US analysts grapple with the ogre of 'pro forma' reporting
By Andrew Hill and Adrian Michaels
Published: August 26 2001 23:23GMT | Last Updated: August 26 2001 23:26GMT
US companies have created a monster, and its name is "pro forma" reporting.
At the height of the bull market, in an attempt to clarify the underlying performance of their business, many growth companies began excluding one-off events from the figures they highlight to the press and Wall Street analysts.
But the habit of selectively presenting results prepared according to generally accepted accounting principles (GAAP) has become so widespread - and the choice of what to exclude from pro forma figures so arbitrary - that some critics believe the practice is distorting commonly accepted measures of share value, such as the price/earnings ratio.
Last month, Cliff Stearns, the Florida congressman who chairs the House of Representatives' sub-committee on commerce, trade and consumer protection, said he believed "some form of standardisation should be applied to pro forma reporting, so that an individual investor, such as myself, could make heads or tails out of them".
The confusion is even beginning to frustrate Wall Street's experts. As Abby Joseph Cohen, Goldman Sachs' equity strategist, put it in a report issued last week: "The bottom line is that there is no commonly accepted bottom line."
The Financial Accounting Standards Board (FASB) last week said it had asked for public comment on whether it should wade into the debate, and possibly order some reforms.
But the change will be slow. The FASB took five years to change merger accounting rules. Ed Jenkins, the board's chairman, said in an interview that he did not think any change on pro forma could come for two or three years.
In addition, the FASB's control is limited only to official earnings numbers filed with US regulators, such as quarterly 10Q statements that are sent to the Securities and Exchange Commission. "We don't have any control over press releases," Mr Jenkins said. "It's a little bit difficult for us to figure out what role we might play."
Mr Jenkins said he was concerned that items are only excluded from earnings when it is beneficial to the company. He wants companies to make it easier for investors to see the difference between GAAP numbers and pro forma numbers.
The difference between the two is often dramatic.
For instance, JDS Uniphase, the optical components group, reported a pro forma loss of $477m for its fourth quarter, but when goodwill and other charges were included that ballooned to $7.9bn.
JDS argued in its announcement that "down turns in telecommunications equipment and financial markets have created unique circumstances with regard to the [accounting] assessment of long-lived assets".
The existence of GAAP ought to allow consistent comparison of financial results. But many analysts work with the pro forma figures, because they believe they give a better picture of underlying growth. Analysts' "consensus" figures then feed into widely used statistics on overall earnings, collated by companies such as Thomson Financial/ First Call, and from there are used to calculate a historic p/e ratio for the whole market.
According to an analysis by the Wall Street Journal, based on the last four quarters of GAAP earnings, and excluding only strictly defined "extraordinary items", the Standard & Poor's 500 index stood at a historic p/e of 36.8 last week, its highest ever. According to First Call's consensus number, stock prices are at 22.2 times earnings. Even Standard & Poor's itself calculates the p/e at 24.2.
Chuck Hill, First Call director, said: "We believe that the best basis is what the majority of analysts want to do. There is no right answer on this. There is no moral and ethical standard."
He says First Call does intervene when it believes analysts are allowing companies to exclude items unjustifiably: "When the majority of analysts wanted to exclude the losses of dotcom subsidiaries, like Disney [the media company] and Staples [the office products group] and so forth, then we stepped in. Did the companies mean that down the road they would still be excluding them when there were earnings?"
This year, the picture is muddied still further by the sharp fall in many companies' earnings - which is encouraging some to portray their results in the rosiest terms possible - and new FASB rules on ending the amortisation of goodwill, which some analysts are not incorporating in their earnings calculations.
Phillip Gainey, Salomon Smith Barney's valuation analyst, says that ideally investors would test their assumptions against alternative methods of valuation such as economic value added, or discounted cash flow.
But those methods have their flaws and may require time and computing power beyond the means of the ordinary investor.
He believes the p/e ratio will remain the principal tool for everyday valuation, but he cautions that "this is a time where people should be very careful about not blindly using p/e or ratios based on earnings, because not everybody is using the same specific definition." Additional reporting by Andrew Balls
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