Hazy Reporting

CPAs can help companies do the right thing with pro forma information.
BY CYNTHIA WALLER VALLARIO, THOMAS J. JR. PHILLIPS AND MICHAEL S. LUEHLFING

 

EXECUTIVE SUMMARY
CONTRARY TO WHAT IS REQUIRED IN AUDITED financial statements, the only SEC regulation governing what companies put in their earnings releases is that the information should not be misleading. There are currently no substantive authoritative guidelines that determine when pro forma information is deceptive.

BOTH CORPORATE CPAs AND EXTERNAL AUDITORS should ask questions if they think a company is selectively editing its earnings reports, understand the problems with inappropriate pro forma reporting and ensure that financial managers release pro forma information in a balanced way, closer to GAAP-based financials.

AT THE SEC’s RECOMMENDATION, Financial Executives International and the National Investor Relations Institute developed guidelines for earnings press releases that stress the need for reconciliation between pro forma and GAAP results. Companies must provide adequate explanation for departures from GAAP.

AN SEC STAFF ADVISORY RECOMMENDS FINANCIAL managers present pro forma and other non-GAAP measures in an “other data” section of selected financial information.

BEFORE A COMPANY ISSUES AN EARNINGS RELEASE, corporate CPAs and external auditors should talk to each other to ensure GAAP-based reporting in subsequent financial statements is not unduly influenced by the release’s numbers and there are not huge discrepancies.

THOMAS J. PHILLIPS JR., CPA, PhD, is the director of the school of professional accountancy and KPMG Endowed Professor at Louisiana Tech University, Ruston. His e-mail address is phillips@cab.latech.edu . MICHAEL S. LUEHLFING, CPA, PhD, is an associate professor of accountancy at Louisiana Tech. His e-mail address is luehlfing@cab.latech.edu . CYNTHIA WALLER VALLARIO, JD, is a senior editor on the JofA. Ms. Vallario is an employee of the American Institute of CPAs. Her views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

ne look at the business pages proves that pro forma financial reporting is on the rise. But there’s a right way and a wrong way to use pro forma numbers. When a company uses such information correctly, it helps investors understand its financial performance. Or it can use pro forma results incorrectly—for example, to hide earnings losses from shareholders and analysts. Such actions obscure the truth and ultimately have the potential to undermine the integrity of the financial markets.

When companies engage in financial shenanigans, investors first point their fingers at management. But hazy financial reporting can jeopardize the credibility of the accounting profession because the public also may associate ambiguous and inaccurate financial information with corporate CPAs and external auditors. Thus corporate CPAs who provide the numbers for earnings press releases, as well as auditors who may review earnings reports with their clients before publication, must ensure that companies disclose transparent, high-quality financial information. In light of recent financial reporting scandals, it’s clear CPAs should step up to the plate to make sure companies don’t report earnings from a biased, inflated perspective.

Contrary to what it requires for audited financial statements, the SEC advises companies only that the information in their earnings releases should not mislead. There currently are no substantive authoritative guidelines to help a CPA determine when pro forma information is deceptive. Both corporate CPAs and external auditors should ask questions if they think a company is selectively editing its earnings reports, understand the problems with inappropriate pro forma reporting and ensure that financial managers release pro forma information in a balanced way, closer to GAAP-based financials (according to interim guidelines issued by FEI/NIRI and SEC staff recommendations).

ANYTHING GOES?
The term pro forma refers to “as if” adjustments to financial information. Financial managers initially employed the term to disclose major, nonrecurring events. The following example illustrates how pro forma numbers can result in misleading investors and other statement users instead. Assume Champ Co. has operating revenues of $1 million, operating expenses of $600,000, a nonrecurring, nonoperating gain of $300,000, and a nonrecurring, nonoperating loss of $800,000. What number does Champ Co. report in its earnings press release?

a. $100,000 loss.
b. $400,000 profit.
c. $700,000 profit.
d. None of the above.

How Companies Report Pro Forma Numbers
A survey of 233 companies’ use of pro forma reporting since Financial Executives International and the National Institute of Investor Relations (FEI/NIRI) released their Earnings Press Release Guidelines in 2001 showed 57% used pro forma information in their quarterly earnings reports but also presented GAAP results. The remaining 43% reported and emphasized only GAAP results.

Source: Survey by National Investors Relations Institute, www.niri.org , January 2002.

Most corporate CPAs and their external auditors would select a since this answer is consistent with GAAP. Operations management most likely would choose b because this answer represents operating profit. Anyone who picks c is playing the pro forma earnings game by excluding the nonrecurring, nonoperating loss from the information reported in the company’s earnings press release (while at the same time including the nonrecurring, nonoperating gain). Still others might choose d because either they think GAAP is deficient or they want to reclassify some of the $600,000 in operating expenses as nonrecurring, nonoperating losses, making pro forma earnings greater than $700,000. Such choices illustrate why some pro forma earnings releases leave investors, analysts and regulators with “hide and seek numbers.”

WALL STREET EXPECTATIONS
Companies may have good reasons to use pro forma reporting (see “When Pro Forma Reporting Works,” right). For example, with respect to a change in accounting principles regarding inventory costing, switching from the first-in, first-out (Fifo) to the last-in, first-out (Lifo) method requires financial managers to report pro forma numbers that disclose how earnings would appear if the company had used Lifo costing for several years. Company managers also may use pro forma numbers to compare two accounting periods by disclosing nonrecurring transactions and events, such as an acquisition, so as not to mislead investors and other stakeholders.

“Initially, CPAs employed pro forma information in financial statements prepared according to GAAP to increase the transparency of unusual information for financial statement users,” says Susan W. Hass, CPA and professor of accounting at Simmons College Graduate School of Management in Boston. Problems with earnings releases developed when shareholders put more pressure on companies to report positive operating results. It’s no secret companies have been tempted to “manage earnings” through pro forma reporting to avoid investors’ wrath and the inevitable impact on stock price when their earnings’ targets aren’t met. (See “SEC Sounds Warning,” below).

Because companies sometimes muddy the waters by the way they disclose financial information, Hass urges investors to thoroughly investigate pro forma amounts included in earnings releases before they make investment decisions. Her concerns about misleading numbers are illustrated in the following actual cases: A fiber optics communications company reported pro forma amounts, including a large gain on the sale of a subsidiary, but excluded an even larger expense for the amortization of purchased intangibles and other items, such as research and development charges. The company should have done the reverse since the gain on the subsidiary’s sale was irrelevant to future trends, but ongoing research and development will have a direct impact on future performance. In another illustration of questionable reporting, a large technology company presented its 2001 pro forma net income as $3.09 billion, but it actually had a net loss of $1.01 billion. Pro forma net income excluded acquisition charges, restructuring costs, payroll taxes on exercised stock options and gains on minority investments, all of which were included in GAAP-based amounts. The company should have opted for a balanced presentation by explaining some of the excluded pro forma charges and reporting the loss rather than selecting information with a positive bias and removing the negative numbers.

When Pro Forma Reporting Works
Here’s how one company uses pro forma reporting to benefit investors.

John Eckart, CPA and controller at Murphy Oil, a Fortune 500 energy company which is headquartered in El Dorado, Arkansas, says his company uses pro forma information in its earnings releases to address unusual transactions. In its press releases for quarterly and year-to-date earnings, Murphy Oil comments on both GAAP and pro forma earnings, using a table to show normalized earnings for each of the company’s operating segments. The company then reconciles its earnings to GAAP net income.

The differences between normalized earnings and net income are unusual or “special” items that tend to skew the results between periods and thus must clearly be disclosed to the reader. For example, in the first half of 2001, Murphy Oil sold its midstream assets in Canada for a healthy gain. “We felt obligated to highlight this special gain separately for users so they could understand why this relatively minor company operation generated such a large profit. Items we generally isolate and report, when significant, below normalized earnings include income tax settlements, gains or losses on asset disposals, asset impairments, legal and environmental settlements and any material ‘one-time’ transaction that is not repeatable or indicative of regular operating results,” says Eckart. The company adopted this presentation in its earnings releases because it gives the user a clearer indication of the company’s financial results.

The company decides what to report separately from normal operations based on what the statement reader needs to know and understand about trends specifically affecting the business, such as unusual income or expense. “We believe failing to disclose these unusual transactions would make it more difficult for readers to get a true picture of the company’s performance,” says Eckart. “We want to have a good reputation with the public for fairly reporting Murphy’s results, and if we no longer disclose the unusual transactions included in our quarterly results, we could damage our reputation.”

WHAT TO DO NOW?
Regulators soon may issue stricter guidelines concerning earnings press releases, but for now companies can go to two sources for help in avoiding confusing or misleading reporting. At the SEC’s suggestion, Financial Executives International (FEI) in Morristown, New Jersey, and the National Investor Relations Institute (NIRI) in Vienna, Virginia, addressed how financial executives can better disclose information in earnings press releases to improve consistency of presentation and provide analysis (for more information, see Earnings Press Release Guidelines, www.fei.org ). These organizations said GAAP information provided a “critical framework” for pro forma results; but if a release furnished adequate explanation for departures from GAAP, the reader would more easily follow what was being said (or not said) and why.

The FEI/NIRI press release guidelines stress that companies should reconcile pro forma and GAAP results and advise preparers to present, in their quarterly reports, a discussion and analysis of both positive and negative factors affecting other non-GAAP measures such as Ebitda (earnings before interest, taxes, depreciation and amortization) or FFO (funds from operations) or some other variation. Although pro forma and other non-GAAP measures may be useful in some circumstances, investors who rely on such information will be confused if a company reports inconsistent numbers.

SEC Sounds Warning
In December the SEC issued an “investor alert” as a reminder that pro forma financial information departs from traditional GAAP-based accounting and thus may not portray an accurate picture of a company’s financial well-being. The commission recommends that when investors review pro forma financial information they ask themselves these questions:

What assumptions are the company’s numbers based on?

What is the company not saying?

How do the pro forma results differ from GAAP-based financials?

Is the company providing pro forma results or a summary of GAAP-based information?

Source: Pro Forma Financial Information: Tips for Investors, www.sec.gov/investor/pubs/proforma12-4.htm , 2001.

Corporate CPAs also can benefit from SEC staff recommendations in the 2001 publication, Division of Corporation Finance: Frequently Requested Accounting and Financial Reporting Interpretations and Guidance (for more information, see www.sec.gov/divisions/corpfin/guidance/cfactfaq.htm ). The SEC staff advises companies to present pro forma and other non-GAAP numbers in an “other data” section of selected financial information. When investors see this information reported separately in a special section rather than mingled with GAAP numbers, they are less likely to emphasize pro forma numbers in lieu of GAAP financials. Additionally, due to considerable variation in underlying definitions or calculations of pro forma or other non-GAAP measures, clear explanations must be provided. That way users can determine whether one company’s measure differs from another’s even though the two use similar labels.

The SEC suggestions make clear that, in their earnings releases, companies should

Avoid reporting any non-GAAP measure in a manner that gives it greater prominence than a conventional measure, thus downplaying or hiding GAAP information.

Provide explanatory footnotes or other references whenever they use a non-GAAP measure (this information could be patterned after financial statement footnotes prepared in accordance with GAAP).

Anticipate how investors might use non-GAAP measures and, to avoid undue reliance on them, identify other significant factors and trends they should consider.

Balance non-GAAP measures of cash (or funds) generated by operations with equally prominent disclosures from the statement of cash flows.

Present non-GAAP measures in an appropriate context—for example, liquidity measures should be presented with other balance sheet measures and their expected use clearly noted so they would not be misconstrued as earnings measures.

Avoid adjustments to alternative, non-GAAP measures that eliminate items noted as nonrecurring, infrequent or unusual.

Because of the limited explanations accompanying most earnings releases, investors (and analysts) may find it difficult or impossible to compare pro forma amounts directly with the GAAP-based figures reported subsequently in the financial statements. Corporate CPAs and other financial managers can remedy this by providing a reconciliation of pro forma amounts to GAAP-based amounts as recommended by both the SEC and the FEI/NIRI guidelines.

“Pro forma numbers are appropriate in an earnings release as long as the numbers are GAAP-based or can be tied easily to GAAP-based amounts,” says Nancy G. Reed, CPA and financial reporting manager at J.C. Penney Co. in Plano, Texas. “But adequate explanation is necessary when companies report any pro forma numbers because the presentation of non-GAAP amounts can weaken a company’s credibility with investors. I think it’s much safer to use GAAP measures, or measures consistent with GAAP,” says Reed. (For information about a related FASB project, see “FASB Takes a Look,” below.)

COMMUNICATE SOONER RATHER THAN LATER
Problems sometimes arise when financial managers, and ultimately investors, view pro forma numbers as “benchmarks” for GAAP-based earnings. If the company wants to meet the pro forma numbers, then financial managers may make last minute “adjustments” to the GAAP-based amounts they will report in their financial statements so they correspond to the pro forma data previously released. Corporate CPAs and external auditors should talk to each other before a company issues its earnings release to ensure that it does not unduly influence what’s reported in the financial statement or that the numbers do not contain huge discrepancies. This dialogue can help financial managers avoid either “surprising” their auditors or being surprised by the audit firm’s stance on reporting issues. Because external auditors have an intimate understanding of the client’s operations, their timely involvement before the client reports earnings to the press can help resolve differences without compromising the integrity of the financial reporting process.

Companies should use pro forma reporting to complement GAAP-based reporting and avoid what Lynn Turner, former SEC chief accountant, refers to as EBS (everything but the bad stuff) reporting. Until the SEC or FASB provides additional guidance on using pro forma and other non-GAAP measures, as well as GAAP-compliant information, the SEC recommends using the FEI/NIRI guidelines and making sure pro forma performance measures closely resemble their GAAP counterparts. CPAs can help their employers and clients alleviate concerns over confusing and sometimes deceptive financial information by making sure pro forma disclosures are transparent and not based on hide and seek numbers.

FASB Takes a Look
A project FASB initiated last fall addresses how to improve the quality of GAAP-based information displayed by companies in financial statements and whether these statements contain sufficient information to permit investors, creditors and other statement users to calculate key financial measures, such as “operating” free cash flow, return on invested capital and “adjusted,” “normalized” or “operating” earnings. This project progresses against the backdrop of some companies’ use of misleading and inconsistent numbers in an effort to portray their earnings and performance in the best possible light. Often these numbers have little resemblance to numbers derived from traditional, GAAP-based measures which statement users are accustomed to seeing.

As FASB examines whether certain GAAP-based measures themselves can be improved to better meet investors’ current needs, Ronald J. Bossio, CPA and a senior project manager at FASB, says the project is not designed to tell companies what they can report in press releases because the board does not have jurisdiction over such matters. He says the “what ifs” and “as ifs” of pro forma reporting are fine as long as companies clearly convey to the statement users the assumptions underlying the information.

But, from the standpoint of defining commonly used terms, he says, the FASB project has indirect implications for earnings releases. “For example, in many cases the term Ebitda (earnings before interest, taxes, depreciation and amortization) is easily understood,” says Bossio. “However, for a manufacturing company, does Ebitda mean that no depreciation is included in the production costs and, thus, cost of goods sold? If FASB issues guidance on these definitions, companies would have difficulty using them differently in a press release.” (For more information, see “Reporting Information about the Financial Performance of Business Enterprises: Focusing on the Form and Content of Financial Statements” at www.fasb.org .)

Nancy G. Reed, CPA and financial reporting manager at J.C. Penney Co. in Plano, Texas, agrees. “There is a real demand for standardization with respect to non-GAAP measures because it lessens the need for interpretation by financial statement users and minimizes unintentional miscommunication. FASB’s involvement can help meet this need.”

Standard & Poor’s, a credit ratings agency, supports FASB’s efforts to reduce investor frustration by demanding companies report their earnings clearly and consistently. In May S&P announced it was adopting new standards for calculating a company’s operating earnings, which will be hard for investors and analysts to ignore because those analysts—and others—use its data as the basis for computing widely watched stock market indices.

In 2001 S&P’s equity investment group attempted to find common definitions for various earnings measures and discovered companies and analysts did not agree on even the most popular one— operating earnings. S&P said it will include in its definition of operating earnings purchased research and development, restructuring costs, writedowns from ongoing operations and stock option expenses but not acquisition or merger-related expenses, pension plan investment gains, impairment of goodwill, litigation settlement and gains or losses on sales of assets. (More information is available at www.standardandpoors.com/PressRoom .)

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