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
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.
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
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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