ACCOUNTING & AUDITING

Accounting

Managed Disclosure and Pro Forma Earnings

By Stephen Bryan and Steven Lilien

The accounting profession has attempted to create a rich information environment that provides relevant and reliable financial disclosures. The auditing profession has attempted to provide some degree of assurance that management’s financial disclosures are presented in accordance with the rules of the accounting profession. Broadly speaking, the oversight practiced by the audit profession helps to prevent investors from basing decisions upon data that misrepresents an investment opportunity. However, questions have arisen about whether financial information, even if presented “properly” in accordance with accounting rules, provides for optimal asset allocations.

The primary basis for the rethinking of accounting and auditing roles is the growing body of research which suggests that financial markets react more to “pro forma” earnings measures than to GAAP earnings measures. Pro forma means “as if” or “for the sake of form.” There are several uses of the term. For instance, GAAP mandates pro forma earnings disclosures for certain accounting changes. GAAP also requires pro forma earnings disclosures for stock options that are not charged against GAAP earnings. The SEC mandates pro forma disclosures in certain circumstances involving business combinations. Analysts routinely project companies’ financial statements (called pro forma statements) in order to provide a basis for an estimate of value. However, none of these uses of the term pro forma corresponds to the reasons for the concerns about accounting and auditing roles. When companies remove certain items from GAAP earnings, purportedly to present a more accurate portrayal of their performance that they believe GAAP distorts, they present the pro forma earnings that are the focus of this paper, and of the SEC.

Some observers argue that companies use pro forma earnings to spin their results and influence investors’ perceptions. In carrying out their mandate, the SEC is reining in some practices. Regulation G requires firms to reconcile pro forma earnings measures to GAAP and requires firms to “furnish” earnings releases in Form
8-K. The SEC has taken an appropriately broad view of what constitutes pro forma:

Similarly, any disclosure of earnings that varies from GAAP mandated earnings (basic and diluted) should be considered a pro forma earnings measure. These pro forma earnings measures question the relevance and reliability of GAAP earnings, especially because unfolding research appears to indicate that investors increasingly follow pro forma measures. By extension, not only does pro forma challenge the underlying principles of GAAP, pro forma also calls into question the role of the audit. (FASB, aware of this, initiated a new project, “Reporting Information About the Financial Performance of Business Enterprises,” at www.fasb.org/project/performance.pdf.) Why audit or review a number that the market does not use? A measure that is virtually free of third-party oversight raises another question: Why not audit or review a number upon which the markets rely?

The U.S. financial reporting system is expanding beyond the Form 10-Q and the audited Form 10-K. In addition to these formal parts of the reporting system, the informal, and largely unregulated, reporting mediums must be considered. The greater timeliness of this informal system, and the fewer restrictions placed upon it, allow companies to exercise a considerable degree of control over the information environment. It is a managed disclosure system that allows management to exercise significant discretion and judgment with respect to which components of GAAP earnings are retained and which are omitted.

This article follows the disclosures for one company across 10 quarters. It demonstrates how a company could manage earnings surprises through prefiling press releases, guidance, and even definitions of pro forma. Without procedural guidance from the accounting profession and oversight from the audit profession, companies may be inclined to engineer allocations and estimations to achieve a desired pro forma result. Furthermore, the processes used in one quarter might not be followed in a subsequent quarter.

Indeed, pro forma earnings are both company-specific and time-specific. Even companies within the same industry can have different ways of measuring pro forma earnings, and the same firm across time may change how it calculates pro forma earnings. As noted by the SEC, pro forma earnings may simply be GAAP earnings with “nonrecurring” expenses, restructuring costs, and cumulative effects of accounting changes either added back or deducted. However, pro forma does not necessarily, directly, correspond to items on the income statement. For example, companies may carve out certain portions of the cost of goods sold and selling, general, and administrative expenses.

In addition to the confusion over the definition of pro forma, there is confusion over nomenclature. For example, analysts frequently refer to a company’s “actual” earnings results, where actual means pro forma, not GAAP. Analysts’ consensus earnings have become averages of individual analyst’s nonstandardized pro forma estimates, but many sources do not clearly distinguish pro forma earnings measures from GAAP.

The Regulatory Environment

Under Regulation S-X, Article 10-01(d), interim financial statements included in a Form 10-Q must be reviewed by independent accountants prior to being filed. Statement of Auditing Standard (SAS) 100, Interim Financial Information, governs audit review standards. SAS 100 notes that the objective of a review is not to express an opinion, but to communicate whether the accountant is aware of any material modifications that should be made to financial information to conform with GAAP.

Even though reviews of 10-Qs are required, references to such reviews are not required, unless the registrant states that a review was performed, in which case a report from the independent accountant is included.

Interim reports are adjusted, ex post, as needed when registrants file their audited Form 10-Ks. Recently, the SEC has expressed concern over the significant year-end adjustments that many registrants make in their 10-Ks. Such adjustments may suggest insufficient control over the interim earnings measurement process. Therefore, the SEC now requires auditor reviews as well as auditor discussions with the audit committees, with the hope that such reviews and discussions will impose more discipline over the measurement of interim earnings. The need for better control over the interim earnings measures is greater now that the SEC requires more-timely production of interim earnings information. Below is an excerpt of the SEC rationale and requirements:

Audit committees play a critical role in the financial reporting system by overseeing and monitoring management’s and the independent auditors’ participation in the financial reporting process. We have seen a number of significant changes in our markets, such as technological developments and increasing pressure on companies to meet earnings expectations, that make it ever more important for the financial reporting process to remain disciplined and credible. We believe that additional disclosures about a company’s audit committee and its interaction with the company’s auditors and management will promote investor confidence in the integrity of the financial reporting process. In addition, increasing the level of scrutiny by independent auditors of companies’ quarterly financial statements should lead to fewer year-end adjustments, and, therefore, more reliable financial information about companies throughout the reporting year. (“Audit Committee Disclosure,” 17 CFR Parts 210, 228, 229, and 240, Release 34-42266, File No. S7-22-99, December 22, 1999)

The rules require the following:

On December 4, 2001, the SEC issued separate releases that cautioned investors of the risks associated with pro forma information and that cautioned registrants to include a clear reconciliation between GAAP earnings and pro forma earnings. These admonishments were formalized on January 22, 2003, when the SEC issued final rules implementing section 401(b) of the Sarbanes-Oxley Act in “Conditions for Use of Non-GAAP Financial Measures” (referred to as Regulation G). In addition, the SEC requires firms to furnish on Form 8-K any public announcements or releases of material nonpublic information regarding a registrant’s results of operations or financial condition (e.g., earnings releases) for a completed quarterly or annual fiscal period.

Historically, most of the SEC’s initiatives have focused on the formal disclosure system (10-Ks and 10-Qs). Even though the new 10-Q requirements may impose discipline on the measurement of interim earnings, by the time the 10-Q is filed, the markets already have press releases with pro forma earnings. Regulation G requires reconciliation of pro forma earnings to GAAP earnings in press releases, but the lack of any required auditor involvement raises concerns about consistency in definitions and in the processes used to generate the pro forma numbers. Analysts’ reliance on the pro forma number is evidenced by the growing body of academic research, as well as the case study that follows.

The Case of Eastman Kodak

The authors used Eastman Kodak (EK)—chosen randomly from the Dow Jones Industrial Average-—to illustrate the intersection of the formal and managed disclosure systems. Figure 1 shows the stock price of EK over the period covered by the analysis. EK’s market value per share hovered around $30 for most of the period. The highest price was $45.52 (June 21, 2001), and the lowest was $23.02 (November 2, 2001).

Exhibit 1 presents 10 periods of earnings data drawn from EK’s press releases and from analysts’ reports. Over the 10 quarters, cumulative GAAP earnings were $3.60 and cumulative pro forma earnings were $5.79. Thus, EK excluded $2.19 in net expenses or losses from GAAP earnings, or EK suggested that approximately 61% of GAAP earnings distorts the picture of its performance.

Exhibit 2 provides a list of the items excluded from GAAP earnings to arrive at pro forma earnings. Most excluded items are restructurings and impairments. Apparently EK included goodwill amortization through the first quarter of 2002, but then EK stopped goodwill amortization because of SFAS 142, Goodwill and Other Intangible Assets. This leads to a troublesome break in the time series definition of pro forma earnings.

Exhibit 1 shows the initial guides from EK to analysts, which are included in the prior quarters’ earnings announcements. For example, on October 24, 2001, EK announced its third quarter 2001 results: GAAP earnings per share were $0.33 and pro forma earnings per share were $0.52. The initial guide for 3q01was the range estimate of $0.90 to $1.20 (given on July 17, 2001, with the prior quarter’s earnings announcement), but this range was subsequently reduced to an upper-bounded estimate of $0.65.

A review of analysts’ reactions shows that analysts routinely followed the initial guide and any subsequent new guide. For 3q01, the initial analyst consensus was $1.04, corresponding to the EK guidance of $0.90 to $1.20. After EK announced the new guide of $0.65 (maximum), the new consensus was changed to $0.60.

The parallel between the analyst estimate and analyst actual reflects the analyst community’s close synchronization with EK’s guidance. Figure 2 gives the time series earnings trends for five of the earnings metrics that are shown in Exhibit 1, highlighting the close parallel among EK’s pro forma, EK’s guide point, the analyst estimate, and the analyst actual over the 10 quarters. It also reveals the greater variability of GAAP earnings compared to that of the other earnings measures. Notably, the accounting profession’s and the audit profession’s resources are directed toward the GAAP time series, with no or limited efforts dedicated to the other time series.

Exhibit 3 is taken from EK’s most recent earnings press release. EK modifies income from continuing operations to arrive at “operational earnings.” The adjustments made to GAAP earnings include the following items: accelerated depreciation in connection with focused cost reductions; intellectual property settlement; in-process research and development; and a tax benefit from donation of intellectual capital. It is noteworthy that operational earnings nearly always equaled the analyst actual measure, as shown in Exhibit 1. It is improbable that analysts are able to predict such intra-income allocations and therefore precisely forecast EK’s pro forma earnings. Rather, analysts used the guidance offered by EK, and EK has the discretion in its pro forma calculation to arrive at or near the analysts’ consensus estimate.

Earnings are not only used by Wall Street to gauge performance, they are also used by the company to set executive compensation. Companies are required to provide (and to describe the basis for) executive compensation in their annual proxy statements. EK’s 2002 proxy (dated March 28, 2003) states that the executive bonuses are based primarily upon two performance measures: revenue growth and economic profit. The proxy gives the reasoning as follows: “The inclusion of revenue growth as a performance metric emphasizes the Company’s need for sustained profitable growth. The use of economic profit stresses the continuing need for earnings growth and balance sheet management.”

In commenting on the actual bonuses awarded to management, EK stated:

It is not clear which earnings measure is used in the bonus calculations. Given that GAAP earnings can be substantially lower than pro forma earnings, and that management has discretion over how pro forma is measured, more disclosure of bonus calculations may be warranted.

In addition to earnings announcements, EK also made several other press announcements over the time period. There were two notable negative reactions on the dates of two of the earnings announcements. The first reaction occurred on October 24, 2001, which followed the negative reaction to the downward guidance, released on September 19, 2001. This earnings surprise was the largest of the 10 quarters in our study ($0.08 below analysts’ estimate). The other significant negative reaction occurred on January 22, 2003, when the stock fell 11.7% in one day. EK provided no new guidance prior to this particular announcement. The earnings announcement for 4q02 was $0.03 lower than analysts’ estimates. These two examples were the only negative surprises during the period. Positive surprises were found when EK reported unexpected positive results in pre-announcement releases.

Perils of Pro Forma

This case study highlights the following main points:

However, earnings guidance is regularly given to analysts, who immediately incorporate the guidance into their estimates.

In summary, analysts clearly focus on EK’s pro forma earnings, estimates for which, and realizations for which, are provided by the company itself. Earnings surprise is minimized through the managed disclosure system. Accounting and auditing involvement in this environment of managed disclosure is not currently mandated.

Because auditors are not involved in pro forma measurement and disclosure, and the allocations require significant managerial judgment and discretion (including those about effective tax rates), pro forma earnings can vary widely. FASB’s “Financial Performance Reporting by Business Enterprises” project is a step in the right direction, but FASB should provide further guidance, not unlike that provided for segmental disclosures. Only with such guidance would the audit profession be able to develop procedures leading to oversight of the process used to derive pro forma earnings. Auditor involvement can ensure that the allocation methods used are consistently applied from period to period. At a time when regulators and investors are calling for accelerated release of information, the need to have audit oversight of estimations and allocations is great.

Regulation G can improve the overall disclosure system through its requirement to reconcile pro forma to GAAP, as well as its requirement to furnish earnings announcements on Form 8-K. Even though they are now a part of Form 8-K, press releases will not be subject to auditor scrutiny. Auditor involvement with the processes used to derive the numbers given in these press releases is warranted, especially in light of the frequency and magnitude of subsequent adjustments to the interim numbers, as well as the widely unsupervised discretion afforded management in determining pro forma earnings. A review by the auditor of the processes used in generating the financial numbers flowing through the managed disclosure system will minimize year-end accounting adjustments and improve the effectiveness and efficiency of the annual audit.