A:

Great question, but it is not easily answered, because pro forma earnings figures are inherently different for different companies. There are no universal guidelines that companies must follow when reporting pro forma earnings, which is why the distinction between pro forma and earnings reported using Generally Accepted Accounting Principles (GAAP) is very, very important.

GAAP enforces strict guidelines that companies must follow when reporting earnings, but pro forma figures are better thought of as "hypothetical", computed according to the estimated relevance of certain events/conditions experienced by the company. Basically, companies use their own discretion in calculating pro forma earnings, including or excluding items depending on what they feel accurately represents the company's true performance.

Items often left out of pro forma figures include the following: depreciation, goodwill, amortization, restructuring and merger costs, interest and taxes, stock-based employee pay, losses at affiliates and one-time expenses. The theory behind excluding non-cash items such as amortization is that these are not true expenses and therefore do not represent the company's actual earnings potential. Amortization, for example, is not an item that is paid for as a part of cash flow. But under GAAP, amortization is considered an expense because it represents the loss of value of an asset.

One-time cash expenses are often excluded from pro forma because they are not a regular part of operations and are therefore considered an irrelevant factor in the performance of a company's core activities. Under GAAP, however, a one-time expense is included in earnings calculations because, even though it is not a part of operations, a one-time expense is still a sum of money that exited the company and therefore decreased income.

The smart investor has to be very cognizant of a company's intentions when calculating or releasing pro forma earnings. Companies can use pro forma figures as a means of lessening the blow if actual GAAP earnings are below estimates. For this reason, investors must examine not only the pro forma earnings, but also the GAAP earnings. And never mistake pro forma for GAAP! Although a company reporting pro forma earnings is not doing anything fraudulent or dishonest (because it does report exactly what is and what is not included), it is very important for investors to know and evaluate what went into the company's pro forma calculation, as well as to compare the pro forma figure to the GAAP figure. Often, companies can have a positive pro forma earnings figure while having a negative GAAP earnings figure. When analyzing any company, it's up to the investor to decide which figure is a better indication of performance.

A final cautionary note for when you are analyzing pro forma figures: because companies' definitions of pro forma vary, you must be very careful when comparing pro forma figures between different companies. If you are not aware of how the companies define their pro forma figures, you may be inadvertently comparing apples to oranges.

(For more information on earnings and pro forma calculations, check out these articles: Types of EPS and The Tricks and Treats of Pro Forma Earnings.)

RELATED FAQS
  1. Can pro forma financial statements be more helpful to analysts and investors than ...

    Examine the controversy over GAAP reporting standards as compared to pro forma statements, and learn which are considered ... Read Answer >>
  2. Which pro forma financial statements should always be included in a business plan?

    Understand which pro forma financial statements should be included in a business plan and why a pro forma financial statement ... Read Answer >>
  3. What are the key differences between pro forma statements and GAAP statements?

    Learn the key differences between pro forma and GAAP statements. Review examples and cautionary notes about reliance on pro ... Read Answer >>
  4. What is earnings management?

    Before diving into what earnings management is, it is important to have a solid understanding of what we mean when we refer ... Read Answer >>
  5. What is the pro rata condition of average on an insurance claim?

    Find out what an insurance policy means when it has a clause stating pro rata condition of average for damage claims when ... Read Answer >>
  6. How do I import QuickBooks Pro Account trial balances for the first time?

    Import your data for the first time from Intuit's QuickBooks Pro to an Excel spreadsheet as easily as one, two, three with ... Read Answer >>
Related Articles
  1. Investing

    Pro Forma

    Pro Forma is a Latin term that means "for the sake of form." It's a term mostly used in accounting, for financial statements prepared by accountants. So why would anyone do anything for the sake ...
  2. Investing

    The 5 Types Of Earnings Per Share

    A look at the five varieties of EPS and what each represents can help an investor determine whether a company is a good value, or not.
  3. Investing

    Accretion / Dilution Analysis: A Merger Mystery

    This analysis tool is an effective way to value mergers and acquisitions. The deal's on the table, but should you sign the papers?
  4. Investing

    Applied Materials Stumbles on Weak Guidance (AMAT)

    On Friday, shareholders of one particular well-known tech company were anything but happy. The reason: Applied Materials (NASDAQ: AMAT) failed to hit analyst forecasts for its fiscal 2015 third ...
  5. Investing

    The 5 Types Of Earnings Per Share

    Understanding the many varieties of earnings per share will help investors make informed decisions.
  6. Investing

    Lender Processing Services Your Mortgage

    This business process outsourcing company is thriving on the mortgage meltdown and down economy.
  7. Insights

    Has Apple Cancelled the iPhone 7 Pro? (AAPL)

    Earlier this week, Apple announced it would launch new versions of its iPhones, Apple watch and MacBook Pro on September 7. Unfortunately, there's a rumor circulating that the company may drop ...
  8. Investing

    Core Earnings Strip Away "Creative" Accounting

    This metric is an attempt to counteract creative accounting, but it poses its own set of challenges.
  9. Insights

    Apple MacBook Pro Battery Life Under Scrutiny (AAPL)

    The company promised ten hours of battery life, but the laptop averages between three to six hours.
  10. Investing

    The Trouble With SAIC Earnings

    Shares of government contractor SAIC (NYSE: SAIC) took a 13% tumble on Tuesday after the company reported earnings that failed to please investors. The consensus analyst estimate pegged earnings ...
RELATED TERMS
  1. Pro Forma

    A Latin term meaning "for the sake of form". In the investing ...
  2. Pro-Forma Earnings

    Projected earnings based on a set of assumptions and often used ...
  3. Pro Bono

    Professional services dispensed on a voluntary basis at no cost ...
  4. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning ...
  5. Book Value Reduction

    Reducing the value at which an asset is carried on the books ...
  6. Non-GAAP Earnings

    An alternative earnings measure of the performance of a company. ...
Hot Definitions
  1. Efficient Frontier

    A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a ...
  2. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  3. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by smaller, younger companies seeking the ...
  4. Border Adjustment Tax

    A tax levied on goods based on where they are sold – exported goods are exempt from tax; those imported and sold in the ...
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  6. Blind Trust

    A trust in which the trustees have full discretion over the assets, and the trust beneficiaries have no knowledge of the ...
Trading Center