Pro Forma's Bottom Line

Industry Week
John S. McClenahen

"If firms would give both the pro formas and the GAAP numbers in the public releases, they probably aren't going to get clobbered."

-- J. Edward Ketz, Pennsylvania State University's Smeal College of Business

In effect, the U.S. Securities & Exchange Commission (SEC), the federal regulatory agency that polices the financial statements of publicly traded companies, will be slapping warning labels on many of the annual reports and quarterly earnings statements being issued during the next several weeks. Concerned that so-called pro forma presentation of financial information could mislead investors, the SEC six weeks ago pointedly reminded companies that the antifraud provisions of federal securities laws also apply to firms not reporting results according to U.S. GAAP, a traditional set of generally accepted accounting principles.

Increasingly popular, especially among high-tech companies, pro forma earnings reports present an "as if" picture of a firm's financial status. Frequently, that means pro forma financial statements leave out such things as restructuring charges and merger-related expenses, which, if reported, would lower earnings. However, in the financial world, pro forma earnings reporting has no standard definition and no consistent format.

It's even possible for an operating loss to become a profit under pro forma earnings reporting. For example, for its 2001 fiscal year, which ended last July 28, Cisco Systems Inc., a San Jose, Calif.-based maker of computer networking systems, reported net income of $3.09 billion on a pro forma basis but simultaneously reported a net loss of $1.01 billion on a GAAP basis. Cisco's pro forma profit specifically excluded acquisition charges, payroll tax on the exercise of stock options, restructuring costs and other special charges, an excess inventory charge, and net gains on minority investments.

"Because . . . pro forma financial information by its very nature departs from traditional accounting conventions, its use can make it hard for investors to compare an issuer's financial information with other reporting periods and with other companies," insists the SEC.

The SEC's take on pro forma reporting differs dramatically from the view of Nokia Corp., a Finnish firm that's the world's leading manufacturer of mobile phones. Partially in response to requests from shareholders and securities analysts, says Nokia, it began reporting pro forma results with the first calendar quarter of 2001. Pro forma results provide a clearer picture of the company's continuing operations and offer investors "more meaningful" information, Nokia says.

In Nokia's reporting, pro forma definitely has produced results different from those generated by traditional accounting. For example, in 2001's third quarter, Nokia reported a net profit of US$676.2 million (760 million euros) on a pro forma basis. However, based on International Accounting Standards, the traditional format the company also uses in its financial reporting, Nokia reported a smaller net profit of $165.5 million (186 million euros). Nokia's pro forma report excluded amortization for goodwill and for items described as "nonrecurring."

More companies now report their financial performances on a pro forma basis than they were just two or three years ago, confirms Robert O'Connor Jr., president and CEO of Softrax Corp., a Canton, Mass.-based producer of revenue management software. "There's been a lot more of it -- and certainly a lot more to come," states O'Connor.

Indeed, that seems likely. For example, among both manufacturing and nonmanufacturing firms, more executives really do believe that compared with U.S. GAAP, pro forma presents a clearer picture of their companies' continuing operations, O'Connor and other financial accounting experts state. Strip away the one-time charges and nonrecurring expenses and the core of the business is more evident, the executives contend. What's more, like Nokia, other companies say they're reporting on a pro forma basis because securities and financial analysts have asked them to do so. A third reason for the growing use of pro forma reporting -- although companies probably wouldn't admit it -- is that it gives executives a chance to put "somewhat of a spin on things," to explain what the executives see as their companies' unique circumstances, says Softrax's O'Connor.

Nevertheless, there are clear and present dangers to pro forma. "If firms would give both the pro formas and the GAAP numbers in the public releases, they probably aren't going to get clobbered," suggests J. Edward Ketz, an associate professor of accounting at Pennsylvania State University's Smeal College of Business in University Park, Pa. But "if you get a PR guy writing these [pro forma releases] in such a slick way that the market perceives that you are trying to hide some dirty laundry someplace, then I think you are going to get hit-even if it's not true," says Ketz. For example, when Computer Associates International Inc. changed its accounting for revenue recognition and released its results as pro forma last year, the market "immediately thought something bad was going on," says Ketz. "Computer Associates has had to spend a lot of time and effort explaining [what] they tried to do," adds Ketz.

What's a company to do? The Financial Executives International, Morristown, N.J., and the National Investor Relations Institute, Vienna, Va., have come up with guidelines for clear and consistent public statements of corporate earnings. Five key suggestions:

Prominently display in the headlines of the earnings press release the most meaningful information. Usually, this is GAAP or pro forma earnings-per-share -- or a combination of the two.

Prepare earnings press releases with a reasonably balanced perspective of operating performance. This includes a discussion of both positive and negative factors significantly affecting revenue, profitability, and other key financial indicators, such as the debt-to-equity ratio, that measure a company's performance. Significant factors may include noncore gains and losses, accounting changes, competitors' actions, weather disruptions, interest rate changes, price changes and fluctuations in currency exchange rates.

Treat reconciliation between GAAP and pro forma results in a similar fashion for comparable reporting periods.

Discuss, with appropriate legal qualifications, the outlook for coming fiscal quarters.

To return to Media Coverage click here .

REPORTERS & EDITORS: For more information, please contact Wyatt DuBois in the Smeal College of Business Media Relations Office at 814-863-3798 or wed112@psu.edu .

Penn State's Smeal College of Business offers highly ranked undergraduate, MBA, executive MBA, Ph.D., and executive education opportunities to more than 5,500 students at all levels. Featuring academic departments of accounting, finance, marketing, insurance and real estate, management, and supply chain and information systems, the college is also home to major research centers such as the Center for Supply Chain Research, the Institute for the Study of Business Markets, the eBusiness Research Center, the Farrell Center for Corporate Innovation and Entrepreneurship, the Center for Global Business Studies, and the Center for the Management of Technological and Organizational Change.

Click here for more news.