Reynolds Center

Watch Out! Pro-Forma Financial Reports

Reporters need to be cautious when looking at a company’s pro-forma financial reports, which can camouflage bad news. (Image via Pixabay user Pexels)

Financial statements and documents are a primary tool for the business reporter. Public companies registered in the U.S. must report all manners of their operations and actions because securities regulations require disclosure for transparency for investors. Without honest reporting, a public market to raise capital could quickly become a feeding ground for grifters.

But rules will be bent and used if not broken. Companies have many ways of making indifferent or even bad results look better. Making use of pro-forma results is one.

The problem with pro-forma results

In financial filings and releases, public companies are required to provide results that conform to generally accepted accounting principles (GAAP). GAAP is a complex collection of accepted definitions and ways of handling transactions that allow investors, lenders, business partners and others to make reasonable comparisons among companies. There are rules covering when a company recognizes revenues and expenses, how to account for capital expenses and depreciation, and so on.

Although GAAP is a great tool, it’s a series of conventions that don’t necessarily convey a thorough picture. As an example, a company’s factory might have been destroyed in a natural catastrophe. The business undertakes a major financial loss, but it is outside of usual business. In such a case, the company might offer additional offer pro-forma results that employ measures other than GAAP. An alternative handling could show how the company would have done without the loss, a respectable and reasonable use of the technique.

However, an increasing number of companies have become addicted to pro-forma explanations because they want to appear more profitable than they are.

Deceptive data

The Wall Street Journal reported last year on the use of pro forma results among the S&P 500. Using data from financial data company FactSet, the Journal showed that the S&P 500 on the average had earnings per share that were 0.4 percent higher in 2015 than in 2014. Such a level of growth would have been the weakest since 2009.

However, things were actually worse. The earnings were based on pro-forma financial reports. If you looked at GAAP financials instead, earnings per share in 2015 were 12.7 percent lower than in 2014. Furthermore, the actual GAAP earnings per share were 25 percent lower than those shown under the pro-forma treatments. As the WSJ wrote, that was “the widest difference since 2008 when companies took a record amount of charges [to their financial results].” In other words, the S&P 500’s real earnings per share were only three-quarters of what the pro-forma statements showed.

Pro-forma treatments allow all manner of sleight-of-hand moves. Companies might exclude restructuring, stock-based compensation, amortization or depreciation.

Cherry-picking the details

As Gretchen Morgenson wrote in the New York Times in October 2015, that’s exactly what pharmaceutical company Valeant did. Some of the items pulled out of GAAP standards to create a pro-forma view of the company’s financials included the costs of acquiring other drug companies, which was part of Valeant’s basic business model. Management stripped out amortization, which effectively inflated the value of intangible assets, and depreciation, which indicates how much value hard assets lose over time.

I remember once fighting with the CEO of a big semiconductor company about their use of pro-forma statements every quarter. I insisted on reporting GAAP performance. He claimed the pro-forma measures were standard in that industry. My reply: If you do it every time it’s no longer pro-forma. It’s habitual misdirection.

Or there was Groupon which, when it went public, invented a financial metric it called “Adjusted Consolidated Segment Operating Income.” The number looked good because it ignored the company’s enormous marketing budget.

Don’t fall for similar tricks when looking at a company’s financial reports. Non-GAAP reporting may have a point, but be attentive to what is removed. Millions, if not billions, ride on definitions and make many executives less concerned with truth than image.