Pro forma earnings (sometimes spelled “proforma” or “pro-forma”) are included by some companies in their quarterly or annual reports as a way to discount “unusual and non-recurring transactions” to more accurately reflect their true financial health. But while actual earnings are calculated using Generally Accepted Accounting Principles (“GAAP”), the US standard for corporate accounting, pro forma earnings are used as guidance for investors to demonstrate how much money a company would have earned had unusual and one-time charges not occurred. As one would expect, pro forma reporting has had a history of abuse and therefore should be approached with great care.

The Deceptive Pro forma

Pro forma earnings can serve a useful purpose. For example, suppose Acme Co buys rival Jones Co. Although Acme revenues may have doubled because of its purchase of Jones Co, pro forma results of the combined companies would show combined year-over-year revenues that were flat or declining. Despite their positive uses such as in this example, companies can take advantage of pro forma results because they amount to an interpretation of their own financial statements which the SEC does not regulate as carefully.

“Unusual or non-recurring” charges could begin to show up regularly and if so, red flags should go up in the diligent investor’s mind. The Federal government prohibits companies from engaging in fraud in federal filings, however because these reports are interpretive by nature there is room for companies to overly discount their own losses. Management’s explanation of pro forma earnings should be reviewed carefully — and remember, when in doubt don’t give its benefit to the company.

Pro formas can be a very useful tool in trending sales growth and operating margins, but not for long-term profit growth. In any business there are unusual expenses. Even in your own life they exist. Just because your car breaks down, does that mean you can pro forma that $600 back into your bank account? Of course not, and neither can any company. So while useful for financial analysis it may be wise to stay away from pro forma results on a long-term basis where a responsible management team should have already factored in unusual and one time expenses.

What to do?

Always, always, always look at actual, GAAP-based, earnings first. Then scrutinize pro forma earnings, and see if what management says makes sense. Personally, if I don’t understand what expenses are being deducting, I would choose to ignore it. If a company can’t explain plainly why something is unusual or non-recurring then why would I give them the benefit of the doubt unless they have a long, well-documented history of fiduciary responsibility? When investing your money always be skeptical and remember to build in margins of safety into every investment you make.

References

[1] DeCarlo, Scott and Michael Maiello. “Faux Forma.” Apr 15, 2002. Accessed Jan 29, 2006. http://www.forbes.com/forbes/2002/0415/166.html. Forbes.com. http://www.forbes.com.
[2] Investopedia Staff. “Understanding Pro-Forma Earnings.” Jun 17, 2005. Accessed Jan 29, 2006. http://www.investopedia.com/articles/01/103101.asp. Investopedia. http://www.investopedia.com/.
[3] Securities & Exchange Commission. “Cautionary Advice Regarding the Use of ‘Pro Forma’ Financial Information in Earnings Releases.” Dec 4, 2001. Accessed Jan 29, 2006. http://www.sec.gov/rules/other/33-8039.htm. Securities & Exchange Commission Web site. http://www.sec.gov/.