Pro Forma Deception

In the past decade, investors have been confronted with the steady rise of a peculiar and sometimes ill-intended managerial practice; the endorsement of so-called "pro forma" financial statements. These adjusted numbers have important implications for all parties involved – shareholders, bond holders, vendors, and employees. Before you pick up another annual report, it is important to understand the potential abuses and benefits of the non-GAAP financial figures frequently found in annual reports and press releases.

The Definition of Pro Forma Earnings

Public companies in the United States are required to publish financial statements in accordance with GAAP (Generally Accepted Accounting Principles). If management feels that these statements don’t represent economic reality, they may create a separate set of financial statements and report them to shareholders under the heading of pro forma – which essentially means they have been modified to reflect what the CEO thinks is a more realistic representation of the company's economic performance.

Historically, pro forma financial statements were used to give an estimate of what a newly-public or recently spun-off business would have earned had it been an independent public company. In a few cases, pro forma financial statements are used to provide shareholders a greater degree of clarity in evaluating operations. Berkshire Hathaway, for example, has long offered pro forma statements alongside its GAAP statements that allow the owners to see the performance of each business segment as if it had operated independent of the parent company.

Sadly, there are many more companies that use the widespread acceptance of pro forma statements as a chance to stretch the financial, operating and economic realities of the business. In Howard Schilit’s Financial Shenanigans – 2nd Edition, the author points out that these types of fairy-tale pro forma reports can be so distorted, they essentially equate to fraud. Schilit writes:

That’s just what happened at Computer Associates International (CA), whose accounting was challenged in an April 2001 story in the New York Times. By changing the terms of its software sales and how it accounts for them, CA reported 42 cents of pro forma earnings per share in the final quarter of last year, versus a 59-cent loss under GAAP . Company officials say that the new presentation is actually more conservative and that the purpose of the change was not enhancing growth.” (Emphasis added)

How big of a difference is there between a 59 cent loss and a 42 cent profit? In my book, the divergence is serious enough to cause me to question management’s motives and integrity. There are very few, if any, cases where such a large discrepancy is justified.

The Moral

The average investor would best be served by avoiding stocks and bonds of companies that habitually publish pie-in-the-sky pro forma earnings revisions unless they are convinced that these revisions are justified. At the very least, if you insist on holding onto your investment, bring copies of the company’s financial statements to an accountant and ask them to look them over for any signs of aggressive earnings “management” or accounting practices. Corporate America may be able to wipe out losses with imaginary reported earnings, but rest assured, individual investors cannot.