Pro Forma Earnings
By Robert F. Halsey and Virginia E. Soybel,
Assistant Professors, Babson College
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 attempt to portray "operating” results by excluding transitory items, such as asset write-offs. Amazon.com, Inc., for example, defines its pro forma earnings to exclude stock-based compensation, amortization of goodwill and other intangibles, restructuring charges, gains and losses on the sale of assets, equity in losses of equity-method investees, and the cumulative effect of changes in accounting principle. Amazon’s pro forma net loss for the first 3 quarters of 2001 is $58 million. Under GAAP, its loss year-to-date is $170 million. Significant differences between GAAP and pro forma earnings are not uncommon. For example, the Associated Press recently analyzed earnings reports of the 100 largest technology companies in northern California. The wire service calculated that, under GAAP standards, the 100 companies have reported combined losses of around $71 billion. Using pro forma figures, however, these same companies reported a profit of $10 billion. (CFO.com, 10/02/01)
Historically, 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. Compaq, for example, includes pro forma measures of revenue and net income for the years prior to its acquisition of Digital so that financial statement users have annual data for a hypothetically comparable entity. Pro forma results are also disclosed under FAS123 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. The term pro forma means, literally, as a matter of form, and thus provides little guidance for an accepted definition of pro forma earnings. The term’s past use in financial reporting, however, suggests that pro forma results are presented to enhance comparability in time series measures. It is in that sense that companies reporting pro forma earnings contend that their alternate earnings metrics offer more comparable results than GAAP measures which include the effects of anomalous, non-recurring items, such as restructuring charges and gains and losses on the sales of assets. But companies reporting these alternative earnings numbers introduce a cross-sectional comparability problem. Since there is no accepted definition of pro forma or adjusted earnings, financial statement users cannot confidently compare these earnings numbers across different companies. Furthermore, in the absence of an accepted definition of the term, companies are free to change their own versions of pro forma earnings from one year to the next.
This lack of common usage has led the SEC to issue "Tips to Investors" on Pro Forma Financial Information, a general warning urging caution in the use of pro forma earnings and the SEC’s new chairman, Harvey Pitt, to suggest consideration of new accounting standards to define what is to be included under the heading of “pro forma” and “operating” earnings. On October 31, 2001, the FASB requested comments on the need for new standards in this area, conceding that “the current use of alternative and inconsistent measures is often confusing and sometimes misleading. Addressing that problem is a principal reason for this project.” The announcement includes a caveat, however, that “because the FASB does not have authority over how a company describes itself in press releases, analyst presentations and similar media, the FASB project will not address the use of pro forma earnings commonly used in corporate press releases.”
The diversity of definitions for alternate measures of earnings can be illustrated by comparing three companies. Consider the reporting strategies of Dynegy, the Williams Companies, and the now infamous Enron Corporation in their 2000 annual reports. Enron’s management discussion and analysis (MD&A) discloses “net income before items impacting comparability” and lists those items -- asset writedowns, one-time gains, and the cumulative effect of an accounting change -- in a table. In a similar disclosure in its 2000 annual report, Dynegy’s MD&A focuses on “recurring net income” which has been adjusted for asset writedowns, one-time gains and losses, severance charges, and acquisition costs. In contrast, the Williams Companies 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 $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 might argue that Enron and Dynegy provided information to investors in a more readily accessible form than Williams by aggregating all non-recurring items and disclosing their after-tax effects on income in one prominent place. One problem, however, with this ad hoc earnings reporting system, is that Enron and Dynegy each made its own selection of non-recurring items. Enron, for example, 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 pension plan. This issue gets to the heart of recent calls for reform and regulation (see, e.g., “Confused About Earnings?” Business Week, 11/26/01) of pro forma or adjusted earnings. How can financial statement users compare the performance of companies that do not use consistent measures of net income?
The desire to purge the income statement of transitory items is, of course, nothing new. Accountants have been reporting income from continuing operations (net of discontinued operations, extraordinary items and changes in accounting principles) for 30 years (APB 20, effective 1971 and APB 30, effective 1973). Despite the passage of these standards, however, income statements continue to include significant amounts of transitory items in the form of restructuring expenses (asset write-offs and accruals of severance and other restructuring costs), and gains and losses on the sales of assets.
“Income from continuing operations” under GAAP, once the key measure of company performance, has now been supplanted by “pro forma” income in company annual and quarterly financial statements and press releases. During the transition, companies redefined the benchmark against which they should be evaluated. Beginning with GAAP income from continuing operations (excluding discontinued operations, extraordinary items and changes in accounting principle), the additional transitory items (most notably, restructuring charges) remaining in income from continuing operations are now routinely excluded in computing pro forma income. In addition, companies are also excluding expenses arising from acquisitions (goodwill amortization and other acquisition costs), compensation expense in the form of stock options, income (losses) from equity method investees, research and development expenditures, and others. Companies view the objective of this reformulation as providing the analyst community with an earnings figure closer to “core” earnings, purged of transitory and non-operating charges. This view of the company’s earnings should have the greatest predictive value and the highest relevance for determining stock price.
What are the risks to companies in pro forma reporting? Consider the remarks of 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 percent chance that a company that is capable of doing that without appropriate disclosure will have defrauded or confused its investors," he said, according to Reuters. "Companies that choose to do pro forma financials as a means of focusing people's attention have to be on notice that ... there can be absolutely no possibility an investor who sees the pro formas will misunderstand what really happened," he said.
Financial Executives International (FEI) and the National Investor Relations Institute (NIRI) have recently issued best practices guidelines concerning press releases involving pro forma earnings. Their conclusion:
Earnings press releases should include "reported" results for the period presented under generally accepted accounting principles (GAAP). Pro forma "cash basis" or "adjusted," "underlying," "ongoing" or "core" results are often used to supplement the period's GAAP results, and are provided to clarify both that period's performance as well as future prospects. GAAP results provide a critical framework for pro forma results, although the pro forma results may be more analytically useful. It is important to provide the pro forma results in context of their GAAP framework. The order in which reported or pro forma results are presented in the release is not as important as their context. Pro forma results should always be accompanied by clearly described reconciliation to GAAP results; this reconciliation is often provided in tabular form.
It is generally acknowledged that additional disclosures by management can help investors understand the core drivers of shareholder value. These provide insight into the way 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 to enhance year-to-year comparability. Although this might be justified on the basis that the resulting earnings have greater predictive ability, important information has been lost in the process. Accounting is beneficial in reporting how effective management has been in its stewardship of invested capital. Asset write-offs, liability accruals, and other charges that are eliminated in this process may reflect the outcomes of poor investment decisions or poor management of corporate invested capital. Investors should not blindly eliminate the information contained in non-recurring or “non-core” items by focusing solely on pro forma earnings. A systematic definition of operating earnings and a standard income statement format might offer helpful clarification, but it could not be a substitute for the due diligence and thorough examination of the footnotes that constitute comprehensive financial statement analysis.