What Is Pro Forma?
Pro forma is a Latin term that means “for the sake of form” or “as a matter of form.” In the world of accounting and investing, pro forma refers to a method by which firms calculate financial results using certain projections or presumptions, as pro forma financial statements.
A pro forma income statement is usually a financial statement that uses the pro forma calculation method, often designed to draw potential investors' focus to specific figures when a company issues an earnings announcement. Companies may also design these pro forma statements to assess the potential earnings value of a proposed business change, such as an acquisition or a merger.
- Pro forma financials can be issued to the public to highlight certain items for potential investors, or they can be used internally by management for business decisions.
- Pro forma financials ignore the effects of one-time or unusual items, and therefore, are not presented in compliance with generally accepted accounting principles (GAAP).
- Pro forma financial results should use the most conservative possible estimates of revenue and expense in order to not mislead investors.
- The SEC regulates publicly traded companies, and it has clarified that it is illegal and punishable by law to mislead investors with pro forma financials.
Understanding Pro Forma
Investors should be aware that a company’s pro forma financial statements may hold figures or calculations that are not in compliance with generally accepted accounting principles (GAAP). Sometimes, pro forma figures differ vastly from those generated within a GAAP framework, as pro forma results will make adjustments to GAAP numbers to highlight important aspects of the company's operating performance.
In financial accounting, pro forma refers to a report of the company's earnings that excludes unusual or nonrecurring transactions. Excluded expenses could include declining investment values, restructuring costs, and adjustments made on the company’s balance sheet that fix accounting errors from prior years.
In managerial accounting, accountants design financial statements prepared in the pro forma method ahead of a planned transaction such as an acquisition, merger, change in capital structure, or a new capital investment. These models forecast the expected result of the proposed transaction, with emphasis placed on estimated net revenues, cash flows, and taxes. Managers are then able to make business decisions based on the potential benefits and costs.
Pro Forma Example
Today, there are several places where you can find a boilerplate template for generating a pro forma financial statement, such as the income statement, including Excel spreadsheets that will automatically populate and calculate the correct entries based on your inputs. Still, you may want to know how to create a pro forma income statement by hand.
- Step 1: Calculate the estimated revenue projections for your business (this is called pro forma forecasting). Use realistic market assumptions and not just numbers that make you or your investors feel optimistic. Do your research and speak with experts and accountants to determine what a normal annual revenue stream is, as well as asset accumulation assumptions. Your estimates should be conservative.
- Step 2: Estimate your total liabilities and costs. Your liabilities include loans and lines of credit. Your costs will include items such as your lease expense, utilities, employee pay, insurance, licenses, permits, materials, taxes, etc. Put in a great deal of thought into each expense and keep your estimates realistic.
- Step 3: To create the first part of your pro forma, you’ll use the revenue projections from Step 1 and the total costs found in Step 2. This portion of the pro forma statement will project your future net income (NI).
- Step 4: Estimate the cash flows. This portion of the pro forma statement will identify the net effect on cash if the proposed business change is implemented. Cash flow differs from net income because, under accrual accounting, certain revenues and expenses are recognized prior to or after cash changes hands.
History of Pro Forma
Pro forma financials in the United States boomed in the late 1990s surrounding dot-com companies that used the method to make losses appear like profits or, at a minimum, to reveal much greater gains than indicated through U.S. GAAP accounting methods. The U.S. Securities and Exchange Commission (SEC) responded by firmly requiring that publicly traded companies in the country report and make public U.S. GAAP-based financial results. The SEC also clarified that it would deem using pro forma results to grossly misconstrue GAAP-based results and mislead investors fraudulent and punishable by law.