During the late 1990s and early 2000s, companies increasingly made reference in press releases and published materials to an alternative measure of performance, loosely [if inaccurately] referred to as “pro forma earnings” [The term “pro forma” more properly suggests that amounts that are not actual historical results are being cast in the form of a report on historical performance—e.g., when after a midyear business acquisition the full year’s results are presented as if the merger had occurred on January 1. This is not, however, the case with the more controversial recent usage of this term]. This practice has generated controversy and confusion because there is no standard definition for “pro forma earnings”. Different reporting entities can, and have, defined pro forma earnings on a wide range of ad hoc bases, and sometimes a given entity fails even to consistently define this amount from period to period.
Through this post, I am going to overview what pro forma earning is and how it is used. Follow on!
The reporting of pro forma earnings proliferated over the years preceding the enactment of Sarbanes-Oxley and the subsequent promulgation of Regulation G by the SEC. Often, even when GAAP-basis earnings are stated in the same announcement as the pro forma measure, it is the latter which receives most of the attention. In a number of instances, pro forma earnings have been based on very aggressive exclusions of operating costs and, sometimes, the inclusion of onetime gains. Such practices ultimately came to be widely recognized as being misleading and inappropriate and popular sentiment turned against employment of such devices.
Some companies defended their use of pro forma calculations as merely responding to the marketplace’s need for a measure that gives insight into the company’s future performance. Pro forma earnings, they said, were necessary to compensate for deficiencies in GAAP. Because GAAP-basis net income is affected by various noncash charges and credits, as well as by nonrecurring gains and losses, some argued that this traditional measure may not provide investors with the most meaningful and accurate guide to the entity’s future results of operations. They held that investors needed access to a number that measures only the performance of the reporting entity’s ongoing “normalized” operations.
As with many arguments, there was probably an element of truth to this assertion. However, assuming for the moment that GAAP-basis net income is a flawed indicator of future performance, their argument would have had greater validity if a standardized pro forma measure had been promulgated by the accounting profession or uniformly applied by the investment community. Such a standard definition does not exist, however. Despite the lack of standardization, there has been an increasing willingness on the part of investors to accept the pro forma expressions without understanding what they are or how they have been computed.
For reporting entities, part of the allure of pro forma earnings is that it can be defined to exclude some or all of a range of “unusual” items. Not surprisingly, most of the excluded items have been charges, such as those for worker layoffs, restructurings, assets impairments, and inventory obsolescence. Even if truly not expected to recur annually, many of these charges are quite normal and may be anticipated to recur at irregular intervals in the life of a given business. Furthermore, many such charges can be viewed as “catch-ups” for under-recognition of expenses in earlier periods, and since those charges would have been fully reflected in current earnings, the subsequent period’s catch-up should, logically, also be included in the current period measure of operating results.
A further practice, which is improper but unfortunately has not been uncommon, has been for reporting entities to opportunistically charge off an exaggerated loss in the current period, perhaps in connection with such randomly occurring events as discontinued operations. The loss is then excluded from pro forma earnings.
The excess reserves [sometimes referred to as “cookie jar reserves”] then become available to be drawn down in future periods, as the provided-for expenses fail to materialize in the amounts reserved. The draw-downs of the excess reserves increase net income in future periods, but those draw-downs will not be excluded from pro forma earnings the way the original loss had been. The result will be to boost both GAAP-basis net income and pro forma earnings in future years.
This is not, however, to suggest that all companies that announce pro forma earnings use “cookie jar reserves” to commit financial fraud. However, investor’s acceptance of undefined measures of earnings increases the temptation to engage in irregularities that misstate the results of operations, and surveys have found consistently that misapplication of reserve accounting has been either the most, or second-most, common reason for subsequently announced restatements of previously announced results of operations.
The SEC adopted Regulation G to curtail the use of pro forma earnings statements. Regulation G states that a public company, or a person acting on its behalf, is not to make public a non-GAAP financial measure that, taken together with the information accompanying that measure, either contains an untrue statement of a material fact or omits a material fact that would be necessary to make the presentation of the non-GAAP financial measure not misleading. Further, Regulation G requires a public company that discloses or releases a non-GAAP financial measure to include in that disclosure or release a presentation of the most directly comparable GAAP financial measure and a reconciliation of the disclosed non-GAAP measure to that directly comparable GAAP financial measure.
The regulations also prohibit certain non-GAAP measures from inclusion in SEC filings.
Public companies must not:
- Exclude from non-GAAP liquidity measures charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner. However, earnings before interest and taxes (EBIT) and earnings before interest, taxes, depreciation, and amortization (EBITDA) are permissible.
- Create a non-GAAP performance measure that eliminates items identified as non-recurring, infrequent, or unusual if the nature of the excluded item is such that it is:
(1) reasonably likely to recur within two years; or (2) similar to a charge or gain that occurred within the prior two years.
- Present non-GAAP financial measures on the face of the registrant’s financial statements prepared in accordance with GAAP or in the accompanying notes.
- Present non-GAAP financial measures on the face of any pro forma financial information required to be disclosed by Article 11 of Regulation S-X (e.g., business combinations or disposals).
- Use titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP measures.
The SEC’s action has served to curb the abuse of pro forma earnings measures, but it does little to standardize the measures in use. Others, however, have proposed approaches to standardize the computation of pro forma earnings. For example: the rating agency Standard & Poor (S&P) has introduced a measure that it will use in its COMPUSTAT database, in its US equity indices, and in its financial statement analysis. It has denoted this measure as “core earnings”.
S&P defines core earnings as net income, as defined by GAAP, specifically including these items:
- Employee stock option grant expenses
- Restructuring charges from ongoing operations
- Write-downs of depreciable or amortizable operating assets
- Pension costs
- Purchased research and development
And specifically excluding these items:
- Discontinued operations
- Extraordinary items
- Impairment of goodwill charges
- Gains and losses from asset sales
- Pension gains
- Unrealized gains and losses from hedging activities
- Merger and acquisition fees
- Litigation settlements
S&P’s definition may help investors and also serve to reverse, or at least constrain, the expanding use of subjectively defined, alternative income measures. Although there may be a demand for a performance measure other than net income or comprehensive income, such a measure will not be useful unless it is standardized so that comparisons can be confidently made among different entities or within the same entity over time.
The FASB’s Financial Statement Presentation project (originally, Reporting Financial Performance) may eventually serve to further reduce the abuses inherent in the use of alternative measures of performance commonly known as “pro forma”.