Pro Forma' Financial Results May Get A Harder Look

San Diego Union-Tribune
Bruce V. Bigelow

If the past year has demonstrated anything to investors, it's that financial reporting by many publicly traded companies is like the climactic scene in "The Wizard of Oz."

That's where the flame-spewing, projected image of the great and powerful Oz shouts, "Pay no attention to that man behind the curtain!"

Many companies want investors to focus on the awe-inspiring version of earnings that management announces every three months -- and not on the sometimes bumbling results that include excess inventory, investment losses and other one-time aberrations. But lately investors' attention has been shifting.

Questions that began with last year's technology selloff -- and intensified in the Enron debacle -- have raised concerns about some of the arcane accounting practices that companies can employ. So investors may be focusing elsewhere on balance sheets as corporations release their 2001 fourth-quarter earnings results.

Apart from Enron's accounting, which increasingly looks fraudulent, many companies often use terms such as "pro forma" earnings or "adjusted" net income to distinguish the version of financial results they prefer from the results based on GAAP, or generally accepted accounting principles. But while the accounting industry has clearly defined standards for GAAP reporting, experts say there is no single definition of pro forma as it applies to earnings reports. So each company uses its own recipe.

In San Diego, the list of companies that use pro forma results includes Applied Micro Circuits Corp., Titan Corp., JNI Corp., HNC Software and Peregrine Systems. Some even insist that news accounts should focus on pro forma results in preference to those based on generally accepted accounting principles.

San Diego-based Qualcomm, for example, reported pro forma net income of $788.9 million, or 98 cents a share, for the 12 months that ended Sept. 30.

But the fiscal 2001 results based on GAAP, which Qualcomm prepared in accordance with government requirements, show a net loss of $548.7 million, or 73 cents a share. In its Nov. 6 announcement, Qualcomm said that the $1.3 billion difference between making money and losing money consisted of special charges and writeoffs the company incurred -- but excluded from its GAAP results.

In excluding the losses, Qualcomm cited a variety of long-established accounting rules. One category, called "amortization of goodwill," allows a company to write off losses stemming from the devaluation of "intangible assets" following a corporate acquisition.

To Bill Keitel, a Qualcomm senior vice president and controller, pro forma techniques enable shareholders to "clearly see the performance of our ongoing operations" apart from isolated, one-time costs that cloud the picture.

For example, Keitel said Qualcomm excludes the results of futures contracts and other derivatives from its overall results because "we don't see that as an indicator of our financial performance."

Wall Street investment bankers and financial analysts began to embrace the pro forma approach to corporate operations in the mid-1990s, and the use of pro forma techniques has mushroomed in recent years. Forty-eight companies on the Standard & Poor's 500 index issued pro forma results last year, up from just a handful as recently as 1998, said Thomson Financial/First Call Corp.

But the practice has been meeting with increasing skepticism.

"The problem is these pro formas are a way of saying, 'We don't want to report the bad stuff,' " said Ed Ketz, an associate professor of accounting at Penn State University's Smeal College of Business. "I've never seen pro forma results exclude anything positive."

Keitel insists that's not the case at Qualcomm, but in some ranks the battle lines have already been formed.

"It's just inherently misleading to have a different set of numbers," said Bill Lerach, the San Diego lawyer who oversees the largest share of corporate shareholder lawsuits filed each year. "We already have GAAP, and they they should be required to stick by the rules."

Outside auditors ostensibly ensure that corporations comply with GAAP rules, but Lerach argues there is "a recurring problem in this country of accountants who are not fulfilling their public watchdog function."

The Securities and Exchange Commission also joined the fray last month, warning that pro forma practices "may not convey a true and accurate picture of a company's financial well-being."

In a Dec. 4 statement, the SEC added, "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."

The SEC followed through on its warning last week by launching "cease-and-desist" proceedings against Trump Hotels and Casino Resorts for making misleading statements in the company's third-quarter 1999 earnings release.

"This is the first commission enforcement action addressing the abuse of pro forma earnings figures," said Stephen M. Cutler, director of the SEC division of enforcement. Developer Donald Trump said the company's business wouldn't be affected by the SEC action. "This type of accounting is something that many, many companies do," Trump told Bloomberg News.

In a speech last month, SEC Chairman Harvey Pitt noted that recommendations from the Financial Executives Institute on how to handle pro forma results are a beneficial and constructive first step for companies to follow.

Still, Pitt added, "We have to decide on our own the extent to which the use of pro formas helps investors focus on important issues or obscures the real results of the company. It's obvious that one result is perfectly fine and the other result is unacceptable."

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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.

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