The U.S. generally accepted accounting principles (GAAP) require companies to adhere to uniform reporting standards that govern accounting in the U.S. However, companies increasingly supplement their GAAP reporting with pro forma financial statements. Management argues that GAAP statements do not provide a true picture of the company’s operations, and it adjusts GAAP statements to provide investors with a better understanding of the company’s financial matters, enter: pro forma financials.
- Pro forma statements include adjustments made to GAAP statements to provide a “true” picture of the company’s finances.
- Such adjustments include removing non-recurring charges, such as restructuring and litigation costs.
- Pro forma statements can be more accurate but they can also be abused, as certain charges that really belong can be excluded, such as stock-based compensation.
Pro Forma Statements
Adjustments made to GAAP statements to create pro forma statements include litigation costs, restructuring charges, and other non-recurring items. Unlike GAAP’s emphasis on historical transactions, a company can use pro forma statements to show projections of its earnings.
Occasionally, pro forma financial statements refer to a forecasting method under which financial numbers from the previous two or three years are used. The company’s management prepares pro forma financial statements for mergers and acquisitions proposals as well as loan applications.
GAAP requires a company to report any losses or gains associated with litigation that are ordinarily of a non-recurring nature and are unlikely to repeat in the future. A company that wishes to inform its investors about the non-recurring nature of litigation prepares a pro forma income statement to adjust GAAP earnings for any litigation gains or losses.
For example, Best Buy booked an income of $229 million in 2014, associated with the LCD screens settlement. Because this is a non-recurring item, the company subtracted this gain from its operating profit in the pro forma income statement.
Other non-recurring items that companies tend to use in adjusting GAAP earnings for pro forma statements are restructuring charges. In 2014, Best Buy reported $159 million of charges associated with restructuring its business, and the company did not expect to incur such charges in the future. On its pro forma income statement, Best Buy added back this restructuring charge to its net income.
The pro forma financial statement is often a more accurate representation of the company’s financial results and position. However, a company might abuse pro forma statements by excluding certain charges that really belong in the financial statement. One prominent example is stock-based compensation.
Stock options may not represent an immediate cash charge to the company, so it might exclude expenses associated with stock options on the pro forma statement. However, stock options are traded, they have value and affect the company’s earnings through dilution. Ignoring stock-based compensation can mislead investors, especially if most of the employees’ compensation is in the form of stock options.
A company’s claims that certain charges are non-recurring should also be taken with care. Certain companies incur litigation charges very frequently due to the inherent nature of the business, such as medical practices. If these charges recur every year and the company excludes them on the pro forma statements, the company’s management may be misleading its investors.