The financial reporting practices of publicly held companies have come under the microscope of the general investing public in recent years. The public demise of Enron Corporation has emphasized the critical need, to the benefit of investors and creditors, for the issuance of financial statements that are easy to understand, consistent and comprehensible. Over the past decade, management of public companies has, without the guidance of the Securities and Exchange Commission (SEC) or the Financial Accounting Standards Board (FASB), developed a new financial reporting format referred to as pro forma financial statements. Pro forma financial statements and earnings disclosures have evolved into subjective interpretations of generally accepted accounting principles (GAAP) by public companies. These interpretations are suited to the particular needs of public companies to present financial results in a manner to improve the performance of stock prices. Pro forma presentations have become the primary presentation of the results of operations, with results under GAAP being relegated to the back portion of company press releases.
Recently, Standard and Poor’s (S;P) has jumped into the fray and issued a self-defined measure of the definition of earnings for public companies, complicating matters even further for investors and creditors. This paper will present the case for the regulation of pro forma financial statements and earnings disclosures by public companies. The paper will start with an introduction of the evolution of pro forma financial statements and earnings disclosures compared to GAAP. The next sections present the major arguments behind why pro forma financial statements must be 1 regulated which are: (1) Pro forma earnings disclosures are biased, misleading and inconsistent; (2) Companies use pro forma disclosures to manage earnings perceptions; and (3) Pro forma financial statements are not in accordance with GAAP and must be reconciled to GAAP.
The paper will conclude with the benefits to companies, investors, shareholders, and creditors of regulating pro forma disclosures. The terms “pro forma financial statements,” “pro forma earnings,” “GAAP financial statements,” and “GAAP earnings” are used interchangeably throughout this paper. EVOLUTION OF PRO FORMA AND GAAP FINANCIAL STATEMENTS Investors and creditors, to evaluate the future cash flows and growth prospects of firms, have historically utilized financial statements prepared in accordance with GAAP. The manner in which companies conduct business has become more complicated in recent years. Firms routinely buy and sell operations and make business decisions that significantly impact reported financial results. The preparation and presentation of pro forma financial information is directly related to the changes in the way businesses operate.
Many companies have decided that GAAP financial statements do not present relevant information regarding the results of operations and growth prospects of the firm required by investors, creditors, stockholders, and stock analysts. To fill this information gap inherent in GAAP financial statements, firms started to prepare and aggressively market pro forma financial statements and earnings data. Public company press releases often prominently highlight pro forma earnings results before or in place of GAAP earnings results. In 200 1, over sixty percent of the companies in the S;P 500 2 prepared and reported prominently in public press releases pro forma earning results. Even more revealing is that for these companies, “60 cents of every dollar of pro forma earnings was due to the exclusion of expenses recorded under GAAP” (Doyle, Lundholm, and Soliman 2002, 1).
Stock market analysts have also changed company share valuation models to reflect primarily the pro forma earnings information reported by public companies instead of GAAP earnings. Companies have adopted the use of pro forma financial statements to disclose such items as- restructuring charges (in some cases, quarter-after quarter); write-downs of receivables and inventories; impairment of long-term assets such as goodwill and fixed assets; numerous one-time and nonrecurring charges (including acquired in-process research and development expenses); changes in business models (such as changing the sales channel strategy from direct selling to selling through distributors); changes in key accounting policies (including revenue recognition and deferral of expenses expensed in previous periods); costs and expenses associated with disposal of product lines; reversals of write-offs from purchase accounting; and stock option compensation expenses, to name just a few. Public criticism has grown rapidly regarding these practices of presenting pro forma information with disclosures of exceptions to GAAP.
The SEC issued cautionary advice late in 200 1, warning corporations could face civil-fraud lawsuits for touting potentially misleading pro forma earnings in news releases (SEC 2001). The Financial Executives International (FEI) and the National Investor Relations Institute (NIRI) have jointly issued guidelines for companies to follow regarding press releases containing pro forma information (NMI 2001). The FASB and the SEC are studying what actions should be taken to possibly 3 regulate and standardize pro forma financial statements (Eccles and others 2002, 117). Additionally, the press has had a field day ridiculing pro forma financial reporting and the accounting profession in general, using firms like Enron, World Com, Tyco, and Xerox as examples. Ironically, GAAP has actually encouraged the evolution of pro forma reporting. Starting with some of the early pronouncements such as APB 30, the APB and the FASB have required separate disclosure in company financial statements for items defined as extraordinary and for material changes in accounting principles. An argument can be made that companies are extending these special GAAP disclosures, in the format of proforma presentations, to present relevant information to their constituents.
Many firms have extended the use of pro forma presentations to report “cash basis,” “adjusted,” 4C ongoing,” and “core” financial results to supplement GAAP financial results. However, the evolution of unregulated and homemade pro forma reports has harmed the usefulness of pro forma information to the public, damaged the reputation of the accounting profession, and contributed to the recent poor stock market performance. With this background, the rest of this paper will be devoted to the reasons why pro forma earnings disclosures should be regulated. PRO FORMA EARNINGS DISCLOSURES ARE BIASED, MISLEADING, AND INCONSISTENT The purpose of pro forma earnings disclosures is to inform investors and creditors regarding unusual or one-time expenses and events that impact the future earnings and cash 4 flows of a firm. Stock market analysts and an efficient market should be able to properly impound the information presented in pro forma disclosures to determine the most efficient stock price of a company. Evidence available to date suggests that proforma information is biased, misleading, and inconsistent, limiting their value to both investors and analysts. Over the past twenty years, studies have shown a dramatic increase in the differences companies report between GAAP earnings and pro forma earnings.
“Further, there is a very strong bias toward the reporting of a Street [pro forma] earnings number that exceeds the GAAP eamings number” (Bradshaw and Sloan 2002, 42). Companies also strategically present and disclose one-time gains and losses to “highlight the most favorable change in earnings” (Schrand and Walther 2000, 15 1). Firms experiencing rapid declines in earnings and stock market values also reported large amounts of “discretionary write-offs equal to at least 1% of assets” in another study (Elliot and Shaw 1988, 113). The selective, unregulated disclosure by firms of one-time charges and unusual events has undermined the credibility of pro forma disclosures and created a sense of insecurity with investors and the general public. Many examples exist of pro forma disclosures by firms that appear biased and deceptive in nature. In 1999, the SEC censored Trump Hotels & Casino Resorts, Inc. (Trump) for the issuance of pro forma results that were biased and misleading. In an October 1999 release, Trump reported a pro forma profit for the latest quarter that excluded a one-time charge to earnings, The CEO of Trump, in the Company’s quarterly press release, stated that the improved results of the firm were due to the improved operating performance of the business during the quarter.
The SEC found in their investigation that Trump’s pro forma earnings disclosures had conveniently omitted the disclosure of a one-time 5 accounting gain (the termination of a lease agreement). If Trump, as is required, had included the one-time accounting gain in the pro forma presentation, the company would have reported a pro forma loss instead of a profit for the quarter. Another example of a pro forma earnings disclosure that was biased, misleading and inconsistent related to Uniphase, a manufacturer of telecommunications equipment. In the second quarter of 1988, Uniphase announced GAAP earnings of $4.5 million and pro forma earnings of $11.2 million. Uniphase’s explanation of the adjustments made from GAAP earnings to the higher pro forma earnings included such items as the reversal of acquisition and divestiture charges including in-process research and development (R&D) costs, merger costs, and the costs and expenses associated with the disposal of a product line. The Uniphase explanation poses more questions than provides answers to the investor regarding the information content of its pro forma earnings disclosures.
Uniphase did not explain in any detail why the pro forma results were helpful to an investor attempting to determine the future prospects of the company, In fact, a person with any accounting knowledge or an analyst attempting to determine the impact of the Uniphase adjustments would have the following questions: (1) the sale of inventory at a profit or a loss is a normal business transaction and should be included in GAAP financial statements and not excluded in the calculation of pro forma earnings; and (2) the in-process R&D adjustments raise many questions, such as the accuracy of the original accounting entries made to book in-process R&D. Many examples exist of companies issuing pro forma financial statements that are unbiased and informative. Large companies like IIBM, Disney, and General Electric have gone to great lengths, especially in their latest annual reports and Form 10-K filings in 2002, 6 to provide expanded disclosure of pro forma financial information.
The trend to expand pro forma disclosures and information is the result of market pressures, the present political environment in the United States and the desire of companies to protect stock market valuations. While the trend to expand disclosure is positive, regulation by the SEC and FASB is required to assure the marketplace that pro forma disclosures are clear, consistent, informative, and free from management bias. COMPANIES USE PRO FORMA DISCLOSURES TO MANAGE MARKET PERCEPTIONS OF EARNINGS Before pro forma earnings disclosures by public companies exploded in the 1990’s, analysts relied primarily on GAAP financial statements to determine the value of a firm. The trend towards more pro forma financial reporting started innocently and in accordance with GAAP, with many firms reporting and thoroughly explaining extraordinary items and the pro forma impact of acquisitions and divestitures in income statements and supplementary footnotes. Over the past decade, firms have become more aggressive determining which financial statement items to include in pro forma financial statements.
Many chief executives and chief financial officers have complained that GAAP financial statements do not adequately present the “core” operating results, future growth prospects, and future cash flow potential of their firms. The SEC has also admitted that GAAP-based earnings (which are based upon historical cost) do not adequately measure key value drivers of today’s listed firms. Top management of publicly listed companies is paid to maximize company share value-for the benefit of 7 shareholders, investors, creditors, and themselves. Without the restriction of outside regulation, firms have developed the concept of proforma earnings press releases and financial disclosures to manage earnings perceptions in a marketplace. Analysts have developed consensus forecasts of firm earnings, with pro forma disclosure components, to produce what is commonly called “Street Earnings” as the primary measure of firm quarterly performances compared to forecasts. Analysts also utilize pro forma earnings information to determine if firm nonrecurring expenses and write-offs are permanent in nature or transitory (Ali, Mein, and Rosenfield 1992).
Scholarly research performed on alternative measures of pro forma earnings on stock prices has expanded in recent years, defending the information content, predictive ability, and relevance of pro forma earnings disclosures. These studies have compared a variety of earnings measures over time, including pro forma or “Street” earnings, GAAP earnings, and earnings before extraordinary items and discontinued operations (EBED). One study “suggests that users of financial information can obtain higher quality of earnings measures using pro-forma operating income released by managers than they can by perusing less timely [GAAP] I O-Q and I O-K filings with the SEC” (Brown and Sivakumar 2001, 3). The Brown and Sivakumar study is flawed for the following reasons: (1) the data used in the study is based upon earnings data reported between 1989 and 1997, a period of mainly high growth in stock market prices; (2) the authors, themselves, state “the results should not be interpreted as suggesting that pro-forma earnings are of high quality” (Brown and Sivakumar 2001, 27); and (3) the study focuses on short-term returns in stock prices, and ignores the long-term impact of pro forma earnings disclosures on future cash flows and earnings.
Another study also concluded that a closer 8 relationship exists between the street definition of earnings and stock prices than GAAP-based earnings and street prices (Bradshaw, Moberg, and Sloan 2000). However, this study does not consider the long-term impact on cash flows and stock prices of pro forma earnings disclosures. Since 1999, the U.S. stock market had undergone a significant correction, especially the NASDAQ index. The valuations of Internet start-up firms, telecommunication firms and other high-tech industries have been dramatically reduced during this period of stock market correction. How relevant has the management of pro forma earnings by firms been to stock market valuations before 1999 and after 1999? One study researched the impact on stock prices of both pro forma and GAAP earnings between 1997 and 2000 for firms in the Information Technology (IT) sector.
The results of this study were that “pro forma earnings numbers exhibit superior association to stock prices and returns over GAAP only during periods of high growth” (Bryant, Henning, and Shaw 2002, 1). As this study included the year 2000 (the stock market contracted significantly in 2000), the impact of pro forma earnings disclosures was analyzed during a period of both stock market price expansion and contraction. One of the most comprehensive studies illustrating how companies use pro forma earnings disclosures to manage earnings perceptions was performed recently at the University of Michigan (Doyle, Lundholm, and Soliman 2002). The study reviewed more than 120,000 company earnings announcements and cash flows from 1988-1999. The results of this study were: (1) the costs that companies are excluding from pro forma earnings presentations are not one-time events nor irrelevant to future performance and cash flows; (2) “the higher level 9 of excluded expenses [that firms omit from pro forma earnings presentations] eventually leads to lower future cash flows”; and (3) “every dollar of [excluded pro forma] expenses per share in a quarter leads to roughly [$] .83 fewer dollars of [future] cash flow” for the studied firms (Doyle, Lundholm, and Soliman 2002, 5).
Another study takes the assertion that companies use pro forma earnings disclosures to manage earnings perceptions another step (Kinney and Trezevant, 1997). This study analyzed a sample of firm earnings over a ten-year period. The conclusions of this study were: (1) “firms with large earnings changes are found on average to recognize significant negative income from special items; and (2) the placement of the description of special items in the financial statements is used to manage investors’ perceptions by emphasizing the [supposedly] transitory nature of any decrease in earnings and by de-emphasizing the transitory nature of any increases [in profits] caused by special items” (Kinney and Trezevant 1997, 50). The study also found, alarmingly, that many companies recognized and disclosed a large number of special and unusual pro forma adjustment items in the fourth quarter of the financial year, a finding also confirmed by Bradshaw and Sloan (2002).
Unquestionably, firms are using pro forma disclosures to mislead the marketplace, innocently or purposely, as to the future earnings prospects and cash flow potential of the company. The regulation of the presentation of pro forma earnings presentations will help restore the confidence of analysts, investors, and creditors in the credibility of pro forma presentations. 10 PRO FORMA PRESENTATIONS MUST BE RECONCELED TO GAAP The most compelling reason pro forma disclosures should be regulated is they simply A not presentations prepared in accordance with GAAP. Given the lack of regulation of how pro forma presentations are to be prepared and presented, companies have self determined which financial statement items to present in pro forma presentations. Until recently, very few companies provided any reconciliation of pro forma results to GAAP results. Even today, companies that provide such reconciliation are shallow in their explanations, evasive in their comments, and admit that pro forma presentations are not in accordance with GAAP. GAAP, to a certain degree, allows for considerable discretion by firms in the measurement of earnings and of financial statement disclosures of the results of operations.
Investors reviewing firm GAAP financial statements, though, generally have concluded in the past (before pro forma earnings disclosures became so predominant) that GAAP was being followed in the presented financial information and GAAP policies were consistently applied from period to period. GAAP financial statements have always been a tool to benchmark and compare the financial performances, in an objective manner, of firms in a similar industry; “[and that] can’t be said about pro forma” [financial statements] (Henry 2001). Why must pro forma presentations be reconciled to GAAP? One study found that companies that “do not reconcile pro forma earnings with GAAP earnings are characterized by more frequent losses, negative earnings surprises, earnings variability, and proportion of special items” (Lougee and Marquardt 2002, 4). Opponents argue that GAAP financial statements are no longer relevant in today’s new economy. Studies by Collins, Maydew, and Weiss (1997) and Francis and Schipper (1999) concluded that GAAP book values have 11 increased in relevance as firms report negative GAAP earnings and increases in nonrecurring charges included in pro forma earnings.
There are a number of challenges involved in regulating the reconciliation of pro forma earning statements to GAAP financial statements. Companies generally release pro forma information simultaneously when announcing quarterly earnings information; GAAP financial statements are generally completed, filed with the SEC, and released at a much later date. Public pressure has grown recently to require the filing of 10Q’s and 10K’s by public companies with the SEC in a much shorter time frame to narrow the gap between the release of pro forma information and the filing of GAAP financial statements. A more practical solution is to require firms to prepare and release on the earnings release date all pro forma and GAAP financial information in a standard format simultaneously. The SEC has issued guidelines, in conjunction with the FEI and NHU, for the content of earnings press releases in 2001 that require the reconciliation of GAAP earnings to pro forma earnings. The next step is to expand these guidelines and formalize the exact content and presentation of the reconciliation of GAAP earnings to pro forma earnings. The ultimate goal of the reconciliation must be to provide a clear and comprehensive presentation that is easy to understand and consistently applied by all public firms.
The chief accountant of the SEC has termed the quality of pro forma financial information released by firms as “earnings before bad stuff’ (Turner 2000). The information provided by pro forma earnings disclosures is unquestionably useful in determining the future 12 earnings and cash flow potential of publicly traded companies. In today’s fast-changing business world, the market, investors, creditors, and analysts require full and comprehensive disclosure of company financial results, including all material events (both gains and losses) that impact every company. Company presentations of pro forma earnings started as an attempt to accurately portray events that were unusual in occurrence, infrequent in nature, and not indicative of “core” firm earnings prospects and future cash flows. Pro forma presentations have degenerated over the past decade to the point that earnings disclosures are biased, misleading, and inconsistent. Finns are using pro forma earnings to manage market perceptions of “core” earnings results. A significant step towards restoring confidence in the stock market would be for the FASB and SEC to issue regulations prescribing how companies are to prepare and present pro forma operating results to the public.
The regulations should include detailed guidelines of what types of information should be presented in pro forma disclosures, the explanations firms must provide together with pro forma information to improve their relevance and reliability, and a consistent format for reconciling GAAP earnings to pro forma earnings. GAAP financial statements are still a critical component today in evaluating the growth prospects of a Company. GAAP statements based solely upon historical cost do not provide enough information about a firms prospects or results of operations; supplemental disclosures, in the form of regulated pro forma information, can support the intrinsic value of GAAP statements and improve the overall efficiency of the capital markets. The unregulated presentations of pro forma information have clearly failed to serve the objective of improving the efficiency of our capital markets on a long-term basis. 13
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