How Companies Use Pro-Forma Earnings

Pro-forma earnings are financial statements with hypothetical estimates that provide a “picture” of a company’s profits if certain nonrecurring items are excluded. They may allow companies to elaborate their earnings figures, and investors should be wary of the data. The Securities and Exchange Commission (SEC) investigates companies suspected of trying to deceive investors or misrepresent performance.

Key Takeaways

• Pro-forma earnings project a company’s profits based on hypothetical estimates.
• These statements do not adhere to Generally Accepted Accounting Principles (GAAP).
• Investors must evaluate pro-forma earnings along with a company’s true financial performance.

What Are Pro-Forma Earnings?

Pro-forma earnings are estimates on business financial statements that project a company’s profits, excluding nonrecurring gains or losses. Pro-forma earnings are not computed using standard Generally Accepted Accounting Principles (GAAP) and may leave out one-time expenses, such as restructuring costs following a merger.

A pro forma financial statement can exclude anything a company believes obscures the accuracy of its future outlook. GAAP net income is the “official” profitability determined by accountants, but pro-forma earnings can also be informative. For example, net income doesn’t reflect a company’s financial picture if a company has one-time charges irrelevant to future profitability. A company appears profitable even when losing money by omitting items that reduce earnings.

Company Reports

Companies may release earnings reports that exclude stock-based compensation and acquisition-related expenses. When reporting pro forma earnings, companies may remove unsold inventory from balance sheets. However, pro forma doesn’t mean the numbers are automatically manipulated. For some companies, pro-forma earnings provide a more accurate view of their financial performance because of the nature of their businesses.

Companies in certain industries utilize pro forma reporting more than others. For example, telecommunication companies rarely make a net operating profit because they write down depreciation costs. When a company undergoes restructuring or completes a merger, one-time charges can occur. These types of expenses do not compose part of the ongoing cost structure of the business and, therefore, can unfairly weigh on short-term profit numbers.

Pro forma statements are useful to corporate managers and investment banks to assess operations and assist in the valuation of takeover targets.

Important

Pro-forma financial statements may help managers identify a company’s core value drivers and analyze changing trends within company operations.

How Investors Evaluate Earnings

Pro-forma earnings give investors a view of a company’s operations. However, they are not regulated financial statements falling under GAAP rules. Because traders and brokers focus so closely on whether or not a company beats or meets analyst expectations, the headlines that follow earnings announcements are important.

If a company misses non-pro-forma expectations but states that it beats the pro-forma expectations, its stock price may react positively in the short term. To evaluate the legitimacy of pro-forma earnings, investors should look at what costs are excluded. Intangibles like depreciation and goodwill are acceptable to write down occasionally, but if the company repeats this every quarter, the reasons for doing so might be questionable.

What Is the Difference Between GAAP and Pro-Forma Earnings?

American companies report financial statements that adhere to Generally Accepted Accounting Principles (GAAP), a standard set of rules that make reporting consistent and comparable across publicly traded companies. Pro-forma earnings may exclude certain non-recurring items and do not follow GAAP standards. Pro-forma earnings may also include projections, whereas GAAP rules focus on historical performance over a quarter or fiscal year.

Why Do Companies Use Pro-Forma Earnings?

Pro-forma earnings may be used for strategic planning, forecast earnings, and guide decision-making in investment scenarios.

What Is the Difference Between EPS and Pro-Forma EPS?

While EPS is calculated by dividing net income by the company’s outstanding shares, pro-forma EPS relates to the projected EPS in a future merger and acquisition. Pro-forma EPS is calculated by adding together the net income of the target company and acquiring company plus incremental adjustments and dividing this by the new shares issued and acquirers’ shares outstanding.

The Bottom Line

Pro-forma earnings are informative but investors should discern why a company treats its earnings as such. Pro-forma figures do not face the same level of scrutiny as GAAP earnings and are not subject to the same level of regulation.