Category Archives: Pro Forma versus GAAP Earnings

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.

The article “Confused About Earnings” from the November 26, 2001 issue of Business Week, discusses the discrepancy between corporate earnings as reported according to GAAP rules vs. other earnings numbers published by companies according to their own methods of accounting. As you would expect, companies use their own methods for calculating earnings in order to portray a better financial picture than what would have otherwise been displayed by the GAAP earnings. I do not fault the companies for choosing numbers that paint them in a better light as long as the methods are fully disclosed and the GAAP numbers are also available to the public.  I believe that fault can be found with the investors and the analysts on which they rely who are pressuring the companies to “perform” better and better so that they can “sell” them to investors, even if they are a bad investment choice.

            I do agree that more oversight in terms of how earnings are reported would greatly benefit investors that are truly looking to objectively evaluate a company and a standard for reporting this information should be the goal of any new legislation on the issue of financial reporting.

            Until such a standard can be successfully developed and adopted by corporations, Investors should stop contributing to the problem by refusing to invest in a company that can not clearly explain how their earnings figure into the standardized GAAP reporting and exactly how and why they were calculated if they differ from the GAAP standard.

            People, however, will continue to invest in companies that portray higher and higher earnings regardless of whether the earnings can be substantiated. They will only cry foul once the company goes under, and they will certainly not blame themselves for not properly investigating the company before investing.

How do we determine the value of a company? What do investors need to know? Companies provide financial statements; these financial statements are designed to show how well a company is doing, how well they are performing, how much money is being generated or lost, and what we can expect from the future. Investors look at financial statements. Without investors a company wouldn’t exist. Therefore it’s obvious that a company try’s its best to appeal to investors and to make them want to continue investing their money. If people don’t invest then the company loses money, if the company loses money then people get fired, bonuses go away, funding is cut…etc. This puts a lot of pressure on managers to keep their investors happy. Managers must show positive numbers on financial statements. Companies have different opinions what standards should be used in creating these financial statements. On one hand we the GAAP. Some companies feel that by applying GAAP investors aren’t getting the real sense of what company is producing. Many analysts and accountants consider GAAP to be inconsequential because under GAAP many noncash and one time charges are included. Because of the effects that following GAAP has many companies prefer the pro forma approach. The pro forma approach is a method that a company uses to create its financial statements according to its own discretion. However pro forma methods vary from company to company. The ending numbers using GAAP and pro forma end up being very different. So now how does an investor really know what to expect? GAAP doesn’t leave much room for change, even if specific issues were to arise that affect accounting it can take years to changes to be implemented within GAAP. On the other extreme pro forma calculations allow so many changes and eliminations that numbers could be changed completely. Should GAAP with all the included figures be used as a reliable source for investors or should a company’s pro forma calculations be deemed more reliable?

I say that both methods should be used as a baseline for investors. If you have a GAAP based report and pro forma based report you can see both spectrums of the financial statements. With both reports you can see the difference in the numbers and depending on how extreme they are you can prepare the right questions. If the statements are slightly off then you know small adjustments were made and the reports will probably stay consistent in the future. Now if according to GAAP the company is losing money and according to por forma numbers a company is making great profits then you know there are explanations needed. By using both reports you can have a better insight on what to expect from companies.