Proper pro forma reports: pro forma earnings reports may have their place but make sure your company uses them properly. By considering a few basic best practices, this shouldn't be difficult.
Recently, managers' reporting of pro forma earnings has come under close scrutiny for two reasons. First, there is a perception that managers are increasingly disclosing these alternative measures. Our recent study supports this perception--we found that 42% and 77% of large Canadian and U.S. firms, respectively, reported pro forma measures in their annual earnings press releases. Second, there has been considerable debate about managers' intentions when reporting pro forma measures. Do managers disclose pro forma earnings to inform or mislead investors? Managers generally claim that pro formas are used to provide information not otherwise provided through traditional GAAP earnings--that they are providing value relevant information. It has been argued elsewhere that managers have a strategic motive for reporting pro formas--to manage investors' perceptions of firm performance.
It's generally accepted that pro formas shouldn't be used to manage perceptions or to mislead. Further, there is a common belief (among managers and securities regulators) that pro formas, if used properly, can inform investors. However, guidance for managers of what constitutes best practice is disparate; that is, it's unclear how pro formas should be presented so that it informs rather than misleads. By focusing on three sources--regulation, industry guidelines, and an analysis of more than 1,000 earnings press releases--we attempt to synthesize and expand on best practice for reporting pro forma earnings.
Sources for best practices
The first source we examined in developing best practice is securities regulation. To address the concern that managers may be using pro forma earnings to manage expectations or to mislead investors, the leading securities commissions in Canada and the U.S. recently introduced pro forma regulations. The OSC in 2002 issued Staff Notice 52-303, entitled "Non-GAAP Earnings Measures" (1), while the SEC in 2003 issued "Conditions for Use of Non-GAAP Financial Measures" (2). These regulations don't prevent managers from reporting pro forma earnings; rather, they are aimed at ensuring adequate transparency in such reporting, and in reducing (or preferably eliminating) the possibility that investors will be misled by pro forma earnings.
As a second source for defining best practice, we examined financial industry guidelines. Financial Executives International (FEI) and the National Investor Relations Institute (NIRI), both important players in the financial markets, have recently issued guidance to help ensure the appropriate reporting of pro forma earnings. (1)
The final source used to develop best practice is the annual earnings press releases of large companies in Canada and the U.S. We analyzed the press releases of more than 1,000 Canadian and U.S. companies--those listed on the Canada S & P/TSX 300 and the U.S. S & P 500 for the years 2001 to 2003.
The following best practices for reporting pro forma earnings come from an analysis of these three sources. These best practices have a central purpose--to ensure that investors will not be potentially misled through pro forma reporting. Note that very few of the more than 1,000 earnings press releases examined followed all of these best practices. We believe that almost all the releases we examined could have been improved by following these practices.
The overriding objective for reporting pro forma earnings should be to provide value-relevant information. For pro forma information to be value relevant, it must help predict the future earning power of the company. In contrast, providing pro forma information to manage expectations--for example, to help meet or exceed analysts' forecasts--is a strategic motive that could potentially mislead investors.
Let us discuss in turn each of the specific best practice recommendations. To illustrate, we will refer to Inco Limited's 2003 annual earnings press release, which reflects many of these best practices. (4)
1. Explain why investors should care about the pro forma--For investors to properly evaluate pro forma measures, they have to understand its purpose, so it's important that management provide investors with a rationale for the use of these measures (i.e. how this information is value relevant). Very few firms in our sample (both in Canada and the U.S.) provided an explanation for the inclusion of a pro forma measure. Inco Limited's 2003 release, however, did provide one. Their release describes why a pro forma measure (adjusted net earnings) is used and states that certain items were excluded because "the timing or extent of such items ... do not reflect or relate to our ongoing operating performance." They then provided a discussion of the nature of these excluded items.
2. Provide a reconciliation--To understand the nature of the pro forma measure, it's important that investors recognize exactly how it differs from GAAP earnings. Pro forma earnings should therefore always be accompanied by full reconciliation to GAAP earnings. This reconciliation should show all the adjustments that are made to GAAP-based earnings to arrive at the pro forma measure. It's also important that this reconciliation be presented in tabular form, as is done in Inco Limited's 2003 release. Note that most firms in our sample that used pro forma provided a full reconciliation to GAAP.
3. Prepare pro forma on a consistent basis--To allow for a meaningful comparison of results over time, it's important that management determine pro forma earnings on a basis consistent with prior periods, or explain any changes in the composition of the pro forma earnings measure. That is, for comparative purposes, the nature of adjustments should remain consistent across periods. For example, Inco Limited made similar adjustments (backing out one-time items) to calculate its pro forma measures in 2002 and 2003. In our sample, there is evidence that many firms didn't measure pro forma earnings consistently from year to year, nor did they adequately disclose how the determination of the pro forma measure had changed.
4. Do not use GAAP terminology--Pro forma earnings shouldn't be described using traditional GAAP terminology, as investors may mistakenly believe the measure is GAAP earnings. Such terms as net income and earnings per share (EPS) shouldn't be used to refer to pro formas. While our research found a large number of cases in which companies used GAAP terminology to refer to pro forma earnings, the number declined from 2001 to 2003. (Note that, consistent with this best practice guidance, Inco Limited's 2003 release did not use GAAP terminology in describing its pro forma measure.)
5. Place greater, or at least equal, emphasis on GAAP earnings--GAAP earnings are determined based on a set of accepted accounting rules and are subject to the annual audit process. The principle purpose of earnings releases has historically been, and continues to be, the release of this information. Therefore it's important that GAAP earnings receive at least equal prominence by management when discussing the firm's performance for the period. We suggest that this prominence exist both in the headline of the press release, as well as in the accompanying narrative. Note that contrary to this best practice recommendation, Inco Limited's 2003 release provides greater prominence to its pro forma measure, both by placing it prior to GAAP earnings, and discussing it in greater depth.
To ensure that financial markets operate in an efficient manner, investors must be provided with useful (i.e. value-relevant) information. Managers have argued that pro forma earnings measures provide such value relevant information to investors, allowing them to better evaluate firm performance. However, these pro forma earnings measures also have the potential to mislead investors. This concern has been expressed by securities regulators, and is consistent with our analysis of past and current practice. Managers must ensure that their pro forma measures will not potentially mislead--otherwise, their use may be prohibited through future regulation. The guidelines presented in this article can assist managers in ensuring that the presentation of pro forma measures in their earnings releases are not potentially misleading.
The authors would like to acknowledge the diligent research assistance provided by Jacqueline Woods. Funding for the full study was provided by Deloitte & Touche, the Canadian Academic Accounting Association, and the Social Sciences and Humanities Research Council.
1 Available online at: www.osc.gov.on.ca/en/Regulation/Rulemaking/Notices/csanotices/2002/csan_52-303_20020107_non-gaap-earn.htm.
2 Available online at: www.sec.gov/rules/final/33-8176.htm.
3 Available online at: www.niri.org/irresource_pubs/alerts/EA20020117.cfm.
4 Available online at: http://www.inco.com/investorinfo/news/default.asp?year=2004&posting_id=2276
RELATED ARTICLE: Pro forma reporting best practices
Pro formas should be used to provide value-relevant information--they should never be used to manage investor expectations or to potentially mislead investors
1. Explain why investors should care about the pro forma measure (i.e., why it's value relevant)
2. Provide a reconciliation of pro forma earnings to GAAP earnings
3. Prepare pro forma earnings on a consistent basis, or clearly state any change in method
4. Don't use GAAP terminology to describe a pro forma measure
5. Place greater, or at least equal, emphasis on GAAP earnings as you do on pro forma
By Gary Entwistle, CA, Glenn Feltham, CMA, and Chima Mbagwu
Glenn Feltham, CMA, (firstname.lastname@example.org) is professor, Dean, and CA Manitoba Chair in Business Leadership at the I.H. Asper School of Business, Universtiy of Manitoba. Gary Entwistle, CA, is an associate professor and Meyers Norris Penny Scholar in the department of accounting at College of Commerce, University of Saskatchewan. Chima Mbagwu is in the department of accounting, College of Commerce, University of Saskatchewan.
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|Date:||Jun 1, 2004|
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