10/18/2017 Pro Forma Financial Statements

ProFormaFinancialStatements
investopedia.com /walkthrough/corporatefinance/4/capitalinvestmentdecisions/proforma.aspx
3/28/2012

Manycompaniesissueproformafinancialstatementsinadditiontogenerallyacceptedaccountingprinciples
(GAAP)adjustedstatementsasawaytoprovideinvestorswithabetterunderstandingofoperatingresults.In
legitimatecases,proformafinancialstatementstakeoutonetimechargestosmoothearnings.However,
companiescanalsomanipulatetheirfinancialresultsundertheguiseofproformafinancialstatementstoprovidea
picturethatisrosierthanreality.Let'stakeacloserlookatwhatproformafinancialstatementsare,whentheyare
usefulandhowcompaniescanusethemtodupeinvestors.

WhatAreProFormaEarnings?
Proformaearningsdescribeafinancialstatementthathashypotheticalamounts,orestimates,builtintothedatato
givea"picture"ofacompany'sprofitsifcertainnonrecurringitemswereexcluded.Proformaearningsarenot
computedusingstandardGAAPandusuallyleaveoutonetimeexpensesthatarenotpartofnormalcompany
operations,suchasrestructuringcostsfollowingamerger.Suchanexpensecanberightfullyviewedasaonetime
itemthatdoesnotcontributetothecompany'srepresentativevaluation.

Essentially,aproformafinancialstatementcanexcludeanythingacompanybelievesobscurestheaccuracyofits
financialoutlook,anditcanbeausefulpieceofinformationtohelpassessacompany'sfutureprospects.Every
investorshouldstressGAAPnetincome,whichisthe"official"profitabilitydeterminedbyaccountants,butalookat
proformaearningscanalsobeaninformativeexercise.

Proformaearningsfiguresareinherentlydifferentfordifferentcompanies.Therearenouniversalguidelinesthat
companiesmustfollowwhenreportingproformaearnings,whichiswhythedistinctionbetweenproformaand
earningsreportedusingGAAPisvery,veryimportant.

GAAPenforcesstrictguidelinesthatcompaniesmustfollowwhenreportingearnings,butproformafiguresare
betterthoughtofas"hypothetical,"computedaccordingtotheestimatedrelevanceofcertaineventsandconditions
experiencedbythecompany.Basically,companiesusetheirowndiscretionincalculatingproformaearnings,
includingorexcludingitemsdependingonwhattheyfeelaccuratelyrepresentsthecompany'strueperformance.

Forexample,netincomedoesnottellthewholestorywhenacompanyhasonetimechargesthatareirrelevantto
futureprofitability.Somecompaniesthereforestripoutcertaincoststhatgetintheway.Thiskindofearnings
informationcanbeveryusefultoinvestorswhowantanaccurateviewofacompany'snormalearningsoutlook,but
byomittingitemsthatreducereportedearnings,thisprocesscanmakeacompanyappearprofitableevenwhenitis
losingmoney.Weliketocallproformathe"everythingbutthebadstuffearnings."

Theproblem,however,isthatthereisn'tnearlyasmuchregulationofproformaearningsasthereisoffinancial
statementsfallingunderGAAPrules,sosometimescompaniesbendorevenabusetherulestomakeearnings
appearbetterthantheyreallyare.Becausetradersandbrokersfocussocloselyonwhetherthecompanybeatsor
meetsanalystexpectations,theheadlinesthatfollowacompany'searningsannouncementscanmeaneverything.
And,ifacompanymissednonproformaexpectationsbutstatedthatitbeattheproformaexpectations,itsstock
pricewillnotsufferasbadlyitmightevengoupatleastintheshortterm.

ProblemswithProForma
Despitethepositivereasoningbehindproformastatements,therearemanywaysinwhichproformaearningscan
bemanipulated.Itemsoftenleftoutofproformafiguresincludethefollowing:depreciation,goodwill,amortization,
restructuringandmergercosts,interestandtaxes,stockbasedemployeepay,lossesataffiliatesandonetime
expenses.Thetheorybehindexcludingnoncashitemssuchasamortizationisthatthesearenottrueexpenses
andthereforedonotrepresentthecompany'sactualearningspotential.Amortization,forexample,isnotanitem
thatispaidforasapartofcashflow.ButunderGAAP,amortizationisconsideredanexpensebecauseitrepresents
thelossofvalueofanasset.(SeeWhatisthedifferencebetweenamortizationanddepreciation?tolearnmore.)
10/18/2017 Pro Forma Financial Statements

Onetimecashexpensesareoftenexcludedfromproformabecausetheyarenotaregularpartofoperationsand
arethereforeconsideredanirrelevantfactorintheperformanceofacompany'scoreactivities.UnderGAAP,
however,aonetimeexpenseisincludedinearningscalculationsbecause,eventhoughitisnotapartof
operations,aonetimeexpenseisstillasumofmoneythatexitedthecompanyandthereforedecreasedincome.

Sometimescompanieseventakeunsoldinventoryofftheirbalancesheetswhenreportingproformaearnings.Ask
yourselfthis:doesproducingthatinventorycostmoney?Ofcourseitdoes,sowhyshouldthecompanysimplybe
abletowriteitoff?Itisbadmanagementtoproducegoodsthatcan'tbesold,andacompany'spoordecisions
shouldn'tbeerasedfromthefinancialstatements.TheSecuritiesandExchangeCommission(SEC)willinvestigate
companiessuspectedoftryingtodeceiveinvestorsintheproformamodificationofearnings.(Readmoreabout
howcompaniesareregulatedinCompliance:ThePriceCompaniesPay.)

Thisisn'ttosaycompaniesarealwaysdishonestwithproformaearningsproformadoesn'tmeanthenumbersare
automaticallybeingmanipulated.Butbybeingskepticalwhenreadingproformaearnings,youmayendupsaving
yourselfbigmoney.Toevaluatethelegitimacyofproformaearnings,besuretolookatwhattheexcludedcostsare
anddecidewhetherthesecostsshouldbeconsideringimpactful.Intangibleslikedepreciationandgoodwillareokay
towritedownoccasionally,butifthecompanyisdoingiteveryquarter,thereasonsfordoingsomightbelessthan
honorable.(Forfurtherreading,seeImpairmentCharges:TheGood,TheBadandTheUgly.)

Thedotcomeraofthelate1990ssawsomeoftheworstabusersofproformaearningsmanipulations.Many
Nasdaqlistedcompaniesutilizedproformaearningsmanagementtoreportmorerobustproformanumbers.Taken
cumulatively,thedifferencebetweenGAAPearningsandproformaearningsforthedotcomsectorduringitsheyday
exceededbillionsofdollars.

OneofthemorenotableoccurrencesofthisphenomenonisNetworkAssociates.Thecompanywentsofarasto
excludeitsdotcomdepartment'soperatingearnings.Thedotcomdepartmentwasn'tmakingorspendingpretend
money,sowhydidthecompanyexcludethesenumbers?Nodoubtthedepartmentwaslosingmoneyanddecided
tohidethosenumbersthatreflectedpoorcompanystrategyfrominvestors.(Learnaboutdotcomcompaniesthat
madeitin5SuccessfulCompaniesThatSurvivedTheDotcomBubble.)

BenefitsofProFormaAnalysis
Proformafiguresaresupposedtogiveinvestorsaclearerviewofcompanyoperations.Forsomecompanies,pro
formaearningsprovideamuchmoreaccurateviewoftheirfinancialperformanceandoutlookbecauseofthenature
oftheirbusinesses.Companiesincertainindustriestendtouseproformareportingmorethanothers,asthe
impetustoreportproformanumbersisusuallyaresultofindustrycharacteristics.Forexample,somecableand
telephonecompaniesalmostnevermakeanetoperatingprofitbecausetheyareconstantlywritingdownbig
depreciationcosts.

Incaseswhereproformaearningsdonotincludenoncashcharges,investorscanseewhattheactualcashprofit
is.Forexample,recallAOLTimeWarner'smassivegoodwillwriteoffofabout$54billionin2002toreflectthevalue
ofAOL'smergerwithTimeWarnerinthepreviousyear.Withaccountingchargesnearing$100billion,Time
Warner'sGAAPearningsfortheyearprobablywouldnothavebeenaverygoodpredictoroffutureprospects
thoseextraordinaryexpenseswouldprobablyneveroccuragain.Analysisofproformaearningsisanimportant
exercisetoundertakebeforeconsideringaninvestmentinacompanythatreportsproformanumbers,sobesureto
doso.

Also,whenacompanyundergoessubstantialrestructuringorcompletesamerger,significantonetimechargescan
occur.Thesetypesofexpensesdonotcomposepartofthebusiness'songoingcoststructureandthereforecan
unfairlyweighonshorttermprofitnumbers.Aninvestorconcernedwithvaluingthelongtermpotentialofthe
companywoulddowelltoanalyzeproformaearnings,whichexcludethesenonrecurringexpenses.

Proformafinancialstatementsarealsopreparedandusedbycorporatemanagersandinvestmentbankstoassess
theoperatingprospectsfortheirownbusinessesinthefutureandtoassistinthevaluationofpotentialtakeover
targets.Theyareusefultoolstohelpidentifyacompany'scorevaluedriversandanalyzechangingtrendswithin
companyoperations.
10/18/2017 Pro Forma Financial Statements

GAAPManipulation
Asidefrommisusingproformaincomestatements,companiescanalsomisleadinvestorsbycreativelyclassifying
theirincomeinseveralways,includingthefollowing:

OperatingincomeisnotstrictlydefinedundertheGAAPbecauseclassificationlinesareoftensubjectto
discretion.Itemsthatareclassifiedintothiselementcanbeselectivelychosenbymanagement.Forexample,
nonrecurringincomesuchasspecialcharges,shareholderclassactionsettlementsandunusualeventsmay
beincludedoromittedwithinthemetrictopresentavaluethatwillpleaseshareholders.

SalesandgrossprofitscanalsobemanipulatedinmanywayswithintheconstraintsoftheGAAP.For
example,companiescanclassifysalesaseitherthegrossamountbilledtoacustomerorexpectedamounts
tobereceived.Furthermore,salescanalsodependonwhetherornotshippingandhandlingistreatedasa
partofrevenues.Finally,grossmarginscanbemanipulatedbymovingcertainexpensesbetweenSG&Aand
othercostsofsales.

Intheend,thesechangescreateartificiallyhigherorlowerincomestatementmetricsthatcanmislead
shareholders.

TheBottomLine
Tosumup,proformaearningsareinformativewhenofficialearningsareblurredbylargeamountsofasset
depreciationandgoodwill.But,whenyouseeproforma,it'suptoyoutodigdeepertoseewhythecompanyis
treatingitsearningsassuch.Rememberthatwhenyoureadproformafigures,theyhavenotundergonethesame
levelofscrutinyasGAAPearningsandarenotsubjecttothesamelevelofregulation.

Althoughacompanyreportingproformaearningsisnotdoinganythingfraudulentordishonest(becauseitdoes
reportexactlywhatisandwhatisnotincluded),itisveryimportantforinvestorstoknowandevaluatewhatwent
intothecompany'sproformacalculation,aswellastocomparetheproformafiguretotheGAAPfigure.Often,
companiescanhaveapositiveproformaearningsfigurewhilehavinganegativeGAAPearningsfigure.

Afinalcautionarynoteforwhenyouareanalyzingproformafigures:becausecompanies'definitionsofproforma
vary,youmustbeverycarefulwhencomparingproformafiguresbetweendifferentcompanies.Ifyouarenotaware
ofhowthecompaniesdefinetheirproformafigures,youmaybeinadvertentlycomparingapplestooranges.

Doyourhomeworkandmaintainabalancedperspectivewhenreadingproformastatements.Trytoidentifythekey
differencesbetweenGAAPearningsandproformaearningsanddeterminewhetherthedifferencesarereasonable
oriftheyareonlytheretomakealosingcompanylookbetter.Youwanttobaseyourdecisionsonascleara
financialpictureaspossible.

OperatingCashFlowAndAlternativeDefinitionsOfOperatingCashFlow