Hazy reporting: CPAs can help companies do the right thing with pro forma information.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 As a matter of form or for the sake of form. Used to describe accounting, financial, and other statements or conclusions based upon assumed or anticipated facts. The phrase pro forma information is deceptive de·cep·tive adj. Deceptive or tending to deceive. de·cep  tive·ness n. .* BOTH CORPORATE CPAs AND EXTERNAL AUDITORS The examples and perspective in this article or section may not represent a worldwide view of the subject. Please [ improve this article] or discuss the issue on the talk page. 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 The National Investor Relations Institute, known as "NIRI", is the professional association for investor relations professionals in the United States. NIRI was founded in 1969 and has more than 4,500 members, both from the United States and other countries. developed guidelines for earnings press releases that stress the need for reconciliation between pro forma and GAAP GAAP See: Generally Accepted Accounting Principles GAAP See generally accepted accounting principles (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. One 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 shenanigans Noun, pl Informal 1. mischief or nonsense 2. trickery or deception [origin unknown] , investors first point their fingers at management. But hazy haz·y adj. haz·i·er, haz·i·est 1. Marked by the presence of haze; misty: hazy sunshine. 2. financial reporting can jeopardize jeop·ard·ize tr.v. jeop·ard·ized, jeop·ard·iz·ing, jeop·ard·izes To expose to loss or injury; imperil. See Synonyms at endanger. 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 mis·lead tr.v. mis·led , mis·lead·ing, mis·leads 1. To lead in the wrong direction. 2. To lead into error of thought or action, especially by intentionally deceiving. See Synonyms at deceive. . There currently are no substantive authoritative guidelines to help a CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. 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 according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. 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 operating revenue Revenue from any regular source. Revenue from sales is adjusted for discounts and returns when calculating operating revenue. Compare other revenue. of $1 million, operating expenses Operating expenses The amount paid for asset maintenance or the cost of doing business, excluding depreciation. Earnings are distributed after operating expenses are deducted. 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. Most corporate CPAs and their external auditors would select a since this answer is consistent with GAAP. Operations management Operations management is an area of business that is concerned with the production of goods and services, and involves the responsibility of ensuring that business operations are efficient and effective. most likely would choose b because this answer represents operating profit Operating profit (or loss) Revenue from a firm's regular activities less costs and expenses and before income deductions. operating profit See operating income. . Anyone who picks c is playing the pro forma earnings pro forma earnings Income not necessarily calculated in accordance with generally accepted accounting principles. For example, a company might report pro forma earnings that exclude depreciation expense and nonrecurring expenses such as restructuring costs. 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 de·fi·cient adj. 1. Lacking an essential quality or element. 2. Inadequate in amount or degree; insufficient. deficient a state of being in deficit. or they want to reclassify Verb 1. reclassify - classify anew, change the previous classification; "The zoologists had to reclassify the mollusks after they found new species" class, classify, sort out, assort, sort, separate - arrange or order by classes or categories; "How would you 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," page 49). For example, with respect to a change in accounting principles regarding inventory costing, switching from the first-in, first-out first-in, first-out n. A method of inventory accounting in which the oldest remaining items are assumed to have been the first sold. In a period of rising prices, this method yields a higher ending inventory, a lower cost of goods sold, a higher gross (Fifo) to the last-in, first-out last-in, first-out n. A method of inventory accounting in which the most recently acquired items are assumed to have been the first sold. In a period of rising prices, this method yields a lower ending inventory, a higher cost of goods sold, a lower (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 Stakeholders All parties that have an interest, financial or otherwise, in a firm-stockholders, creditors, bondholders, employees, customers, management, the community, and the government. . 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." "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 Simmons College may refer to:
n. 1. Forceful, often vindictive anger. See Synonyms at anger. 2. a. Punishment or vengeance as a manifestation of anger. b. Divine retribution for sin. adj. and the inevitable impact on stock price when their earnings' targets aren't met. (See "SEC Sounds Warning" page 50). 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. 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 fiber optics, transmission of digitized messages or information by light pulses along hair-thin glass fibers. Each fiber is surrounded by a cladding having a high index of refractance so that the light is internally reflected and travels the length of the fiber communications company Communications Company is a communications unit of the United States Marine Corps. They are part of Combat Logistics Regiment 37 , 3rd Marine Logistics Group (3MLG) and III Marine Expeditionary Force (III MEF). The unit is based out of the Marine Corps Base Camp Smedley D. 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 Payroll Tax Tax an employer withholds and/or pays on behalf of their employees based on the wage or salary of the employee. In most countries, including the U.S., both state and federal authorities collect some form of payroll tax. 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. 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 FEI Fédération Équestre Internationale. ) in Morristown, New Jersey Morristown is a town in Morris County, New Jersey, United States. As of the United States 2000 Census, the town population was 18,544. Its estimated population in 2004 was 18,842. It is the county seat of Morris CountyGR6. , and the National Investor Relations Institute (NIRI NIRI National Investor Relations Institute NIRI Nutrition Intervention Research Initiative (Mississippi) NIRI Near Infrared Imager NIRI National Institute on Recreation Inclusion NIRI New Ideas Research Institute ) in Vienna, Virginia Vienna is a town in Fairfax County, Virginia, United States. The population was 14,453 at the 2000 census and it has grown by about 3% since[1]. In July of 2005, CNN/Money and Money , 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 Earnings before interest, taxes, depreciation and amortization (EBITDA) is a non-GAAP metric that can be used to evaluate a company's profitability.
See: Funds from operations (funds from operations Funds From Operations (FFO) Used by real estate and other investment trusts to define the cash flow from trust operations; earnings with depreciation and amortization added back. ) 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. 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 Instead of; in place of; in substitution of. It does not mean in addition to. 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 in·fre·quent adj. 1. Not occurring regularly; occasional or rare: an infrequent guest. 2. 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 Plano (IPA: /ˈpleɪnoʊ/) is a wealthy suburb of Dallas, Texas, located to the north, mainly within Collin County, but also extending into Denton County. According to the 2000 U.S. . "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 FASB See: Financial Accounting Standards Board FASB See Financial Accounting Standards Board (FASB). project, see "FASB Takes a Look," below.) 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 Piano, 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.) 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 Lynn Turner may refer to:
EBS See electronic blue sheet (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. RELATED ARTICLE: 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 Investor relations The process by which the corporation communicates with its investors. (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. THOMAS J. PHILLIPS JR., CPA, PhD, is the director of the school of professional accountancy and KPMG KPMG Klynveld Peat Marwick Goerdeler (accounting firm) KPMG Kaiser Permanente Medical Group KPMG Keiner Prüft Mehr Genau (German) KPMG Kommen Prüfen Meckern Gehen Endowed en·dow tr.v. en·dowed, en·dow·ing, en·dows 1. To provide with property, income, or a source of income. 2. a. Professor at Louisiana Tech University Louisiana Tech University, at Ruston; coeducational; state supported; chartered 1894, opened 1895 as an industrial institute. It became Louisiana Polytechnic Institute in 1921 and attained university status in 1970. , Ruston. His e-mail address See Internet address. e-mail address - electronic 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 AICPA See American Institute of Certified Public Accountants (AICPA). . Official positions are determined through certain specific committee procedures, due process and deliberation deliberation n. the act of considering, discussing, and, hopefully, reaching a conclusion, such as a jury's discussions, voting and decision-making. DELIBERATION, contracts, crimes. . |
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