Academic journal article Accounting Horizons

Empirical Evidence on Recent Trends in Pro Forma Reporting

Academic journal article Accounting Horizons

Empirical Evidence on Recent Trends in Pro Forma Reporting

Article excerpt

SYNOPSIS: This study provides descriptive evidence on the controversial trend adopted by many firms in recent years of reporting earnings figures on a pro forma basis, pro forma earnings exclude normal income statement items that managers deem to be nonrecurring or nonrepresentative of ongoing operations. We examine a large sample of actual pro forma press releases issued between January 1998 and December 2000. We find that pro forma announcers tend to be relatively "young" firms that are concentrated primarily in the tech sector and business services industries, and that they are significantly less profitable, more liquid, and have higher debt levels, P-E ratios, and book-to-market ratios than other firms in their own industries. Our results indicate that while firms commonly exclude multiple expenses in arriving at their pro forma earnings figure, they usually do not exclude the same items in subsequent pro forma announcements. These results support the criticism that pro forma announcements are often motivated by managers' desires to meet or beat analysts' expectations or to avoid earnings decreases.

Keywords: Pro forma earnings; street earnings; corporate disclosure; analysts' expectations.

INTRODUCTION AND BACKGROUND

In recent years, many companies have begun reporting a nonstandard profitability measure commonly known as "pro forma" or "street" earnings along with their audited earnings number, based on generally accepted accounting principles (GAAP). (1) This practice fuels an intense debate between supporters and critics of pro forma disclosure. Both camps generally use anecdotal evidence and rhetoric to support their respective views, and prior research only documents limited empirical evidence on pro forma reporting practices (Wallace 2002). This study provides descripxtive empirical evidence regarding recent trends in pro forma disclosure practices from 1998 through 2000 by analyzing a large hand-collected sample of actual pro forma press releases.

The Pro Forma Debate

Managers often assert that they arrive at pro forma earnings by excluding one-time or unusual items from GAAP earnings (Halsey and Soybel 2002). They contend that pro forma earnings demystify complex accounting disclosures and provide a clearer picture of the "core earnings" that they expect to persist in future periods (Pitt 2001; Phillips et al. 2002). Some proponents of pro forma reporting argue that because GAAP earnings include nonrecurring items, such as restructuring charges and gains and losses on asset sales, alternative earnings metrics that exclude such items are more comparable (Bray 2001; Halsey and Soybel 2002). (2) The former chairman of the Securities and Exchange Commission (SEC), Harvey Pitt, stated that "investors anxious for current, simplified and comprehensible financial reporting are today more likely to rely on a company's 'pro forma' disclosures than the same company's meticulously prepared, mandated GAAP financial disclosures" (Pitt 2001).

Regulators and other critics of pro forma reporting, however, are skeptical about managers' claims (Liesman and Weil 2001a, 2001b). The ad hoc and nonstandard nature of pro forma reporting brought it under the scrutiny of lawmakers and regulators. Moreover, several highly publicized accounting scandals added to critics' skepticism about unaudited, nonstandard corporate disclosures (Dreman 2001; D'Avolio et al. 2001). The Financial Accounting Standards Board (FASB) expressed concern that the proliferation of earnings reports undermines the quality of financial reporting (FASB 2002). The SEC also warned that firms could face civil fraud lawsuits for reporting potentially misleading pro forma numbers in their earnings press releases if they do not also provide a "clear and comprehensible" reconciliation between the pro forma and GAAP numbers (Weil 2001b).

The financial press also raised many questions, including whether managers opportunistically exclude normal recurring expenses that should be included in GAAP operating income rather than "one time" or "unusual" items (Cowan and Munk 2002; Sidel 2002). …

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