The Dangers of Pro Forma Reporting
By Kevin L. James and Franklin A. Michello
The use of pro forma earnings statements in press releases issued by publicly held companies has become a popular trend, but these statements are considerably different from what has traditionally been called pro forma. Traditional pro forma financial statements were commonly used to show the results of some assumed event primarily to ensure amounts from the prior period could be compared to current period amounts. For example, prior year statements of a merged company could be stated as if the merger had taken place a year earlier, to facilitate comparability.
In contrast, pro forma earnings statements in current usage have come to mean that many items are excluded from the calculation of net income at the discretion of management. These items may include charges or gains for certain items that are noncash or that management regards as one-time or irrelevant to the core operations of the company. Expenses commonly excluded from pro forma earnings include restructuring charges, amortization of certain intangible assets, and noncash expenses paid with equity. Commonly excluded gains include unrealized investment gains and gains from one-time sales of assets.
Pitfalls of Pro Forma Reporting
Many critics argue that pro forma earnings reports are simply an attempt by management to cast the company’s earnings in a more positive light or to excuse poor financial performance. They cite that such reports seem especially handy at turning a GAAP loss into a pro forma profit. A review of 185 quarterly earnings announcements found in the Wall Street Journal for a recent three-month period (November 2001 through January 2002) shows that when pro forma earnings were reported, they were almost always (88% of the time) higher than GAAP earnings. The net effect of pro forma reporting for the 58 companies that used it was to increase net earnings $11.4 billion over GAAP earnings. Furthermore, companies with a GAAP loss were more likely to state pro forma earnings amounts than companies with a GAAP profit (40% versus 27%).
There seems to be support for the contention that GAAP losses are often recast as pro forma profits. Twenty-seven companies with a loss under GAAP also stated a pro forma earnings amount, 59% of which were pro forma profits. When January 2002 is examined separately, that percentage jumps considerably, to 80%. This may be due to the fact that in November and December 2001, 41% of companies with a GAAP loss attributed it to the effects of the September 11 terrorist attacks, thereby giving them less incentive to use pro forma reporting to excuse net losses.
Pro forma earnings reports are not reviewed by any independent party prior to their release, so there are no checks on the reasonableness of which items management chooses to exclude. As a result, there is no consistency in the calculation of pro forma earnings, no regulatory guidance or standard definitions. The specific expenses or gains excluded from the calculation of pro forma net income vary from company to company, often within the same industry, making comparisons between two companies very difficult. More disturbing is the fact that items excluded from pro forma earnings sometimes vary from one period to the next based upon what the company’s management chooses to emphasize.
Considerable variance exists in the relative prominence given to pro forma versus GAAP earnings among companies that state both in their press releases. Some companies provide a table detailing the items and amounts excluded from GAAP earnings, which allows the reader to reconcile pro forma earnings to GAAP. Other companies provide a narrative description of reconciling items but fail to list the amounts of these items. Still other companies provide no reconciling information at all.
Probably the most controversial approach is the release of pro forma earnings before audited GAAP financial statements are available for comparison, and with little or no reconciling information. Early release of pro forma earnings encourages investors to make uninformed stock decisions. The noncash items and one-time charges that are not reflected in pro forma earnings are nonetheless generally important enough to be folded into stock prices. For example, the inclusion of a one-time write-off of unsellable inventory may not add predictive value for earnings, but it does provide information about the effectiveness of management and the health of the company. This concern, coupled with the tendency for pro forma earnings amounts to paint an overly positive picture, raises the concern that reporting pro forma earnings outside of the context of GAAP earnings can be a deliberate attempt by management to manipulate investor perception and, hence, stock price.
Merits of Pro Forma Reporting
Many company managers have asserted, and the SEC has agreed, that pro forma reports can provide useful management interpretation of financial results, similar to management’s discussion and analysis (MD&A). One group, Financial Executives International (FEI), has taken steps toward increasing the uniformity, informativeness, and fairness of pro forma earnings reports. Joined by the National Investor Relations Institute (NIRI), a professional association of corporate officers and investor relations consultants, FEI issued a statement of best practices on earnings press releases. The statement encourages companies to always accompany pro forma earnings with a reconciliation to GAAP earnings. The statement does not address what items should or should not be included in pro forma earnings, thus hampering comparability between companies. The statement does recommend that companies maintain consistency between periods with respect to the items that reconcile pro forma and GAAP earnings.
In January 2002, NIRI released the results of a survey conducted to assess the extent to which its own member companies use pro forma reporting and follow FEI/NIRI guidance. Of the 233 member companies surveyed, 57% reported pro forma information. Approximately 10% of these companies failed to comply with guidance provided in the FEI/NIRI statement.
As primary users of earnings announcement information, individual investors have a huge stake in whether it is ultimately harmful or helpful. In order to gather information on current and potential individual investors’ attitudes toward pro forma reporting, the authors surveyed 79 MBA students, 60% of which currently own stock (with an average of 3.7 years of investing experience).
Our results reveal considerable discomfort on the part of individual investors. While 84% of respondents were familiar with the use of pro forma earnings reports, only 38% used these numbers to make investing decisions.
Survey participants were first asked the general question, “How would you compare the usefulness of pro forma earnings statements to the usefulness of earnings prepared in accordance with GAAP in making financial decisions?” Nearly two-thirds of respondents (63%) indicated that pro forma reports were less useful than those prepared according to GAAP, and only 8% indicated that pro forma reports were more useful than GAAP reports.
To further examine the relative usefulness of pro forma versus GAAP reporting, the survey provided brief statements summarizing the objectives of financial reporting as delineated in FASB’s Concept Statement 2. We first asked respondents to indicate the extent to which they agreed or disagreed that the characteristics in each statement were fulfilled by pro forma earnings reports versus GAAP reports (see the Exhibit). The results reveal a perception that GAAP reports fulfill these characteristics much better than pro forma reports. GAAP statements were considered to provide a more faithful representation of the company’s true financial health, which is consistent with concerns that management might use pro forma reports to distort the company’s financial health. Respondents did perceive some value in pro forma statements in terms of providing relevant and timely information and in having predictive value and feedback value. Nonetheless, GAAP statements still scored slightly better in these categories, and significantly better in the areas of verifiability, neutrality, comparability, and consistency.
Participants strongly agreed (83%) that steps should be taken to increase uniformity and fairness in reporting pro forma amounts through an accounting rule-making body. Furthermore, 71% of respondents agreed that pro forma amounts should be reviewed by an independent CPA prior to being issued to the public. Over 58% of respondents expressed concern that pro forma reports were an attempt by management to manipulate earnings or influence stock prices. Finally, 53% agreed that pro forma results should never be reported before GAAP statements are available for comparison.
Is Stronger Regulation Needed?
Some have called for FASB to intervene by issuing guidance for the use of pro forma financial information. FASB, however, has chosen not to directly address the issue of pro forma earnings and has questioned whether it has authority over press releases not certified by auditors. Nevertheless, it has cited the confusing and inconsistent nature of pro forma reporting as a major reason for the recently adopted project on financial performance reporting. This project seeks to more clearly define and more consistently report financial statement lines, subtotals, and totals. Such standardization may indirectly increase the consistency of reports outside of GAAP statements even though such reports will not be directly addressed. Also, as one part of the project, FASB will consider whether core and noncore activities should be separated in GAAP financial statements, part of what creates the impetus for pro forma statements at some companies. Thus, the project may also lessen the need for pro forma reporting.
The SEC has taken a much more direct approach by issuing a strong caution for companies to be particularly mindful of their duties not to mislead investors when presenting pro forma amounts. In a statement, the SEC recommends disclosing the basis of presentation for pro forma information, such as the transaction being omitted. The statement also instructs companies to pay attention to the materiality of omitted amounts. The SEC will be especially suspicious of an announcement that presents a loss as if it were a profit or omits a material GAAP result without clear explanation of the nature and size of the omission. Finally, the SEC cautions that the antifraud provisions of federal securities laws do apply to companies presenting pro forma financial information. Prior to release of this statement, the financial press had widely reported that the SEC had no authority over the release of pro forma earnings statements unless they were clearly fraudulent.
In its first enforcement action related to pro forma reporting, the SEC cited the positive spin Trump Hotels & Casinos put on its earnings in a 1999 third-quarter press release as being materially misleading. While the company was not accused of stating facts that were literally untrue, it was alleged to have misled investors due to omissions of material information. Specifically, Trump Hotels stated that the net income amount presented in its press release excluded an $81.4 million one-time charge. According to the SEC, stating the exclusion of this one-time item implied that no additional material one-time items were included in the calculation of net income; however, a one-time gain of $17 million was included. The SEC argued that the inclusion of this one-time gain created the false and misleading impression that the company had exceeded operating earnings expectations when it had not.
The SEC has separately advised investors to be wary of incomplete information in press releases and to always read GAAP financial statements of the companies in which they invest. The SEC warns that pro forma information may create a confusing or misleading impression and should be viewed with skepticism. Pro forma results may not present a true and accurate picture of the company’s financial well-being. Finally, the SEC warns investors of inconsistency in the methods of presenting pro forma financial results and notes that pro forma information may make it difficult to compare financial results to other periods or other companies.
Robert H. Colson, PhD, CPA
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