What is Pro Forma?
Pro forma, a Latin term that means “for the sake of form” or “as a matter of form”, refers to a method of calculating financial results using certain projections or presumptions.
- Pro forma, a Latin term that means “for the sake of form” or “as a matter of form”, refers to a method of calculating financial results using certain projections or presumptions.
- Pro forma financials may not be GAAP compliant but can be issued to the public to highlight certain items for potential investors, or they can be used internally by management for business decisions.
- The SEC has stated that it is illegal, and punishable by law, for publicly traded companies to mislead investors with pro forma financial results that do not use the most conservative possible estimates of revenue and expense.
Understanding Pro Forma
The presumptions about hypothetical conditions that occurred in the past and / or may occur in the future are used to project the most likely outcome for corporate results in reports known as pro forma financial statements. For example, a budget is a variation of a pro forma financial statement as it anticipates, based on certain assumptions, the inflow of projected revenues and the outflow of funds for a defined future period, usually a fiscal year.
Essentially, pro forma statements present expected corporate results to outsiders and are often used in investment proposals. 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 pro forma statements to assess the potential earnings value of a proposed business change, such as an acquisition or a merger.
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 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 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 cautioning that publicly traded companies report and make public U.S. GAAP-based financial results as well. 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.
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. The steps are:
- 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.
- 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.
- 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).
- 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.
As an example of a pro forma income statement, here is an image of Tesla, Inc.'s (NASDAQ: TSLA) unaudited pro forma condensed and consolidated income statement for the year ended December 31, 2016.