Pro Forma, Adjusted, or Street Earnings
Managers frequently discuss specific computations of ‘‘earnings’’ that exclude certain line items and refer to such earnings as ‘‘pro forma’’ or ‘‘adjusted’’ earnings; collectively, such presentations of earnings, which are widely followed on Wall Street, are called ‘‘Street’’ earnings. As director of research at First Call, Chuck Hill commented, ‘‘What companies are trying to do is entice analysts into excluding certain charges and value them only on that basis.’’10 Exhibit 4.2 shows a hypothetical approach to computing proforma earnings by sequentially arguing that certain line items on the income statement are nonrecurring or are not relevant to the assessment of current profitability. The example shows revenues of $100, total expenses of $50, and net income of $50. Consider a manager who argues that Expense 5 is a one-time expense, such as severance payments to workers from a closed plant. The manager would report pro forma earnings of $60 after excluding this charge (Pro Forma 1 in Exhibit 4.2). Expense 4 might be for an expenditure such as advertising or R&D (research and development); so a manager might claim that these expenditures generate assets and are not relevant for assessing current performance. Excluding Expense 4 yields pro forma earnings of $70 (Pro Forma 2 in Exhibit 4.2). The manager also might claim that expenses such as depreciation and amortization should be ignored and not deducted in the measurement of ‘‘earnings’’ simply because such expenses do not involve cash outflows in the current period.
If Expense 3 in Exhibit 4.2 represents depreciation and amortization, the manager might report and discuss Pro Forma 3, which reports earnings of $80. A scheming manager even might be inclined to argue against including all expenses, ending up reporting pro forma earnings equal to revenues (Pro Forma 5 in Exhibit 4.2). This may seem farfetched, but it is what Internet firms did during the growth of this sector in the late 1990s. Managers of such firms argued that the key to assessing performance was the level of and growth in revenues, which reflected first-mover advantages to gain market share and growth in customers who would secure the firm’s profitability in the future. Needless to say, most market observers agree that the valuation of such firms reached irrational levels and resulted in a subsequent stock market crash, partially attributable to the temporary disregard for profitability measured to include operating expenses.
Managers frequently discuss specific computations of ‘‘earnings’’ that exclude certain line items and refer to such earnings as ‘‘pro forma’’ or ‘‘adjusted’’ earnings; collectively, such presentations of earnings, which are widely followed on Wall Street, are called ‘‘Street’’ earnings. As director of research at First Call, Chuck Hill commented, ‘‘What companies are trying to do is entice analysts into excluding certain charges and value them only on that basis.’’10 Exhibit 4.2 shows a hypothetical approach to computing proforma earnings by sequentially arguing that certain line items on the income statement are nonrecurring or are not relevant to the assessment of current profitability. The example shows revenues of $100, total expenses of $50, and net income of $50. Consider a manager who argues that Expense 5 is a one-time expense, such as severance payments to workers from a closed plant. The manager would report pro forma earnings of $60 after excluding this charge (Pro Forma 1 in Exhibit 4.2). Expense 4 might be for an expenditure such as advertising or R&D (research and development); so a manager might claim that these expenditures generate assets and are not relevant for assessing current performance. Excluding Expense 4 yields pro forma earnings of $70 (Pro Forma 2 in Exhibit 4.2). The manager also might claim that expenses such as depreciation and amortization should be ignored and not deducted in the measurement of ‘‘earnings’’ simply because such expenses do not involve cash outflows in the current period.
If Expense 3 in Exhibit 4.2 represents depreciation and amortization, the manager might report and discuss Pro Forma 3, which reports earnings of $80. A scheming manager even might be inclined to argue against including all expenses, ending up reporting pro forma earnings equal to revenues (Pro Forma 5 in Exhibit 4.2). This may seem farfetched, but it is what Internet firms did during the growth of this sector in the late 1990s. Managers of such firms argued that the key to assessing performance was the level of and growth in revenues, which reflected first-mover advantages to gain market share and growth in customers who would secure the firm’s profitability in the future. Needless to say, most market observers agree that the valuation of such firms reached irrational levels and resulted in a subsequent stock market crash, partially attributable to the temporary disregard for profitability measured to include operating expenses.
An empirical research study revealed a significant increase in the trend of managers reporting pro forma earnings higher than bottom-line net income, primarily by excluding certain charges and expenses from reported ‘‘pro forma’’ earnings.11 Exhibit 4.3 shows results from the study. The widening gap between plots in the graph makes it clear that firms increasingly excluded expenses from reported pro forma earnings beginning as far back as the late 1980s. A study of how managers highlight nonrecurring gains and losses revealed that managers tend to highlight unusual or one-time expenses or losses in the quarter in which they occur, but when that quarter is used as a benchmark for the announcement of the same quarter’s earnings in the next year, managers tend not to remind investors that the previous year included an unusual or one-time expense or loss. This makes the earnings announcement at that time appear more favorable in terms of year-to-year improvement in profitability In reaction to perceived abuses in the reporting of profits, the U.S. Securities and Exchange Commission (SEC) became concerned that the emphasis placed on pro forma earnings by managers risked misleading the average investor. The SEC issued Regulation G in 2003, which deals with what the SEC calls ‘‘non-GAAP’’ earnings, otherwise known in the investment community as pro forma earnings. Regulation G prohibits firms from placing more emphasis on pro forma earnings relative to bottom-line U.S. GAAP earnings or from identifying an amount as nonrecurring or unusual when such amounts have occurred in the past or are likely to recur in the future. Nevertheless, the
reporting of non-GAAP (or pro forma) earnings is not prohibited outright, so investors
must be diligent in understanding the composition of alternative measures of profits
reporting of non-GAAP (or pro forma) earnings is not prohibited outright, so investors
must be diligent in understanding the composition of alternative measures of profits
For example, firms often include financial highlights in their annual reports but use small fonts for footnotes indicating that certain charges have been excluded from the figures presented. However, most firms now make it easier for investors to understand how management views nonrecurring or unusual charges with separate disclosures. For example, in PepsiCo’s MD&A (Appendix B), the company includes a section titled ‘‘Items Affecting Comparability,’’ which quantifies numerous items that are either nonrecurring or volatile. For example, PepsiCo’s year-over-year comparisons are significantly impacted by merger and integration charges, restructuring and impairment charges, and a variable 52- to 53-week fiscal year convention.
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