Companies use clever methods to fudge and fiddle with their earnings figures, and you should be aware of these methods. It is anticipated that the Securities and Exchange Commission (SEC) will investigate companies that are suspected of attempting to deceive investors regarding pro-forma earnings modification in the future. Check out this explanation of pro-forma earnings to learn more about when they are useful and how companies can use them to defraud investors.
What Are Pro-forma Earnings and How Do They Work?
In accounting, pro-forma earnings are a financial statement that includes hypothetical amounts, or estimates, built into the data to provide a “picture” of a company’s profits if certain nonrecurring items were excluded from the data. It is not necessary to compute pro-forma earnings in accordance with generally accepted accounting principles (GAAP), and it is common to exclude one-time expenses that are not part of the normal course of business, such as restructuring costs following a merger, from the calculation.
An essentially pro- forma financial statement can exclude anything that a company believes obscures the accuracy of its financial outlook, and it can be a useful piece of information to use in assessing a company’s future prospects and prospects. Every investor should place emphasis on GAAP net income, which is the “official” profitability determined by accountants; however, taking a look at pro-forma earnings can also be a fruitful exercise in learning more about a company.
When a company incurs one-time charges that are not relevant to future profitability, net income, for example, does not tell the whole story about the company. As a result, some businesses eliminate certain costs that are in the way of their operations. When it comes to giving investors an accurate picture of a company’s normal earnings outlook, this type of earnings information can be extremely useful. However, by omitting items that reduce reported earnings, this process can make a company appear profitable even when it is actually losing money.
It is important to note that pro-forma earnings are intended to provide investors with a more complete picture of a company’s operations and, by their very nature, exclude one-time expenses and charges. The problem, however, is that pro-forma earnings are subject to far less regulation than financial statements prepared in accordance with generally accepted accounting principles (GAAP), and as a result, companies may take advantage of the rules in order to make earnings appear better than they actually are.
For this reason, because traders and brokers are so focused on whether or not a company beats or meets analyst expectations, the headlines that follow earnings announcements can be extremely important. If a company reports that it missed non-pro-forma expectations while also reporting that it exceeded pro-forma expectations, its stock price will not suffer as much and may even rise – at least in the short term – as a result.
Pro Forma Errors and Obstacles
Company earnings reports that include items such as stock-based compensation and acquisition-related expenses are far too frequently released in a positive manner. Such businesses, on the other hand, rely on the fact that people will forget that these expenses are real and must be factored in.
When reporting pro-forma earnings, some companies will even remove unsold inventory from their balance sheets. Consider the following: did it cost money to produce that inventory? – Of course it does, so why should the company be able to write it off as a simple expense? Producing goods that cannot be sold constitutes poor management, and a company’s poor decisions should not be erased from its financial statements as a result.
This is not to say that companies are always dishonest with pro-forma earnings – just because the numbers are pro forma does not imply that the numbers are being manipulated. However, by exercising caution when reading pro-forma earnings, you may end up saving a significant amount of money.
When determining the legitimacy of pro-forma earnings, it is important to consider what costs have been excluded from the calculation and whether or not these costs are real. Intangibles such as depreciation and goodwill can be written off on a temporary basis, but if a company is writing them off on a quarterly basis, the reasons for doing so may be less than honorable.
Some of the most egregious abusers of pro-forma earnings manipulations emerged during the dotcom boom of the late 1990s. Numerous Nasdaq-listed companies used pro-forma earnings management to report more robust pro-forma numbers than they otherwise would have reported. The difference between GAAP earnings and pro-forma earnings for the dotcom sector during its heyday was in the billions of dollars when taken as a whole.
The Advantages of Pro-Forma Analysis
As previously stated, pro-forma figures are intended to provide investors with a more complete picture of a company’s operations. Pro-forma earnings, due to the nature of some companies’ businesses, provide a much more accurate picture of their financial performance and outlook than traditional earnings reports. Because industry characteristics are often the driving force behind the decision to report pro-forma numbers, companies in certain industries tend to use pro-forma reporting more frequently than other industries. Because they are constantly writing down large depreciation costs, some cable and telephone companies, for example, almost never make a net operating profit.
Additionally, when a company undergoes a significant restructuring or completes a merger, significant one-time charges may be incurred as a result of the restructuring or merger. These types of expenses do not form part of the company’s ongoing cost structure, and as a result, they can have an unfair impact on the company’s short-term profit figures. An investor interested in determining the long-term potential of a company would do well to examine pro-forma earnings, which are earnings that are not affected by these non-recurring expenses.
Additionally, pro-forma financial statements are prepared and used by corporate managers and investment banks to assess the operating prospects of their own businesses in the future and to aid in the valuation of potential takeover candidates. In order to identify a company’s core value drivers and analyze changing trends within the company’s operations, these tools are extremely useful.
What’s the bottom line?
For the purposes of this discussion, pro-forma earnings are useful when official earnings are obscured by large amounts of asset depreciation and goodwill. It is your responsibility to investigate further when you see pro forma earnings in order to determine why the company is treating its earnings in this manner. Always keep in mind that when you read pro-forma figures, they have not been subjected to the same level of scrutiny as GAAP earnings and have not been subjected to the same level of regulation.
Take the time to complete your homework and keep a balanced perspective when reading pro-forma statements. Consider the key differences between GAAP earnings and pro-forma earnings and whether the differences are reasonable or if they are solely intended to make a losing company appear better in the eyes of investors. No matter whether the financial picture is based on pro-forma earnings or actual earnings, you want to be able to base your decisions on as clear a picture as possible.