Pro forma earnings

In business and accounting, pro forma earnings are estimated income figures that companies include on financial statements to investors. Pro forma earnings project what a company's profits would likely be if unusual or randomly occurring expenses were excluded from the company's financial reports. The traditional wisdom of reporting pro forma financial figures instead of actual figures is that random or one-time expenses obscure a company's true financial position because they are not part of standard expenses over a financial quarter, year, or other period. Companies that omit these rare expenses in favor of pro forma figures on financial reports hope to provide investors with more accurate assessments of their financial outlooks.

Investors take some risk when relying on a company's pro forma earnings to make investing decisions. This is because businesses can dishonestly manipulate their estimated financial figures in an attempt to hide the fact that they are performing below expectations. Investors who receive pro forma earnings reports from companies seeking investment are encouraged to examine the expenses excluded from the reports to determine if they are truly irrelevant to the company's long-term financial outlook.

Background

The Latin phrase pro forma means "for the sake of form." The phrase was adopted for the concept of pro forma financial earnings because these figures are used most often to present investors with business plans. Pro forma earnings are simply hypotheses, or projections, of how a company's financial standing would appear if rare or one-time expenses did not exist. Some business leaders may present investors only with pro forma earnings reports because they believe that such expenses are in fact irrelevant to their company's typical financial outlook. Their reasoning is that they pay unique expenses, such as the costs associated with acquiring or merging with other businesses, only one time. Therefore, the business executives might argue that including these expenses on financial statements would inaccurately represent the standard quarterly or yearly financial performances of the company.

Business leaders decide what to report in pro forma earnings statements. No laws or other rules govern what information executives must report in statements of pro forma figures, since these reports are generally known to be only estimates; as such, companies themselves choose which expenses to report and which to omit. This is the difference between pro forma financial figures and figures disclosed under generally accepted accounting principles (GAAP).

These principles are standardized regulations dictating how companies are to prepare and present financial statements. GAAP holds businesses to certain norms of consistency and transparency so investors can easily examine financial statements and make informed investing decisions based on what is presented. Items included on financial reports that are governed by GAAP include recognition of revenue, statements on outstanding shares, and balance sheets of what a company owns versus what it owes to other parties. In the United States, companies must adhere to GAAP if they issue financial reports to any other entity outside of themselves. In the United States, the reports of publicly traded companies must also follow the regulations of the US Securities and Exchange Commission (SEC), an agency of the federal government that enforces financial laws throughout the country.

However, none of these GAAP or SEC regulations applies to statements of pro forma earnings because these statements do not attempt to report exact figures. Pro forma earnings reports would likely appear different to investors if the rules of GAAP were applied to them. For instance, a company might omit its amortization plans from a pro forma earnings statement. Amortization is the repayment of debts through scheduled payment installments. Company leaders who do not report amortization on pro forma statements might argue that paying back debts is not an actual expense because it is not in any way related to the company's day-to-day operations. GAAP regulations, however, would mandate that amortization be listed as an expense simply because it constitutes a decrease in company assets.

Impact

Reporting pro forma earnings instead of GAAP-governed financial statements is not illegal or unethical in any way. Companies that release pro forma earnings reports must also detail the expenses they have excluded from their statements. However, this does not mean that investors should overlook pro forma earnings statements by assuming that a company has accurately assessed its financial outlook.

Pro forma earnings reports may not reflect a business's actual financial situation. This can be the result of company oversight, differences of opinion on what constitutes an expense, or outright deception perpetrated by a company's managers to inflate the business's actual earnings. Compounding this discrepancy is the fact that pro forma earnings statements are not routinely audited by internal or external entities. In many cases, a business's pro forma earnings would appear far lower if GAAP rules or other government regulations were applied to them.

For example, in the late 1990s in the United States, pro forma earnings reports issued by businesses in the dot-com sector falsely inflated company earnings by billions of dollars, contributing to a financial "bubble" that eventually collapsed. Other businesses may remove unsold products from balance sheets on their pro forma earnings reports, arguing that the items should not factor into the financial statements because they were never involved in consumer transactions. However, the companies spent money to manufacture the products and never made their money back by selling them. This fact may be omitted from pro forma earnings statements, but investors should note this kind of practice when deciding whether to invest in a business.

The best way for investors to decide whether they can trust a company's pro forma earnings statements and safely invest in the company is to analyze the costs that have been excluded from the statements and determine whether they were excluded for legitimate reasons. Investors must ultimately assess for themselves whether a pro forma earnings statement or GAAP-sanctioned report more accurately represents a company's typical financial performance. Which of the two reports meets the criteria will be different from case to case, as the items to be included in or excluded from pro forma earnings reports vary by company.

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