Hypothetically, Pro Forma May Be a Mirage
By Fred Barbash
Sunday, April 29, 2001; Page H01
If you follow corporate earnings news releases, you know the term "pro forma" -- as in "The JDS Uniphase Corporation today reported pro forma net income of $160 million."
Pro forma came into heavy usage with the advent of "new economy" companies and has spread rapidly in the past few years. Always, without exception, the pro forma results of a company are better than the real results, which is why the companies have chosen pro forma accounting in the first place.
I looked up "pro forma" in the Random House Dictionary -- fat version. As an accounting term, it means "hypothetical."
So every time you see the word "pro forma" in an earnings announcement, substitute the word "hypothetical."
"The JDS Uniphase Corporation today reported [hypothetical] net income of $160 million."
"Qualcomm reported [hypothetical] earnings per share of $0.29 in the second quarter of fiscal 2001."
" 'We are on track to reach our objective of [hypothetical] operating profitability in the coming December quarter,' said Warren Jenson, Amazon.com's chief financial officer."
It has a different ring, doesn't it?
Pro forma results are not calculated using generally accepted accounting principles (GAAP), which is why companies put them only in news releases and not in reports to the Securities and Exchange Commission.
In fact, there are no hard and fast principles to pro forma accounting. A company can interpret things as it pleases. Generally, it excludes certain items that detract from the appearance of profitability.
It may be payroll tax costs, or losses from investments, or stock-based compensation costs, restructuring costs and sometimes even marketing costs.
Whatever gets excluded, it's amazing how this compassionate counting seems to make the company look more successful.
Lynn Turner, the SEC's chief accountant, has an acronym for news releases deploying pro forma results. He calls them "EBS releases." He says that means "Everything but Bad Stuff." (Personally, I'd go with "Earnings BS.")
Turner has been concerned about the use of pro forma numbers for several years. A few months ago he invited into his office representatives of Financial Executives International (a group of chief financial officers, treasurers and controllers) and the National Investor Relations Institute, the professional organization for investor relations officers.
"I said, 'Here's our concern. Can we get some help from you guys?"
In response, the two organizations last week jointly issued "best practice" guidelines. They suggested, among other things, that "pro forma" results in announcements always be reconciled with the "GAAP framework."
In practice, this means that companies announcing profits using pro forma numbers should also state the profits, or lack of them, using real numbers, and explain the difference.
Many companies do that now.
About 1,000 words after reporting its pro forma net income of $160 million, for example, JDS Uniphase's latest release on quarterly earnings notes that by "generally accepted accounting principles," the company actually lost $1.3 billion.
It's not that the companies that announce pro forma numbers are lying. Charitably speaking, they're just excluding costly items they think are irrelevant to measuring the real performance of the company.
Less charitably speaking, they're trying desperately to make losing look like winning. You can try it in your own home.
"For immediate release: Fred Barbash & Family today announced record pro forma net income for the first quarter of 2001. Excluding one-time-only kindergarten tuition payments, one-time-only renovation to house, one-time-only weather-related charges for heating, air conditioning and food, excluding also losses in value of marketable securities, certain increases in property taxation due to reassessment of home, decline in worth of 401(k) plans, the Barbashes had the best quarter ever, pro forma."
The new guidelines from Financial Executives International and the National Investor Relations Institute in no way criticize the use of pro forma results. Indeed, they describe them as a useful tool that can "clarify" a company's performance and "may be more analytically useful" than GAAP results.
But they say, "pro forma results should always be accompanied by clearly described reconciliation to GAAP results."
There is a debate about the usefulness of pro forma numbers.
Eugene S. Weil, managing director of Milestone Merchant Partners, a Washington merchant bank specializing in financial services, thinks pro forma results are useful, particularly when analyzing the impact of mergers and acquisitions.
"When two companies are coming together, pro forma results can tell you what the core business looks like, what's going to drive value in the future," he said
And conventional accounting glossaries describe pro forma accounting as a way to make estimates, particularly in the context of mergers, not as a way to report facts. Pro forma accounting, according to one of these financial dictionaries, is the "presentation of financial information that gives effect to an assumed event (e.g., MERGER)."
Weil thinks pro forma results have "less of a place" in other contexts.
The SEC's Turner, on the other hand, has little tolerance for pro forma results in any context.
"It got started with new economy companies and reached the point where everybody was doing it," he said. "What concerned me was the spin and hype on numbers that weren't telling people the entire story. . . . Some of the analysts got caught up in that hype. If you could take these things out of the bottom line and say they didn't matter, it made the offering more attractive.
"People will start excluding items such as interest or inventory," Turner said. "But as a businessman, I know I pay cash for interest. I pay cash for inventory. Yet in pro forma numbers, they were trying to say those aren't real costs.
"The arguments I've heard from companies [in support of pro forma numbers] are that they don't think the excluded items are important to their business," Turner continued. "Well, some of the people who said they weren't important to their business -- the dot-coms -- they aren't there today. Cash did turn out to be king."
The SEC has no control over corporate news releases, except in cases of outright lies or fraud. So the new guidelines will have to do.
The guidelines could be better, however. Whenever hypothetical numbers appear at the top of a news release, the real numbers should accompany them at the top as well. The first few lines tend to lead the news stories rushed to the public by wire services, which then appear on Internet-based ticker symbol news trackers.
Even then, the term "pro forma" should be a red flag. Remember: It means hypothetical. And hypothetical earnings produce only hypothetical rewards for investors.
Fred Barbash can be contacted at barbashf@washpost.com |
