Pro Forma Financial Statements

Pro forma financial statements are constructed using projected figures based on assumptions about future sales, income, and cash flow. Pro forma financial statements focus on forecasts of future sales and earnings. These financial statements are not subject to generally accepted accounting principles (GAAP), even though companies are required to file the statements with the Securities and Exchange Commission (SEC).

Pro forma statements often exclude certain expenses and charges, sometimes making their projected earnings look more favorable than they truly are. Restructuring charges typically are excluded, and every type of projected gain is included. The lack of standards for earnings also adds to the confusion, making it difficult to compare the pro forma earnings of one company with those of another in the same industry.

Even though companies may not know the amounts of special restructuring charges that could occur in the future, they should provide more guidance with regard to these special charges and try to quantify them. You should be aware of these shortfalls in your analysis of a company’s pro forma statements and not disregard the results of past financial statements as water under the bridge because past statements still may be more accurate than pro forma statements.

Table 10–8 discusses whether you can trust the numbers put out by management.

Table 10-8
Can You Trust the Numbers Put Out by Management?
After the Enron, WorldCom, and Global Crossing debacles of “cooking the books,” the SEC spent a year reviewing annual reports from the 500 largest companies in the United States and found fault with 350 of the annual reports. The major problem areas were in accounting (the companies did not explain their use of accounting policies and how different interpretations might affect reported profits), revenues (companies did not spell out what they counted as revenue), pensions (companies did not disclose their assumptions on interest rates and how they used them to calculate liabilities on their pension funds), impairments (companies did not disclose how they wrote off their intangible assets), and management discussion (companies failed to analyze industry trends, risks, cash flow, and capital requirements) (McNamee, 2003, p. 74).
This corporate shortfall has been an invitation to lawmakers in Washington, D.C., to step in to regulate and limit the leeway with which corporations can report their numbers. New, tougher accounting rules were set. The SEC demanded that companies provide full explanations whenever they deviate from using GAAP. The Financial Accounting Standards Board put limitations on how companies account for their restructuring costs and has requirements in the works to have companies expense their stock options (Henry and Berner, 2003, pp. 72–73). Accounting scandals probably will continue to occur, so you should continue to look for warnings signs in industries and companies before you invest in their securities. An economy in recession, with declining sales and earnings, seems to provide the right atmosphere for unscrupulous corporate executives to overstate assets and revenues, understate expenses, and hide debt by keeping it off the balance sheet. Similarly, companies that had stellar growth records and were then confronted with slowing sales and earnings also “fudged” their numbers. Another situation was the Tyco story. Growth through aggressive acquisition practices gave the self-serving CEO a chance to pay himself enormous amounts, which were hidden in the numbers pertaining to the acquisition of other companies.
How seriously should you take pro forma earnings? Not very seriously, even though pro forma earnings form the basis of analysts’ forward projections. Moreover, the track records of analysts were not very good for 2002. Analysts, watching projections for 2002, predicted a recovery in the latter half of the year. They forecasted 16 percent earnings increases in the third quarter and 21 percent in the fourth quarter that never came about.

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