Asset Allocation Where There Are Discounted Assets

By Dan L. Heitger and Brian Ballou

Pro forma earnings statements are unaudited, unregulated what-if reports that are not required to conform with GAAP. First used to present a better comparison between two periods after a significant one-time event, such as a merger or acquisition, pro forma earnings usually exclude one or more items that are included in GAAP earnings. The use of pro forma earnings gained acceptance based on the argument that excluding one-time or special items, such as restructuring charges or goodwill amortization, yields an earnings number that is more useful for predicting future cash flows. Companies, however, are increasingly using pro forma earnings statements for many other reasons.

Lynn Turner, while serving as SEC chief accountant, noted in a speech titled “State of Financial Reporting Today: An Unfinished Chapter III” (given on June 21, 2001, and available at www.sec.gov/ news/speecharchive.shtml), “Indeed, the average stockholder today is the average American who lives next door, is your aunt or uncle, a close friend or family member. These stockholders come from all walks of life, young and old, rich and not so rich.” Turner also noted that there were 84 million shareholders in 1998, which represents 44% of the U.S. adult population, a 21% increase from the 69 million shareholders in 1995 and a 61% increase from the 52 million shareholders in 1989. Furthermore, Turner noted that half of all stockholders have income of less than $57,000 and only 18% have income in excess of $100,000. Clearly, the typical investor has changed dramatically over the past 15 years and might not understand that pro forma earnings usually differ significantly from GAAP earnings in amount and preparation.

The Case for Unregulated Pro Forma Earnings

Pro forma earnings contained in quarterly and annual financial reports filed with the SEC are required to carry a notice that they are not presented in accordance with GAAP and are provided for information purposes only. GAAP earnings must also be presented in quarterly and annual financial reports. FASB has no control over the information that companies report in press releases, however, which means that they are not required to follow GAAP and often contain nothing to warn investors of this vital fact.

A debate exists among CPAs, investors, analysts, and companies over whether the use of pro forma earnings should be regulated in some manner. One side of the debate supports the unregulated status quo and asserts that pro forma earnings can help predict future cash flows better than GAAP earnings.

There are two basic arguments for favoring the status quo. One is that pro forma earnings attempt to enable an apples-to-apples comparison by excluding one-time items, both expense and revenue items. This argument is most credible for companies operating in a developing industry, such as technology. For these industries, the impact of items like mergers and stock option exercises is particularly high. A number that some pro forma earnings attempt to “back into” is earnings before interest, taxes, depreciation, and amortization of various items (EBITDA). A second argument is that pro forma earnings attempt to produce an estimate of cash-based earnings, which some analysts find useful in predicting future performance and stock price. For example, many companies originally stressed their pro forma earnings because of GAAP’s requirement that goodwill be expensed even though this does not represent actual cash expenditures. This rationale will be tested as companies implement SFAS 141 and 142, which eliminate the requirement for companies to expense goodwill unless it fails an impairment test.

Accounting researchers Lawrence Brown and Kumar Sivakumar have found evidence suggesting that pro forma results can provide higher-quality earnings measures (i.e., have a greater impact on stock price) than GAAP results. Agreeing with their results, however, requires one to accept several important assumptions, the most crucial being that the stock market is efficient in that it responds to the “right” high-quality information. Without this assumption, Brown and Sivakumar suggest that one might consider their results in the opposite light. That is, the finding that pro forma earnings are more predictive of future stock price than are GAAP earnings might indicate that the market erroneously focuses on lower-quality earnings information.

The Case Against Unregulated Pro Forma Earnings

This side of the debate argues that unregulated pro forma earnings serve only to confuse investors about a company’s actual financial performance. The lack of consistency in the way companies prepare and present pro forma earnings seriously challenges the validity of the claim that pro forma earnings provide more useful information for investors.

Of particular concern is that less-sophisticated investors, who make up an increasingly large percentage of investors, are especially vulnerable to such confusion even if companies are not intentionally attempting to confuse them. For example, a company might attempt to provide a more “permanent” measure of performance by excluding all one-time items. However, if another company does not exclude a similar item when providing pro forma earnings, an unsophisticated investor might be misled. Furthermore, many one-time, nonrecurring items (e.g., restructuring charges, goodwill amortization) excluded in pro forma earnings might not in reality be one-time items. For example, Zacks Investment Research analyzed nonrecurring charges and found that many large companies, including Amazon.com, Procter & Gamble, and Cisco, reported nonrecurring items in every quarter for the past two years.

Companies sometimes intentionally attempt to confuse investors. For example, a company might report pro forma earnings because they are better than GAAP earnings. Cisco’s pro forma earnings for the fiscal year ended July 2000 excluded $531 million of revenues, such as investment gains, but also excluded $1.75 billion of expenses, such as research and development, goodwill write-offs, and merger costs. These adjustments resulted in pro forma earnings of $0.53 per share, which were significantly greater than GAAP earnings of $0.36 per share. Evidence exists that other companies might report pro forma earnings for this reason. Some companies even report pro forma earnings that turn losses into profits. For example, Broadcom Corp., a supplier of communication chips, reported pro forma profit for the first quarter of 2001 of $24 million after excluding $109 million of research and development charges, $200 million of goodwill amortization, and $115 million of stock compensation expense. Its GAAP results, however, showed a loss of $357 million.

The Exhibit presents pro forma earnings, GAAP earnings, and earnings estimates for the third quarter of 2001 for 11 companies. For 10 of them, pro forma earnings are more favorable than GAAP earnings. The only exception, Terayon, arose from GAAP earnings including an extraordinary gain on the early retirement of debt. Excluding this gain, GAAP results would have been a loss of $38.8 million, or an EPS of –$0.57. Even more suspiciously, for four companies, a GAAP loss is turned into pro forma profit, a practice strongly criticized by the SEC. Finally, for eight companies whose GAAP earnings fall short of expectations, their pro forma earnings either exactly met or exceeded expectations.

Lynn Turner observed that companies often seem to use pro forma earnings to distract investors from the real GAAP results. An article in USA Today (June 22, 2001) noted Amazon.com’s reputation for excluding expense items from its pro forma earnings and then attempting to focus investors’ attention on its pro forma earnings rather than on its GAAP earnings. Amazon.com’s GAAP results for the second quarter of 2001 reported a loss of $168 million, or $0.47 a share, which was much worse than the expected loss of $0.22 a share. Amazon.com’s pro forma second-quarter results, however, which excluded several special charges, reported a loss of only $58 million, or $0.16 a share, thereby beating expectations.

Investors can be confused even when items excluded from pro forma earnings appear in a footnote. Such footnote presentations often intentionally omit a dollar amount for the excluded items, thereby preventing any attempt to reconcile pro forma earnings to GAAP.

SEC Commissioner Isaac C. Hunt Jr. noted in an October 26, 2001, speech that “pro forma earnings may be ‘materially misleading’ to reasonable investors, violating the federal securities laws.” Others have also complained that pro forma statements have been abused by some companies. As a result, the practice is coming under more criticism and scrutiny from regulators. The SEC has investigated several companies for stressing pro forma earnings over GAAP earnings.

Ramifications of Abuse

Some investors have lost confidence in companies’ accounting results of any kind. This skepticism partially arises from companies’ managing GAAP earnings, but the questionable use of unregulated pro forma earnings compounds it. Such increased skepticism of all accounting numbers, GAAP or pro forma, is a legitimate concern for FASB to consider.

In January 2002, the SEC took its first enforcement action against a company for an intentionally misleading use of pro forma earnings, against Trump Hotels & Casino Inc. (see the Sidebar). Misleading pro forma numbers appear to affect investor behavior. The stock of Trump Hotels rose 7.8% on the day it released its pro forma earnings announcement and fell 6% three days later when an analyst revealed the misleading nature of the figures.

Engaging in the same misleading acts as Trump Hotels will result in enforcement action by the SEC. Less clear, however, is exactly how far down the tree the ax will fall, so to speak. For example, one of the acts committed by Trump Hotels that led to the SEC’s action was the use of pro forma earnings to imply that the company met or exceeded analysts’ earnings expectations when, in fact, the company’s GAAP earnings did not. Eight of the companies shown in the Exhibit could easily be construed as attempting to commit the same act. Will this be sufficient to trigger SEC action in the future? Trump Hotels settled the dispute without admitting or denying the charges and without paying a fine. In the light of the numerous recent corporate accounting scandals, however, companies facing charges of misleading behavior in the future are likely to encounter harsher treatment from the SEC and investors.

Important Considerations

Some companies, such as Amazon.com, defend their use of pro forma earnings by arguing that their quarterly and annual reports include both GAAP earnings and pro forma earnings. Then–FASB Chairman Ed Jenkins admitted some ambivalence over this frequent use of pro forma earnings, stating in a Barron’s article that “the statement of income presented according to GAAP is still the best predictor of future cash flows.” This position implies that all investors can simply reconcile pro forma earnings to GAAP earnings, but it fails to acknowledge a subtle yet significant point. A select few companies might follow guidelines such as those recommended by the Financial Executives International (FEI) and actually provide a “clearly described reconciliation to GAAP results.” Reconciling pro forma earnings to GAAP earnings, however, might not be enough to prevent some investors from being fooled into thinking that a company is performing better than it actually is.

Research in psychology shows that people often have trouble ignoring information that they want to see (e.g., relatively more favorable pro forma earnings) even when more accurate information (e.g., relatively less favorable, but more objective, GAAP earnings) is presented simultaneously. In addition, research shows that people’s response to the same information can differ depending on the form in which the information is presented. For example, Patrick Hopkins’ research showed that analysts provided with the same GAAP financial performance results valued stocks differently depending on the form in which the GAAP results are presented. Therefore, it is reasonable to wonder whether investors, especially less-sophisticated investors, are able to identify the misleading information conveyed by pro forma earnings, even when GAAP earnings are presented simultaneously.

When evaluating investments and investment opportunities, many argue that the CPA’s interests are best served when investors are able to pay attention to GAAP earnings and discount, or in some cases even ignore, the misleading information conveyed in pro forma earnings. SEC Commissioner Hunt has questioned whether investors are overwhelmed by the sheer volume of filing information. Future regulation and research should consider exactly what investors understand about pro forma earnings and how well investors of differing levels of sophistication can reconcile various presentations of pro forma results to GAAP results. Investors might be fooled by misleading pro forma earnings information even when GAAP earnings are presented simultaneously and reconciled.

In October 2001, FASB added a project on financial performance reporting to its agenda. The primary objectives were to improve the quality of information provided in financial statements and to ensure that sufficient information is contained in the financial statements for calculating key financial measures for the benefit of investors and creditors. FASB acknowledged, however, that this project would affect only what companies report in their financial statements. Thus, this project would not affect pro forma earnings released by companies through other media (e.g., press releases, analyst presentations). Only the SEC has the authority to regulate pro forma information in these other media.

The SEC appears to be very concerned about companies’ current use of unregulated pro forma earnings. Recent press releases and public statements offer a direct warning to public companies that present earnings “on the basis of methodologies other than GAAP” to use caution when releasing such pro forma earnings and to “alert investors to the potential dangers of such information.” It has specifically reminded companies that the antifraud provisions of the federal securities laws apply to pro forma information and that companies should be “particularly mindful of their obligation not to mislead investors when using [pro forma] information.” Finally, the SEC has warned companies against omitting material information in pro forma earnings, such as to recast a loss as if it were a profit.

Possible Solutions

The first and most stringent potential solution would be to regulate what appears in GAAP earnings and forbid the presentation of pro forma earnings in press releases and quarterly and annual financial reports. This has the advantage of clarity for investors, who will still be able to obtain pro forma earnings by “backing out” various items themselves.

A second solution would be to have FASB regulate the use of pro forma earnings. Regulation would bring some degree of consistency to the preparation and presentation of pro forma earnings. For example, pro forma earnings should not be allowed to exclude one-time expenses and losses while including one-time revenues and gains, especially in the same period. Regulation might at least require the earnings management game to be played by rules.

A third, and less stringent, potential solution is to continue to allow unregulated pro forma earnings but require that a CPA audit the reconciliation to GAAP earnings. In fact, a reconciliation of pro forma earnings to GAAP earnings is now required by the Sarbanes-Oxley Act of 2002. Such a reconciliation might help limit the extent to which investors are misled by pro forma earnings. This option allows companies to point out that GAAP earnings sometimes contain significant one-time items. It would also provide some protection to investors by highlighting that pro forma figures are not GAAP and by showing the specific ways in which each item changes GAAP earnings when included or excluded.

The challenge associated with this third solution is the additional burdens on CPAs’ evaluations of the fairness of pro forma presentations. Given the effort needed to provide assurance for GAAP income statements, this option would likely be opposed by CPAs. This solution, however, might restore some of the confidence in reported results. Mitigating companies’ ability to use misleading pro forma earnings in a completely unregulated environment is an important step in restoring investor and public confidence and trust.

Dan L. Heitger is an assistant professor of accounting and
Brian Ballou is an associate professor of accounting, both at Auburn University, Auburn, Ala.