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Pro Forma Definition
Pro forma is a Latin phrase that means “as a matter of form”. In business and investing, it refers to the manner in which a firm calculates and presents its financial results. The pro forma calculation method emphasizes current and projected figures.
A Little More on What is Pro Forma
Pro forma financial statements are designed to emphasize specific figures in a company’s financial reports. The most notable examples of such reports are earnings statements published quarterly by public companies for shareholders and potential investors. Companies also use pro forma statements to highlight different financial transactions, like mergers and acquisitions.
Pro forma statements do not have to comply with Generally Accepted Accounting Principles (GAAP). In fact, a company’s pro forma figures often differ drastically from its standard GAAP documents. Since pro forma statements aren’t restricted by GAAP, companies can create statements to emphasize the most important aspects of their business performance.
Pro Forma in Accounting
Company financial statements are examples of pro forma in the accounting field. These reports are usually included in earnings statements, but they don’t include unusual or nonrecurring transactions. By eliminating miscellaneous costs from financial statements, potential investors can get a clearer picture of core business performance.
Pro Forma in Business
From a business perspective, companies use pro forma financial statements to present an analyze the different aspects of potential investments, planned transaction, and more. These projections usually estimate the impact of a transaction on different areas of the business, including cash flows, projected revenues, tax costs, and more. Using pro forma reports, companies can project the impact of a business move based on recent, accurate financial data.
Creating a Pro Forma Statement
If you want to create your own pro forma financial statement, there are numerous templates available online for free. Here are the basic components of a standard pro forma income statements.
Step one is estimating revenue outlooks for your business, and this step is commonly referred to as pro forma forecasting. Base your estimates on objective measures that you can back up with hard data. Research your topics and consult with experts to determine an average annual revenue stream, cash flow, and asset accumulation projections.
The next step is projecting your liabilities and expenses. This category includes loans, credit balances, and costs from things like leases, utilities, and other operating expenses. Again, use objective measures and be rational when forecasting these figures.
Last, forecast the cash flows. This part of the pro forma statement shows the amount of money going in and out of your business. It includes figures like net earnings, asset sales, dividends, and more.
These three components make up a standard pro forma income statement. You can use them to generate your own pro forma statements for the use of prospective investors and management.
Academic Research on Pro Forma
The predictive value of expenses excluded from pro forma earnings, Doyle, J. T., Lundholm, R. J., & Soliman, M. T. (2003). Review of Accounting Studies, 8(2-3), 145-174. This study looks at the information properties of pro forma earnings statements. The authors have determined that much of the information that the companies omit in their pro forma statements is actually important information that is relevant for current and prospective investors. They noted that higher levels of exclusion predict decreased cash flows. The study also showed that investors did not fully appreciate or understand the impact of reduced cash flow when the earnings statement was first released. They formulated a trading strategy that was based off these findings and found it to be consistently profitable.
Earnings informativeness and strategic disclosure: An empirical examination of “pro forma” earnings, Lougee, B. A., & Marquardt, C. A. (2004). The Accounting Review, 79(3), 769-795. This study found that companies with lower GAAP earnings transparency tend to publish pro forma reports in its press releases than other firms.
Assessing the relative informativeness and permanence of pro forma earnings and GAAP operating earnings, Bhattacharya, N., Black, E. L., Christensen, T. E., & Larson, C. R. (2003). Journal of Accounting and Economics, 36(1-3), 285-319. This study found that pro forma issuers are concentrated in the technology and service sectors. It also determines that pro forma issuers frequently report GAAP losses. The authors found that pro forma reports are more informative and relevant than GAAP operating earnings. The study concludes that market participants, like stock traders, think pro forma reports are more relevant to core earnings than standard GAAP net income statements.
Are investors influenced by pro forma emphasis and reconciliations in earnings announcements?, Elliott, W. B. (2006). The Accounting Review, 81(1), 113-133. This study examines the psychological effects of pro forma earnings on both management and prospective investors.
The effects of pro forma earnings disclosures on analysts’ and nonprofessional investors’ equity valuation judgments, Frederickson, J. R., & Miller, J. S. (2004). The Accounting Review, 79(3), 667-686. This study examined the effect of pro forma reporting and GAAP reporting on company share prices. The study found that amateur investors who received earnings reports with both GAAP and pro forma summaries assessed a higher share price for the company than participants who only received GAAP estimates. Professional equity analysts were not affected by the inclusion or exclusion of the pro forma statement.
Who trades on pro forma earnings information?, Bhattacharya, N., Black, E. L., Christensen, T. E., & Mergenthaler, R. D. (2007). The Accounting Review, 82(3), 581-619. This study claims that many pro forma summaries represent overly optimistic perspectives on company financials. The authors state that pro forma statements can be misleading to investors, and amateur retail investors are the most at risk for falling for the misinformation that professional analysts can easily recognize.
Emphasis on pro forma versus GAAP earnings in quarterly press releases: Determinants, SEC intervention, and market reactions, Bowen, R. M., Davis, A. K., & Matsumoto, D. A. (2005). The Accounting Review, 80(4), 1011-1038. This study takes a look at three things. First, the authors examine the determining factors in a company decision to emphasize pro forma or GAAP earnings. Then, they explore the current shift towards GAAP earnings statements. Finally, the study of whether stock prices can be affected by the emphasis of certain figures in an earnings statement. The study found that earnings metrics have a strong effect on share prices, and that money managers are correct to use pro forma summaries as a disclosure tool because
Are investors misled by “pro forma” earnings?, Johnson, W. B., & Schwartz Jr, W. C. (2005). Contemporary Accounting Research, 22(4), 915-963. This paper investigates the claim that pro forma earnings are misleading to investors using actual historical stock market data. They use narrow-window stock returns to gauge the impact of pro forma earnings reports on the share prices of the reporting company. The study revealed no evidence of a return premium for companies that report pro forma earnings summaries.
Investor sentiment and pro forma earnings disclosures, Brown, N. C., Christensen, T. E., Elliott, W. B., & Mergenthaler, R. D. (2012). Journal of Accounting Research, 50(1), 1-40. This study examines the impact of investor sentiment on discretionary disclosures of pro forma summaries within their quarterly earnings reports. The study found that, as investor sentiment increases, firms tend to exclude higher levels of expenses from pro forma and emphasize them more over other parts of their earnings summaries.
US managers’ use of ‘pro forma‘adjustments to meet strategic earnings targets, Black, D. E., & Christensen, T. E. (2009). Journal of Business Finance & Accounting, 36(3‐4), 297-326. This study investigates how pro forma summaries are used to manipulate figures and help management meet earnings expectation. The study discovered several attributes that indicate a company is using pro forma reports with dishonest intentions.
Written by: Chris Dios