What constitutes pro forma earnings is not easily answered because the numbers are inherently different depending on the company. There are no universal rules that companies must follow when reporting pro forma earnings. This is why it is important for investors to distinguish between pro forma earnings and earnings reported using generally accepted accounting principles (GAAP).

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

Items often left out of pro forma figures include 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 is that these are not true expenses reflective of 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.

Apples and Oranges

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

A smart investor needs to be cognizant of a company's intentions when it releases 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 GAAP earnings, and never mistake one for the other.

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 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 report a positive pro forma figure while also reporting negative GAAP earnings. It's up to the investor to decide which figure better indicates the company's performance.

A final cautionary note: because companies' definitions of pro forma vary, you must be 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. (See also: Types of EPS and Understanding Pro Forma Earnings.)