The Numbers Game

Reporting of pro forma earnings is rising, and so is the debate about it

thin rule
By Bill Alpert, Barron's Online, September 11, 2000

The headline of's June earnings release bragged of "pro forma" operating profits on sales of books and records. Only investors who delved deeply into the financials learned that the online retailer's actual bottom line was a net loss of $317 million, or 91 cents per share. Pro forma earnings used to be a rare sighting, appearing on such extraordinary occasions as a merger or a corporate restructuring. The term -- which Latin lovers will recognize as meaning "according to form" -- once denoted a hypothetical presentation to show what earnings might've been, had some extraordinary event occurred a year earlier. In Wall Street English, the term pro forma earnings now seems to mean earnings. That is, earnings after each company excludes its idiosyncratic choice of such expenses as amortization, depreciation, payroll taxes and investment results.

The reporting of pro forma profits has proliferated at dozens of firms. Cisco Systems, Disney Internet Group and Yahoo feature them in every earnings release. At Amazon, the pro forma numbers get bigger play than the actual figures defined by generally accepted accounting principles -- known in accountant's English as GAAP.

"You can almost think of it as the creation of a de facto GAAP by these companies," argues Patrick E. Hopkins, an assistant professor of accounting at the Kelley School of Business at Indiana University, whose studies show that identical financial results, presented in different styles, will lead analysts to different valuations of a stock. "If you're packaging it to sound like the earnings-per-share number people think they know, is that inaccurate?" asks Hopkins rhetorically.

[Pro forma earnings]

Many financial professionals, however, don't seem to mind. In fact, they welcome pro forma numbers, saying they provide detail on a company's core operations. "My experience with investors is that they tend to pay more attention to pro forma than they do to GAAP net income," says Lehman Brothers' accounting expert Robert Willens.

That's certainly the case with In Wall Street's box scores, Amazon's 91-cent loss in the June quarter never appeared. Instead, analysts displayed a more modest 33-cent shortfall, arrived at through Amazon's pro forma exclusion of these GAAP expenses: amortization of goodwill and other intangibles, losses of partly-owned businesses, stock option costs, and costs related to mergers, acquisitions and investments. Analysts didn't insert so much as an asterisk, to warn that the 33 cents wasn't the number under GAAP.

Lehman's analyst on Amazon, Holly Becker, confirms her preference for Amazon's pro forma EPS: "That's why we use them."

Accounting maven Willens believes that the pro forma earnings phenomenon grew out of the debate over the proper way to account for "goodwill" after mergers. In a merger where one company pays $5 billion to purchase another firm that only had $2 billion in assets, for example, the $3 billion difference went on the surviving firm's books as an intangible asset called goodwill. As with its other assets, the surviving firm must write down the value of goodwill over time, through charges against earnings. Those charges, of course, didn't denote actual cash expenditures, which is why many firms liked to account for mergers in a way called "a pooling of interests," that put no goodwill on the books.

But a year ago, the Financial Accounting Standards Board proposed the elimination of pooling -- a proposal bitterly opposed by executives in the computer and biotech industries, who claim that mandated goodwill write-offs would hamper companies' ability to acquire new technologies and, by extension, end America's technology lead.

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Amid many public hearings, including three before Congress, the Financial Accounting Standards Board is "redeliberating" its merger-accounting proposal. FASB Chairman Edmund L. Jenkins says that the board probably won't adopt new merger rules before the end of next year's first quarter.

But one provision of that draft proposal actually pleased many public companies-a provision that would allow firms to separately report net-income-before-goodwill-charges. Wall Street has called this item "cash earnings" (even though it still includes many non-cash items beyond goodwill), and it likes the way some firms would look under the light of cash earnings ("Cash Ain't Trash," October 25, 1999). Many wondered if cash earnings would become the new bottom line.

In fact, pro forma earnings seem to be the new bottom line. So far this year, over 600 profit releases present pro forma earnings, and half of those releases led with the pro forma numbers in the headline or first paragraph (according to a search of the Dow Jones News Retrieval database).

Many of the outfits reporting these earnings are tech companies whose GAAP numbers aren't yet impressive. But a financial executive at one such firm, who wouldn't speak on the record, said that pro forma adjustments really help tech-stock investors. Actual GAAP earnings only allow an apples-to-apples comparison of one year to the next in a mature industry. In volatile tech businesses, argues the exec, such comparisons are distorted by the lumpiness of events like mergers or stock option exercises.

Because many companies confine their pro forma presentations to press releases, FASB doesn't really have sway over the practice. Where firms carry the pro forma numbers over into financial reports -- a venue that FASB does oversee -- companies carefully attach a Surgeon General's warning. Amazon disclaims thusly: "Presentation of pro forma results from operations on the face of the financial statements is not in conformity with generally accepted accounting principles. We are providing pro forma results of operations for informational purposes only."

FASB director Timothy Lucas opines (unofficially) that pro forma presentations aren't necessarily profane, even when included in the discussion section of a quarterly or annual report. By showing results exclusive of charges that are noncash or non-recurring, managers can highlight the numbers that they think are important. Pro forma can thus be less procrustean than the one-size-fits-all GAAP. "The world's not simple enough that you can capture everything you want to know in one number," says Lucas.[Pro Forma Performer]

Outside investors have long had their own ways of excluding and including expenses to "normalize" earnings trends. That's one explanation, of course, for the appearance of Amazon's pro forma numbers in Wall Street's EPS estimates.

The use of pro forma analysis seems to be a generalized kind of EBITDA, the measure of "earnings before interest, taxes, depreciation and amortization" long preferred by investors in capital-intensive industries like cable television. FASB never defined EBITDA, either. "We periodically get requests to define what should be put into that [EBITDA] bundle," says FASB Chairman Jenkins. "But there isn't any consistency with how people would like for us to do that, so we have stayed out of it."

Consistency is also the main issue with pro forma earnings reports, says Lehman's Bob Willens. "Pretty much any company in the Internet industry has its own quirky definition of pro forma earnings," he says. Firms like BEA Systems and Cisco exclude payroll tax on stock option exercises, but the New York-listed Walt Disney Internet Group doesn't.

The exclusion of taxes on stock-option exercises is controversial, as reported in the Heard on the Street column of Thursday's Wall Street Journal. Compared with other pro forma exclusions, however, those taxes are small change. In the pro forma presentation of its fiscal year ended July, Cisco excluded $51 million in payroll taxes, but also $1.7 billion worth of such other GAAP expenses as merger costs and the writeoff of acquired R&D and goodwill. To be fair, the network giant also excluded $531 million in gains on investments. After Cisco's pro forma adjustments, its July year net income of $2.67 billion, or 36 cents per share, became $3.9 billion, or 53 cents.

But a crucial point about Cisco's reporting is that it gives dollar amounts for each excluded item. Companies such as BEA Systems don't. Itemized pro forma exclusions, notes one financial executive, address all disagreement about which exclusions give the best measure of corporate performance. "You're giving the reader more information to do what they want with it," this person says. "If you think that payroll taxes should be included, the information is there to do that."

"We really do try to go out of our way to be upfront about what adjustments we make," says Tom Staggs, the chief financial officer of Walt Disney. Disney was the only firm among the seven highlighted in this story to respond to Barron's request for comment on an interesting fact: The pro forma earnings in our table all look much better than GAAP earnings. As long as firms clearly show that pro forma earnings aren't their actual profits, they'll probably stay in good graces with the only agency with real power over press releases, as well as financial reports. That, of course, is the U.S. Securities and Exchange Commission. An agency accountant told The Wall Street Journal last week that such practices could be policed as part of the SEC's regulation of "misleading or unbalanced" disclosures.

The issue goes deeper than legal liability, however. FASB Chairman Jenkins admits to some ambivalence toward pro forma's new popularity. "The statement of income presented according to GAAP is still the best predictor of future cash flow," he says.

Wall Street analysts who follow Amazon all told Barron's that they're sufficiently savvy to make rational use of both pro forma and actual numbers. But style can be as important as substance, even among the most rational crowd on Wall Street. In a study published in July's Accounting Review, Indiana B-school professor Hopkins showed 113 buyside analysts a set of financials that differed only in that one version used "pooling" accounting and two other versions did not. The more attractive pooling treatment caused analysts to place higher valuations on the company's shares.

Analysts are only human, notes Hopkins. They're also extremely busy and therefore influenced by pro forma packaging that makes their job easier. Think again about Wall Street's uniform adoption of Amazon's pro forma EPS.

In this Age of CNBC, says Hopkins, an earnings release has as much influence as a 10-Q or 10-K. "This is the 'go-to' document," says the professor. "It probably gets read more thoroughly than the financial statements. It's almost a Trojan Horse."

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  Latest Qtr EPS
Company Symbol Actual Pro Forma What's Excluded AMZN -$0.91 -$0.33 Amortization of goodwill and intangibles, tax on option exercises, equity in losses of investees, merger and investment costs
BEA Systems BEAS 0.01 0.05 Acquisition charges, early note conversions, tax on option exercises
Cisco Systems CSCO 0.11 0.16 Acquisition charges, tax on option exercises, investment gains
Network Appliance NTAP 0.01 0.09 In-process research and development, amortization of intangible assets
Lernout & Hauspie LHSP -0.26 0.05 One-time charges, amortization of goodwill and other business intangibles, in-process research and development, and unrealized foreign-exchange gains or losses
Disney Internet Group DIG -1.75 -0.34 Amortization of intangible assets
Yahoo! YHOO 0.11 0.12 Acquisition charges, tax on option exercises

Source: Company reports