The growing use of “pro forma” financial results — that is, when companies report income or loss figures excluding a host of supposedly “one-time” charges — is drawing attention from critics who say companies may be publishing pro forma earnings to make quarterly earnings reports look better than they actually are.
The U.S. Securities and Exchange Commission (SEC) is reportedly investigating some companies over their use of pro forma results as a tool to prevent such items as big writeoffs for bad investments from blemishing their quarterly reports.
Regulators, however, are not likely to take any broad action to curb the practice, at least in the near future, according to analysts. As a result, investors have to decide on their own how much importance to attach to “one-time” charges and writeoffs.
Big and Bigger
While companies must still report bottom-line figures that comply with U.S. generally accepted accounting principles (GAAP) in their quarterly statements filed with the SEC, those documents are sometimes not available until well after the initial pressreleases announcing quarterly results on a pro forma basis.
The gap between pro forma and net results can be very wide. Online travel company Expedia.com (Nasdaq: EXPE), for example, last month reported a profit for its fiscal fourth quarter of 2001 of US$15 million, or 25 cents per share, before stock-option expense and amortization of goodwill and intangibles.
After including those items, however, Expedia actually lost $4.4 million, or 9 cents per share.
Earlier in July, Amazon.com (Nasdaq: AMZN) reported a pro forma loss of $58 million, or 16 cents per share, while losing $168 million, or 47 cents, after accounting for all its expenses. In other words, some $110 million in charges were in play when Amazon adjusted its results.
Which figures are more meaningful? Investors are left to figure that out forthemselves. Companies, and the analysts who follow them for investmentfirms, tend to focus on the before-all-the-charges numbers. Notably,”one-time” gains and benefits are rarely included in pro forma results.
The practice of highlighting income before certain expenses took hold during the 1990s, as several money-losing but up-and-coming companies like Amazon and Yahoo! (Nasdaq: YHOO) began presenting their results in a manner they said more clearly reflected their businesses. Old-school accounting methods, some argued, did not apply in the New Economy.
However, one problem, Stanford University assistant professor of accounting Karen Nelson told the E-Commerce Times, is that there is no single definition of pro forma as it applies to earnings reports. Thus, questions have arisen about the accuracy and consistency of companies’ pro forma calculations, which can vary from company to company — and sometimes from quarter to quarter within the same company.
“It’s a pasta primavera,” said Mark Bradshaw, assistant professor ofaccounting at Harvard University. “Everybody has their own recipe. That’sthe problem.”
Do the Math
Some companies, for example, exclude research and development costs, whileothers leave out stock compensation or writedowns for investments that havedeclined in value.
“You get into this confusing game of trying to figure out who’s included or who’s excluded, and moreover, are they consistently including and excluding the same things each quarter,” Bradshaw told the E-Commerce Times.
According to Stanford’s Nelson, to understand a company’s earnings report, it is necessary to read the fine print.
“It is coming to the point where it is becoming very confusing for investors to read and understand these earnings,” she said.
True to Pro Forma
None of this, market watchers say, means that the pro forma practice should be scrapped.
“This is a recent phenomenon,” said Bradshaw. “It’s hard to assesswhether the market is being fooled, or focusing on core earnings. We don’tknow whether the expenses and charges being excluded from pro forma earningsrepresent charges that will never result in future dividends, or whetherthey are a transfer of future earnings to current results.”
The pro-forma controversy will likely take several more years to sort itself out, Bradshaw said. If the market is reasonably efficient and investors know that companies are reporting pro forma earnings, he said, it is possible that the information will be interpreted correctly and that stock prices will reflect companies’ true values.
Nelson said regulators should wait and see how the process works, though she believes companies should provide both sets of figures at the same time.
“The important thing is that the earnings release makes clear what the GAAP numbers are, as a benchmark investors need to evaluate performance,” she said.