April 2002

All About Pro Forma Accounting

By Bob Halsey and Ginny Soybel

The use of pro forma earnings has become commonplace as companies seek to redefine the benchmark against which they are to be evaluated. These pro forma earnings purportedly portray better operating results by excluding transitory items such as asset write-offs.

The term pro forma has appeared routinely in financial reporting in the footnotes to describe historical results as if the company had made a particular acquisition or disposition at an earlier date. Pro forma literally means "as a matter of form," which provides little guidance for an accepted definition of pro forma earnings.

The term has been used in financial reporting to enhance comparability in time series measures. In that sense, companies contend that their alternative earnings metrics offer more comparable results than GAAP measures, which include the effects of anomalous, nonrecurring items such as restructuring charges and gains and losses on the sales of assets. But this introduces a comparability problem: With no accepted definition of pro forma earnings, financial statement users cannot confidently compare numbers across different companies.

This lack of common usage led the SEC to issue "Tips to Investors on Pro Forma Financial Information," a general warning urging caution. SEC Chair Harvey Pitt has suggested new accounting standards to define what is to be included under "pro forma" and "operating" earnings.

Significant differences between GAAP and pro forma earnings are not uncommon. For example, when the Associated Press analyzed earnings reports of the 100 largest technology companies in northern California, it calculated that, under GAAP, the 100 companies reported combined losses of $71 billion. Using pro forma figures, however, these same companies reported a profit of $10 billion.

Pro forma results are disclosed under SFAS 123, which requires companies to report net income and earnings per share as if the firm had recorded compensation expense for the fair value of options granted to employees.

A comparison of three companies illustrates the diversity of alternative earnings. Consider the 2000 annual reports of Dynegy, the Williams Companies, and the now infamous Enron Corporation. Enron's management discussion and analysis (MD&A) discloses "net income before items impacting comparability" and lists those items-asset write-downs, one-time gains, and the cumulative effect of an accounting change-in a table. A similar disclosure in Dynegy's 2000 MD&A focuses on "recurring net income," which has been adjusted for asset write-downs, one-time gains and losses, severance charges, and acquisition costs.

In contrast, Williams made no such alternative calculation of earnings, so that the investor who wished to analyze earnings before, for example, acquisition costs would have to read Note 2 of the annual report to know that Williams incurred debt of $80 million in 1998 in connection with its merger with MAPCO. Similarly, asset impairment charges are disclosed in Note 5, while gains and losses on the sale of marketable securities are disclosed in Note 4. Williams does summarize most gains, losses, and impairments in the footnotes to its unaudited quarterly results included in the annual report.

Some may argue that Enron and Dynegy provided information to investors in a more readily accessible form than Williams by aggregating all nonrecurring items and disclosing their after-tax effects on income in one prominent place. But the problem is that Enron and Dynegy made their own selection of nonrecurring items. For example, Enron did not remove the effects of the gains on the sales of "non-merchant" investments, while Dynegy did not remove the effect of pension income (a likely temporary result of an overfunded plan). This issue gets to the heart of calls for reform and regulation of pro forma or adjusted earnings.

What risks do companies incur when they use pro forma reporting? Consider the remarks of SEC Chair Harvey Pitt: "I would say in cases where pro forma statements change a loss into a profit, my view is there is an almost 100% chance that a company that is capable of doing that without appropriate disclosure will have defrauded or confused its investors."

Both Financial Executives International (FEI) and the National Investor Relations Institute (NIRI) have issued best practices guidelines. Their conclusion: Earnings press releases should include "reported" results for the period presented under GAAP. Pro forma "cash basis" or "adjusted," "underlying," "ongoing" or "core" results are often used to supplement GAAP results, and are provided to clarify both performance and future prospects. GAAP results provide a critical context for pro forma results, even where pro forma results are more useful.

It is generally acknowledged that additional disclosures by management can help investors understand the core drivers of shareholder value. These disclosures reveal how companies analyze themselves and can be useful in identifying trends and predicting future operating results. The general effect of pro forma earnings is purportedly to eliminate transitory items and enhance year-to-year comparability. Although this might be justified by greater predictive ability, important information is lost.

Accounting is beneficial in reporting how effective management has been in its stewardship of invested capital. Asset write-offs, liability accruals, and other charges eliminated in this process may reflect the outcomes of poor investment decisions or poor management of corporate capital. Investors should not blindly eliminate this information by focusing solely on pro forma earnings. A systematic definition of operating earnings and a standard income statement format might be helpful, but they are not a substitute for the due diligence and thorough examination of the footnotes that constitute comprehensive financial statement analysis.

Bob Halsey, PhD, and Ginny Soybel, PhD, are associate professors of accounting at Babson College, Babson Park, Mass.