There's a clever way in which companies fudge and fiddle with their earnings figures and you should know about it. The Securities and Exchange Commission (SEC) will investigate companies suspected of trying to deceive investors in the pro-forma modification of earnings. Let's take a look at what pro-forma earnings are, when they are useful and how companies can use them to dupe investors.

What Are Pro-forma Earnings?
Pro-forma earnings describe a financial statement that has hypothetical amounts, or estimates, built into the data to give a "picture" of a company's profits if certain nonrecurring items were excluded. Pro-forma earnings are not computed using standard generally accepted accounting principles (GAAP) and usually leave out one-time expenses that are not part of normal company operations, such as restructuring costs following a merger. Essentially, a pro-forma financial statement can exclude anything a company believes obscures the accuracy of its financial outlook and can be a useful piece of information to help assess a company's future prospects. Every investor should stress GAAP net income, which is the "official" profitability determined by accountants, but a look at pro-forma earnings can also be an informative exercise.

For example, net income doesn't tell the whole story when a company has one-time charges that are irrelevant to future profitability. Some companies therefore strip out certain costs that get in the way. This kind of earnings information can be very useful to investors who want an accurate view of a company's normal earnings outlook, but by omitting items that reduce reported earnings, this process can make a company appear profitable even when it is losing money.

We should stress that pro-forma earnings are designed to give investors a clearer view of a company's operations and, by their nature, exclude unique expenses and charges. The problem, however, is that there isn't nearly as much regulation of pro-forma earnings as there is of financial statements falling under GAAP rules, so sometimes companies abuse the rules to make earnings appear better than they really are. Because traders and brokers focus so closely on whether or not a company beats or meets analyst expectations, the headlines that follow earnings announcements can mean everything. If a company missed non-pro-forma expectations, but stated that it beat the pro-forma expectations, its stock price will not suffer as badly and it might even go up - at least in the short term.

Problems with Pro Forma

Companies all too often release positive earnings reports that exclude things like stock-based compensation and acquisition-related expenses. Such companies, however, are expecting people to forget that these expenses are real and need to be included.

Sometimes companies even take unsold inventory off their balance sheets when reporting pro-forma earnings. Ask yourself this: does producing that inventory cost money? Of course it does, so why should the company simply be able to write it off? It's bad management to produce goods that can't be sold, and a company's poor decisions shouldn't be erased from the financial statements.

This isn't to say companies are always dishonest with pro-forma earnings - pro forma doesn't mean the numbers are automatically being manipulated. But by being skeptical when reading pro-forma earnings, you may end up saving yourself big money. To evaluate the legitimacy of pro-forma earnings, be sure to look at what the excluded costs are and decide whether or not these costs are real. Intangibles like depreciation and goodwill are okay to write down occasionally, but if the company is doing it every quarter, the reasons for doing so might be less than honorable. The dotcom era of the late 90s saw some of the worst abusers of pro-forma earnings manipulations. Many Nasdaq-listed companies utilized pro-forma earnings management to report more robust pro-forma numbers. Taken cumulatively, the difference between GAAP earnings and pro-forma earnings for the dotcom sector during its heyday exceeded billions of dollars.

Benefits of Pro-Forma Analysis
As mentioned earlier, pro-forma figures are supposed to give investors a clearer view of company operations. For some companies, pro-forma earnings provide a much more accurate view of their financial performance and outlook because of the nature of their businesses. Companies in certain industries tend to utilize pro-forma reporting more than others, as the impetus to report pro-forma numbers is usually a result of industry characteristics. For example, some cable and telephone companies almost never make a net operating profit because they are constantly writing down big depreciation costs.

Also, when a company undergoes substantial restructuring or completes a merger, significant one-time charges can occur as a result. 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. An investor concerned with valuing the long-term potential of the company would do well to analyze pro-forma earnings, which exclude these non-recurring expenses.

Pro-forma financial statements are also prepared and used by corporate managers and investment banks to assess the operating prospects for their own businesses in the future and to assist in the valuation of potential takeover targets. They are useful tools to help identify a company's core value drivers and analyze changing trends within company operations.

The Bottom Line
To sum up, pro-forma earnings are informative when official earnings are blurred by large amounts of asset depreciation and goodwill. But, when you see pro forma, it's up to you to dig deeper to see why the company is treating its earnings as such. Remember that when you read pro-forma figures, they have not undergone the same level of scrutiny as GAAP earnings and are not subject to the same level of regulation.

Do your homework and maintain a balanced perspective when reading pro-forma statements. Try to identify the key differences between GAAP earnings and pro-forma earnings, and determine whether the differences are reasonable or if they are only there to make a losing company look better. You want to base your decisions on as clear a financial picture as possible - regardless of whether it comes from pro-forma earnings or not.

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