Pro Forma Earnings Reporting - Essay Example

Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: (3,045 words) Abstract Spotless Group announced a rise in pro forma earnings by 23.6% representing $60.2 million (Binsted, 2015). The announcement has received critics some supporting the figures as a true picture of financial performance, and others against from lack of adherence to Generally Accepted Accounting Principles. Therefore, the essay gives in-depth understanding on pro forma earnings and GAAP, and opinion of whether the practices should be permitted or prohibited by relevant regulatory bodies. Pro Forma Earnings Reporting Pro forma earning reporting is a non-regulated practice where the company provides a theoretical estimate of its profit. The reporting entails the elimination of certain expenses such as impaired goodwill, depreciation and certain types of interest. Most companies urge out that the reporting gives a real picture of the company performance since it focuses on real expenses, it disregards hypothetical expenses like depreciation which only provides a sinking fund. Also, the company can eliminate non-recurrent expenses in preparing pro forma earnings since it does not affect the performance of the company in future (Entwistle, Feltham & Mbagwu, 2006). The reporting is perceived to give a good picture of the real performance of the company. Therefore, the majority of the scholars encourage investors to read through pro forma reports to obtain in-depth understanding since it has a clear perspective of company performance. The company can choose to announce its financial performance through pro forma earnings for good or bad reasons. First, Spotless Group can provide strategic reporting to its potential investors since it eliminates non-recurrent expenses such as amortization that is less likely to affect the future financial performance of the company. The reporting gives potential investors a clear picture of the future company trend thus fostering their information in making an investment decision. Unlike Australian Accounting Standards reporting this emphasizes on the inclusion of all expenses that do not have any effect in future. Secondly, pro forma earnings are always higher than earnings reported using Australian accounting standards due to the elimination of certain expenses. This sends a positive signal to potential investors’ thus increasing demand for company share in Australian stock exchange (ASX). The increase in shares demand and positive signal in the financial markets makes it easy for the Spotless group to raise funds through issuing shares or financing through debt. For example, the announcement of the pro forma profit increased share price by 3%, currently trading at $2.02 (Binsted, 2015). Thirdly, pro forma earnings reporting is very important for managerial use since it gives a simplified and more practical view of the company performance unlike the use of rigid Australian Accounting Standards. The managers can formulate workable strategies in addressing real issues facing the company and eliminating panic that result from poor results reflected report. Fourthly, pro forma reporting eases management effort in explaining to shareholders on company financial performance since it gives a detailed report by emphasizing on major items required in making an investment decision, making it more informative than report prepared using Australian Accounting Standard where various irrelevant items for investment analysis are recorded. According to Entwistle, Feltham & Mbagwu (2006), most investors has shifted from relying on Australian Accounting Standard to Pro forma earnings reports since they consider Australian Accounting Standard reports to have low information content on company performance thus limiting their viability of their investment decision. The company can use pro forma earning reporting in a bad way or as an avenue to hide its poor performance. Pro forma reporting lacks regulations or standards of reporting. Therefore, Spotless can use it as a means to give false perception on company performance to lure potential investors to invest in the company, improve market share price or maintain investor confidence in company performance and management effectiveness (Entwistle, Feltham & Mbagwu, 2006). This form of reporting has gained great acceptance from investors since it is considered to be detailed and informative thus fraudulent managers can easily engage in creative accounting without being detected. The company must be experiencing negative earning with Australian Accounting Standard reporting, but positive earning with pro forma reporting. Therefore, an investor might incur huge losses by basing his or her decision on pro forma report alone. The fraudulent reporting using pro forma reporting affects financial market since it results to share misprice. The pro forma earnings reporting have both positive and negative effects to shareholders. Shareholders are the major users of financial information since they have to keep a good track of the management activities in delivering their roles and responsibilities of ensuring maximization of shareholder wealth, maximization of return and optimization of cost. Therefore, shareholders keep a close look on financial information realized to public domain both financial and non-financial. As seen previously, pro forma earnings are usually higher than those reported using GAAP or Australian Accounting Standards because some expenses are eliminated since they don’t affect prospects of the company. These send the positive signal to financial market on the performance of Spotless Group. The positive signal will stimulate demand since most investors are attracted to the possibility of future high share growth or high dividends payout. According to signaling theory, positive signal entails high dividend payout or any other positive information that boost potential investor confidence of high future growth on company revenue. Therefore, Spotless announcement of an increase in pro forma earnings by 23.6% resulted to share growth. The shareholders earn a return on their investment in two ways which includes dividends and capital gain. In our scenario, the share grew by 3% that represents capital gain income for the shareholder which resulted from information on the growth of the company earning using pro forma reporting thus elaborating one of the merits of using this form of reporting (Binsted, 2015). According to Bowen, Davis, and Matsumoto (2005), the majority of the large company like Spotless Group emphasizes on pro forma earnings on its media release than its official accounting report. The use of pro forma report is to give high positive perception on the company performance compared to other company in the same industry. The emphasis always aims at easing the process of soliciting funds from public, performance of share growth, and customer base since most customers prefer trading with the best, these variables works well in maximizing shareholder wealth (Black & Christensen, 2009). For example, an increase in customer base results raises sales volume and profitability, these spills to the shareholder through dividend payout and capital gain that results from steady share growth due to a continuous increase in profitability level. Therefore, media release acts as a good channel of conveying pro forma earnings and achieve the desired goal of improving investor perception about the company in the financial market, which is advantageous to shareholders. The use of media release enables ensures that it fulfills the market hypothesis assumption by availing the information to investors at the same time, thus making sure all investors are equal, and no one makes a supernormal profit from insider information. The use of pro forma earnings acts as an avenue to release investors from panicking about future of the company, majorly when it is experiencing negative earning based on GAAP or Australian Accounting Standards. The instances of panic arise when company acquire or merge with another company thus cost of goodwill, amortization and depreciation is transferred to company books of accounts. The amount might be huge thus leading to negative earning based on regulation based reporting. Since the financial market is imperfect due to the presence of irrational investors, they might use the negative earning without taking in-depth analysis on issues that might have led to negative earning, decision made by such investors might affect negatively the performance of the share in the financial market (Black & Christensen, 2009). Therefore, use of pro forma earnings report overcome such weakness by detailing the items that only affects the future performance of the company, thus enabling stability and steady growth of shareholder wealth and reputation since share performance in the market gives a true picture of company financial status, this overcomes issues of share misprice. The use of pro forma report promotes the efficient market hypothesis assumption that always assume that majority of investors are rational. The investors are assumed to analyze the company performance properly before making an investment decision, but in real sense management simplifies the reporting for the investors by reducing the number of irrelevant items in the financial report for layman understanding, thus improving rationality of the decision made by investors in the market. The payment of dividends depends on the earnings that remain after payments of all expenses and investments commitments. The dividend acts as one of the sources of income for investors on their share investment in a given company. The decision to pay dividends always arises from the directors and approved by shareholders during the annual general meeting. The dividends cannot be paid from any source other than profits made from trading activities. Therefore, the company will not pay dividends when it is experiencing negative profits or cash flow; thus use of pro forma reporting helps greatly in determining the true picture of company performance. For example, Spotless proposed interim dividends of 4.5% to shareholders as a result of an increase in half-year earnings. The increase might have or not been released if the company used GAAP or Australian Accounting Standards. The announcement of dividends has a direct and indirect impact of shareholder wealth that includes an increase in dividend income and capital gain from the positive signal sent to the market. Lastly, use of pro forma earnings gives a true picture of the company performance thus minimal over or under pricing of the company share price. Accurate pricing of the share price gives investors a better position to construct a real value of their investment portfolio and help decision making on which portfolio to increase, eliminate or reduce (Entwistle, Feltham & Mbagwu, 2006). The issue of mispricing can give upper investor hand when shares are underpriced since investors will discover that shares are underpriced thus increase in demand because every investor wants to make a profit from discrepancy. But overpricing results to the huge loss, the challenge is minimized by using financial reports that gives the true and fair picture of the financial performance of the company. Therefore, pro forma earnings reporting gives immense shareholder benefit in ensuring that he/she maximizes portfolio return. On the other hand, pro forma earnings reporting can be disadvantageous to the shareholder since it has a various weakness that prevents true and fairness of financial report due to lack of reporting standards and regulation. First, the practice is prone to accounting malpractice such as creative accounting and window dressing. The malpractices result to the conveyance of false information to the users of financial information such as creditors, regulators and government who uses this information in making their daily. Therefore, upon the realization that the information used did not reflect the actual status of will cause agency problem between shareholders, directors, management, creditors, regulators and government (Entwistle, Feltham & Mbagwu, 2006). The effect might eat into shareholder shares depending on the type of the company i.e. either limited or unlimited company. The agency problem results to loss of shareholder wealth, which is against management goal of ensuring that they maximize shareholder wealth and return. Secondly, Investors in an efficient market are always rational, thus carry out intense analysis that includes fundamental and technical analysis. Also, industry analysis is considered key to ensuring that the decision takes care of industry future and company with potential growth compared to others in the same industry. Pro forma earning reporting confuses the investor and unfair in comparing different companies or developing industry trend, since each company adopts its standards on pro forma earning preparation, thus making it difficult to compare fairly or get a general perspective of the industry trend (Entwistle, Feltham & Mbagwu, 2006). Therefore, uniformity in reporting must be emphasized to ensure that all companies in the industry are measured uniformly, and failure results in biased analysis that affects investor decision negatively. For example, a performing company might fail to eliminate amortization expense making its earnings lower than a poorly performing company who eliminated all irrelevant expenses. Therefore, an investor might purchase shares of a poorly performing company without carrying out in-depth analysis leading to losing or minimal return from the investment. Thirdly, shareholders can lose their investment through the use of pro forma earnings since they might entirely depend on it. For example, some companies might go against the regulation on issuing profit warnings and hide their poor performance by using pro forma earnings; shareholders are deceived by the false financial performance of the company. Shareholders will hold on their shares, but only to realize a sharp drop in share value, when regulators and other stakeholders notice the trick, management and directors have been playing in altering the performance (James & Michello, 2010). Lastly, agency problem can be created by pro forma earning reporting between shareholders and directors that arises from director bonuses (Kuo, Chang & Yu, 2013). For example, directors may conceal the true performance of the company by eliminating legitimate spending that affects the future trend of the company to record high profit. The directors will then use the high performance as an avenue to award themselves hefty bonuses since shareholders will approve without carrying out further analysis on the credibility of the information (Kuo, Chang & Yu, 2013). The payment of huge bonuses without real improvement in company performance might lead to insolvency of the company, thus losS of shareholder wealth. The management might engage in the same practice without knowledge of the directors who usually approves the reports without making sure that the information is credible. The use of pro forma earnings as a measure of actual financial performance of a company needs not to be taken lightly since it can result in imminence benefit or loss that affects shareholders and potential investors greatly. The majority of shareholders use investment firms to help the in financial decisions with the remaining proportion making an independent decision based on available information. Despite the majority of shareholders wealth being managed by investment firms, they are conscious of information available in public domain and seeking on steps by their agents. The information includes financial or non-financial information. The pro forma earnings are part of the information conveyed to the public domain for investors to decide on the direction of their investments whether managed by an investment firm or individual shareholder. According to the spotless scenario, we can note that announcement of an increase in pro forma earnings by 23.6% changed the direction of its share performance in the market i.e. increase in share price by 3% (Binsted, 2015). Also, its importance is seen from first dividends payout since its listing on Australian Stock Exchange. The payment of dividends and attachment to the performance measure makes the shareholders place emphasis in future during investment analysis. Consequently, shareholders place great value on pro forma earnings since it gives a fair picture of the performance of their company that enables the company to compete favorably with its competitors in the industry. The industry competition relies mostly on financial performance when soliciting of additional funds through issuing of shares or debt financing. Also, good financial performance affects customer perception when deciding the product or service to consume. Lastly, shareholders see value in pro forma reporting since they can make a sound strategic decision. The decision is only successful with the elimination of all elements or items that affects the short-term performance of the company. Therefore, enabling investors to avoid incurring huge losses in future or tap immense profit by holding onto their shares during a short period of company ‘downturn’ i.e. during merger or acquisition. The shareholders values pro forma earnings reports since it is easy to understand and detailed thus minimal or no further explanation are required from a financial analyst. But shareholders must be cautious on the reliance of the information provided in pro forma earnings report by comparing them with those prepared using Australian Accounting Standards or other GAAP (James & Michello, 2010). The comparison enables the shareholders to raise questions on why and how certain items were eliminated in pro forma earnings and basis of qualification of such items as one-time expenses. The consideration of such variables will maximize shareholder value on the reliance on pro forma earnings report. In my opinion, I support the use of pro forma earnings due to various merits to the shareholders and other stakeholders using the information, but on condition that certain requirements must be fulfilled. These requirements include; The relevant bodies should come up with sufficient regulations to control discipline in pro forma earnings reporting. These includes framework on the definition of expenses that can be eliminated or retained. Also, the independent auditor is required to go through the report to determine its credibility and adherence to the set regulation. Implementing these measures will minimize instance of directors or managers using it as an avenue to conceal the actual performance of the company, thus maximizing the value of the information conveyed. Also, shareholders should be educated on the difference between pro forma earnings reporting and official reporting based on recognized accounting principles. The investor education will ensure that shareholders are versed on how well to analyze pro forma earnings report to avoid being deceived. Therefore, balancing their objectivity on company true and fair financial position. As seen earlier, most investors are irrational thus base their decision entirely on information available in the financial market without scrutinizing its credibility. Therefore, investor education is critical in ensuring that shareholders tap on benefits of using pro forma earnings. Consequently, regulatory bodies and other stakeholders should ensure that the company provides both pro forma earnings and profit after tax reports simultaneously to ensure that shareholders can compare between the two and make a sound decision. Lastly, standards should be put in place by industry players or industry regulators to ensure that the measure gives uniformity when carrying out analysis of the company based on industry players. The standardization of reporting will ensure that the decision made by the investor is not biased or does not represent the actual performance or position of the company in the industry. After Implementation of the above measures, I do not see any reason for prohibiting pro forma earnings but instead encouraged. In conclusion, we can note that pros of using pro forma earnings outweigh its demerits. Therefore, reforms are required to minimize or eliminate challenges facing pro forma earning reporting and uphold the merits. The move will create transparency and efficiency in the financial markets due to the conveyance of credible information. Reference: Binsted, T. (2015). Spotless eyes acquisitions among the resources wreck. The Age (24 February 2015) http://www.theage.com.au/business/spotless-eyes-acquisitions-among-the-resources-wreck-20150223-13mwre#ixzz3kYcowXDQ [accessed 7 December 2015]. James, K. L., & Michello, F. A. (2010). 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