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.
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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.”
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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.
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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.
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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
.) |