Pro forma earnings do not include unusual or infrequent transactions. Items excluded include amortization, depreciation, goodwill, and other expenses. The usual intention of these exclusions is to present a clearer picture to investors. But really, is doing so beneficial or potentially detrimental to the statement user who is not cautious? Pro forma figures typically make a firm look for profitable than GAAP figures. Simply put, it is the “earnings before the bad stuff.” The study explores the company’s defense that pro forma earnings provide a better picture for forecasting and if it causes a stock market reaction.
In 2001, General Motors opted to exclude legal settlement costs. In my opinion, it is fair to exclude legal costs as it is not part of a company’s future cash flows/potential, even though the event can reoccur. Regardless, it is up to management whether to include it or not, and it is up to the user to effectively make their decisions.
Since a company is free to use pro forma calculations over that of GAAP, I feel that so long as that is clearly emphasized, it is up to the user to “use” and invest accordingly. I don’t see it as manipulative since an investor should be educated enough to know of the risks involved, and that footnotes are not to be ignored. If not, perhaps he should not be investing, and/or rather paying someone who does know how to properly read the statements to do the reading for him.
The study, however, concludes that exclusions can predict lower future cash flows, and in turn, has a negative effect on stock returns. Earnings announcements cause reactions. But parallel to my thoughts above, it was also concluded that the market can simply be fooled. It may not actually be due to negative implications of future cash flows depending on the excluded expenses.
As such costs are not recurring in nature, they are to be excluded in order to draw a logical inference while assessing a company’s future prospects. However what would constitute such costs has been debatable for the reason being that companies have used this tool to manipulate their financial statements to inflate their earnings figure.
At times unsold inventory has been taken off the balance sheet as “unusual and infrequent”. This has been done to shadow the management’s inefficiency in executing business decisions. During the dotcom bubble, Network Associates excluded its dotcom deparment’s operating earnings. It was at this time for companies when the difference between the GAAP earnings and the Proforma earnings exceeded billions of dollars. This again reflects the artificial inflation of the inflation of the technology index during that period.
As per the wall street journal research in 2001, 300 companies of the 500 S&P companies excluded some expenses from their GAAP earnings. These are stocks that constitute the index which leads to the fact that the performance of the index during that time would not have been in sync with the performance of these companies.
As per the research that was conducted, 1$ of proforma earnings reflected 7.895$ of future cash flows from operations for 3 years. It would also affect the EPS figures as per the example of AT&T where it went from negative to positive. There are multiples that are calculated based on these figures that are used to value stocks and businesses. Even though it is known that valuations are relative and there can not be a single figure, predicted cash flows are used in this process. Therefore, we would be able to visualise the magnitude of the deviation from the predicted cash flows of such companies.
I agree with the authors where they say that the market continues to be fooled by firm’s use of pro-forma earnings.