and amortization are non-cash expenses related to assets that have already been purchased. They are subject to judgment and estimates, including how long the underlying asset will last and whether they get adjusted based on experience or new projections. An internet search will reveal articles and reports of businesses using depreciation to manipulate financial information. Executives and financial companies focus on EBITDA (earnings before interest, taxes, depreciation, and amortization) as one measure of the financial health of a business. EBITDA is often used as a loan covenant, with borrowing limits set as percentages of EBITDA. •Examine the importance of depreciation/amortization to presenting a fair evaluation of a company. Should more emphasis be placed on EBITDA than on financial reports presented according to GAAP? Does the use of EBITDA remove the chance of manipulating depreciation/amortization?

Answer 1

For a fair evaluation of a company,we use depreciation and amortization methods. The concept of depreciation and amortization is to write off the asset over the useful life of the asset in a reasonable manner to the Profit and loss account.The reason being that correct profit or loss for the accounting period cannot be obtained unless all costs , losses ,expenses are accounted.It is used in a company because of the following reasons:

• For ascertaining the correct profit or loss for a period and thereby showing the current financial position of the company.
• To retain out of profits the funds for replacement.It shows the company's future leverage potential.
• To determine the accurate cost of production.

Thus if correct rates and procedures of depreciation and amortization are followed,the company's exact financial position can be ascertained.

No, more emphasis on EBITDA is not desirable because of the following reason:

1. GAAP does not have a clear definition of EBITDA.Thus it is left to the discretion of companies to disclose it according to their wish which results in the fact that it does not show the overall picture of a company's performance.
2. It might make the interests of the company look "easily repayable" when it adds back depreciation and amortization expenses. For example, a company's operating profit amounts to 15 million and its interests amounts to 20 million.By adding back the depreciation of 7 million the operating profit increases to 27 million. The depreciation is added back on the flawed assumption that these are avoidable costs as they are non-cash items(which is basically wrong).Thus suddenly the interests look easy to be paid. It can make any company look fiscally healthy.
3. It is often confused with cash flow.

This suggests that EBITDA alone does not reveal a company's exact financial position.

Manipulation of depreciation in company's may be of the following ways:

• Charging less depreciation on the assets.
• Change in the method of calculation (as in the case of Jet airways which switched from WDV to SLM)
• Keeping no longer used assets in the balance sheet.

Since depreciation and amortization are non-cash expense they are subjected to judgement or estimates which are based on their"useful life ","underlying costs " etc which are prone to fraudulent practices. Thus EBITDA helps to make us identify a far more realistic picture of the operational performance of the company , that is, earnings before interests ,tax ,depreciation. Thus it helps investors be less affected by manipulations in them.