Pro Forma Earnings - Literature review Example

PRO FORMA EARNINGS Name Institution Professor Course Date Introduction Most firms use pro forma earnings and GAAP earnings to account productivity. However, the application of pro forma earnings to report profitability is debatable. Supporters of pro forma earnings use these reports to assist stockholders to centre on the most imperative particulars of financial statements while challengers suppose that pro forma earnings are misrepresented to shed an affirmative light on inauspicious financial results. Pro forma earnings reports have instigated considerable debate about whether their figures are informative and the facets might that impinge on their informativeness. An organisation’s single most essential public disclosure is it earnings. This is because earnings offer a measure of an organisation’s potential and current future operating performance. Some researchers have indicated that pro forma earnings are less valuable compared to GAAP even as other researchers believe that they are value relevant. This essay examines the value relevance of pro forma earnings; give reasons why firms utilise pro forma earnings, and bring to light merits and demerits of pro forma earnings to shareholders. Defining Pro forma Earnings Pro forma earnings entail earnings that have been altered from GAAP often by leaving out one or several costs to provide a clear picture of a firm’s underlying profitability. Pro forma earnings are anticipated earnings founded on a set of assumptions. GAAP do not compute pro forma earnings. Pro forma earnings usually eliminate one-time expenditures that are not an element of a normal firm’s operations. Pro-forma financial statement can leave out anything that a firm’s managers believe obscures the exactness of its financial position. These reports can be useful information that assists in assessing a firm’s future opportunities. According to Shefrin (2000), pro forma earnings pertain to a subset of line items mostly concerning operations and exclude items such as restructuring costs. Therefore, pro forma earnings are more sought-after compared to GAAP earnings. Shefrin (2000) different firms have different meanings of pro forma earnings. Epstein, Nach and Bragg (2009) claim that different organisations can and have described pro forma earnings differently. Pro forma earnings present investors with a comprehensible outlook of an organisation’s operations and leave out distinct expenses. There is no much directives of pro forma earnings. Therefore, firms can exploit the rules to make their earnings seem better. As a result, investors should exercise care when utilising pro forma earnings figures in their basic analysis. Pro forma earnings do not abide by any standardised regulations and rules like GAAP earnings. According to James and Michello (2007), Pro forma earnings reports exclude certain items that firms consider momentary in temperament. The excluded items are expenses needed under GAAP for the computation of net income (Black,Christensen & Heninger 2012). Such expenses may include costs linked to acquisitions and goodwill impairment Therefore, pro forma earnings can turn negative when GAAP rules are employed and when excluded charges and costs are included in the analysis. Reasons The use pro forma earnings flourished following the endorsement of Sarbanes-Oxley Act (SOX) and the following promulgation of Regulation by the SEC. In several instances, pro forma earnings are founded on omission of some costs and the addition of a firm’s onetime gains. Such activities in due course came to be broadly recognised as being misleading and incorrect. However, firms defend their application of pro forma earnings as a way of responding to the needs of the marketplace for measure that provides insight into a firm’s future performance. As a result, one of the reasons why firms use pro forma earnings reports is to help them respond to the market place needs. According to Epstein, Nach and Bragg (2009), pro forma earnings is required to compensate for deficiencies in GAAP earnings. Given that GAAP-basis net income is affected by different noncash credits and charges besides nonrecurring losses and gains, this traditional measure may fail to provide investors with the most accurate and meaningful guide to a firm’s prospective results of operations. Application of pro forma earnings helps firms to provide investors with accurate information on a firm’s current operations. Some firms believe that investors need access to a number that measures the performance of reporting firm’s current normalised operations only. With respect to descriptive accounting theory, pro forma earnings help investors in making observation and drawing on a productive conclusion from the observations. Pro forma earnings has been embraced by firms because of its exclusion of some or all of unusual items. The left out items in pro forma earnings includes charges such worker layoff costs, assets impairments costs, restructuring costs as well as inventory obsolescence costs. Scores of these costs are ordinary and may reappear irregularly in the course of the business. Landsman, Miller and Yeh (2007) assert that the proliferation of pro forma earnings numbers in the earnings of a firm instigates different issues that are of interest to the accounting research as well as accounting policy makers. Firms that use pro forma earning numbers maintain that these numbers mirror perfectly the true earning power of a firm. Several studies have demonstrated that the stock prices are closely linked to pro forma earnings numbers as opposed to GAAP earnings numbers (Landsman, Miller & Yeh 2007). These findings support the accuracy of pro forma earnings. However, critics maintain that firm’s management utilise pro forma earnings to control the perceptions of investors towards a firm’s earning power and the value of stock. Contrary to the GAAP earnings, the pro forma earnings number is a superior indication of the economic performance for scores of firms. Therefore, managers employ the pro forma earnings reports flexibility to divulge helpful and extra information. Conversely, there is proof that some firms utilise pro forma earnings to hide poor operating performance. A study involving over one thousand pro forma earnings announcements made between January 1998 and December 2000 indicated that while only 38.7 % of the announcing firms had GAAP earnings that attained or exceeded the expectations of analysts, the pro forma earnings figures accounted by the same companies attained or exceeded the expectations of analyst’s by 80.1 percent ( Stice & Stice 2013). Stice and Stice (2013) further asserts that one way to view the flexible reporting alternatives a manager has in selecting what to report as pro forma earnings is that these alternatives are just as exaggerated version of the alternatives the same manager has in reporting GAAP income. If a manager is dependable, the GAAP earnings are also dependable. In such a situation, the manager can reveal information regarding the true economic performance of the firm through suitable adjustments while computing pro forma earnings. Utilisation of pro form earnings assists firms in meeting and managing the forecasts of analysts’ earnings. The idea that GAAP income and pro forma earnings are of different quality underlies the discussion of pro forma earnings by the accounting fraternity. The execution of Section 401 (b) of SOX requires that firms to present the most analogous financial measures provided under GAAP. Firms use pro forma earnings to attain the anticipations of the analysts and downplay negative earnings. However, Stice and Stice (2013) claim that firms that use pro forma earnings are less cost-effective, have higher arrears levels and are more liquid than other companies do in their industries. The major question concerning application of pro forma earnings in firms is whether the numbers assists financial statement users in better understanding a firm or whether use of pro forma earnings is a deliberate attempt to conceal poor performance. Advantages and Disadvantages Proponents of pro forma earnings argue that these financial statements offer current, detailed and simplified financial information. More so, pro forma earnings help shareholders to centre on the most imperative particulars of their firms’ financial statement. According to James and Michello (2007), when the informativeness of GAAP earnings is low, investors may rely more on pro forma earnings. Investors consider pro forma earnings to be more pertinent than GAAP earnings. Those who oppose the use of pro forma earnings contend that firms that make use of pro forma earnings to shed an optimistic light on inauspicious financial results. Financial regulators and press contend that pro forma earnings misinform and confuse investors. Pro forma provide useful information to the shareholders who require correct view of a firm’s normal earnings outlook. When an organisation has one-time costs that are irrelevant to future profitability of the organisation, the net income fails to provide a clear picture. Given that there is not much control over pro forma earnings, firms are able to bend rules to make earnings look better. Given that brokers and traders focus on whether a firm meet or beats the expectations of analysts, the headlines following a firm’s earnings announcement mean everything to shareholders. When a firm meets the pro forma anticipations, its stock cannot suffer but goes up although in short term. Therefore, pro forma earnings provide shareholders and investors with a clearer picture of a firm’s operations. It provides much more correct view of a firm’s financial performance to shareholders. In cases where pro forma earnings fail to include non-cash costs, shareholders can get the actual cash profit. According to Christensen, Drake and Thornock (2014), pro forma earnings hold superior content of information as opposed to GAAP earnings. Investors and shareholders show greater concentration to pro forma earnings numbers adjusted by managers as opposed to audited GAAP earnings numbers. Pro forma earnings reports help shareholders in evaluating the operating opportunities of their businesses in the future. They help firms in exceeding the analyst’s forecasts. Pro forma earnings also help in the valuation of latent takeover targets (Binsted 2015). Investors, assign more value to pro forma figures because these figures are helpful tools that help a firm to determine its core value drivers and assess shifting trends within a firm’s operations. Christensen, Drake and Thornock (2014) assert that the particulars excluded from pro forma earnings are crucial as they provide essential information concerning the future earnings of a firm as well as its abnormal returns. Use of pro forma earnings helps shareholders identify weaknesses, strengths, opportunities and threats that facilitate strategic planning. The pro forma earnings offers planners a projected financial stance to inform the shareholders on what anticipated resources are needed to attain development needs and interests. Pro forma earnings can be misleading. According to Berger (2005), pro forma financial information is a projected or hypothetical amount. Therefore, pro forma earnings reports are viewed as an opportunistic effort by managers aimed at misleading shareholders. When used properly, pro form earnings indicate what would take place under given circumstances. In addition, pro forma earnings reports contribute positively to financial reporting. Pro forma earnings figures, on the other hand, contribute negatively to financial reporting. These earnings are subject to manipulation thereby giving wrong information to shareholders. The one-time expenses left out of pro forma are a fund that exits a firm although not a part of business operations. Analysts manipulate pro forma earnings to provide a favourable story about the company Pro forma earnings generate abnormal returns. James and Michello (2007) assert that the excluded street earnings for future firm performance generates great abnormal returns. Some policy makers contend that pro forma earnings are not a true reflection of a firm’s performance because they inaccurate and incomplete. Pro forma financial statement is just a forecast. Pro forma figures can prompt eccentric investor decisions. The figures prevent a helpful comparison of profits and instead focus on beating market expectations. According to Baker and Nofsinger (2010), although pro forma earnings are correct for valuation compared to GAAP income, they are biased. Nonetheless, the extent of bias envisages prospective abnormal returns (Cormier, Antunes and Magnan 2011). Usually, pro forma earnings eliminate charges that are essential in GAAP earnings. Value Relevance Pro forma earnings are value relevant and these earnings are the most value-relevant measure. Pro forma earnings are constantly the most closely linked with stock prices. Shareholders perceive value relevance as the capacity of information revealed by financial statements to summarise and capture firm’s value. Firm value, on the other hand, is the market value of the firm, which entails ordinary shares multiplied by the share price. According to Landsman, Miller and Yeh (2007), value relevance can be measured through statistical links amid information presented by financial statements and stock market returns or values. Therefore, when share price responds to the information, pro forma earnings reports is said to value relevant. Landsman, Miller and Yeh (2007) assert that pro forma earnings figures accurately reflect a firm’s true earning power. Stock prices correspond to the street earnings numbers compared to GAAP earnings. Similarly, a study carried out Wieland, Dawkins and Dugan (2013) indicated that pro forma earnings figures demonstrate great value than GAAP earnings. The findings from the study demonstrated that uniformly calculated earnings measure is a more useful and consistent indicator of future earnings and current performance. Wieland, Dawkins and Dugan (2013) confirmed that compared to pro forma earnings, GAAP earnings are more linked stock returns an aspect that indicates that pro forma earnings is not an imperative improvement over GAAP earnings. However, Albring et al (2010) found out that pro forma earnings is significantly and positively linked to stock returns and process. Pro forma earnings is more likely to be stressed over GAAP earnings when a firm’s earnings have reduced value relevance. This is a clear indication that pro forma earnings are value relevant. More so, pro forma earnings portray improved performance. Based on the Spotless Group, pro forma earnings figures have helped the firm to demonstrate an improved performance (Binsted 2015). In addition, the utilisation of pro forma earnings by the Spotless Group has helped the firm to obtain greater media exposure. As a result, the stock market has responded well to the relative emphasis in the press release. The pro forma earnings posted by the Spotless Group has augmented the firm’s potential to acquire other firms. The improved performance of the firm is as a result exclusion of some charges, which include restricting charges, and use of earnings before interest, depreciation, amortisation and tax. A research carried out by Wieland et al (2007) indicated that pro forma earnings are value germane. The results were attributed to uniform and consistent treatment of non-recurring adjustment that are made to GAAP income. The study indicated that uniformly calculated earnings measure is a more useful and consistent indicator of a firm’s current performance and prospective earnings. Analysts’ exclusion of stock expense from pro forma earnings enhances the predictability of future earnings. Venter, Emanuel and Cahan (2014) confirm that headlines earnings exclusion hold altered incremental value relevance. This suggests that headline earnings are a good summary measure of the performance of a firm. According to Venter, Emanuel and Cahan (2014), the enhanced relative and incremental value relevance of pro forma earnings is pronounced for companies with farthest exclusions of headline earnings. Although pro forma earnings figures are value relevant and provide current, accurate, detailed and simplified financial information, I think that firms should not use pro forma earnings. This is because different firms use diverse descriptions of non-GAAP earnings instead of a consistent definition. These practices compromise the comparability of pro forma earnings. Through pro forma earnings, managers change current recurring expenditures into unusual items to augment mainstay earnings. Such endeavours engender negative unusual items that are demanding and overpower the purpose of reporting using pro forma. More so, pro forma earnings figures are confusing and misleading to investors. Scores of investors fail to comprehend the implications of pro forma earnings exclusions for prospective earnings leading them into not pricing some elements of earnings correctly. Additionally, pro forma earnings figures can be manipulated to cast a positive light on a firm’s performance and can be affected by a firm’s governance leading to scandals such as the Enron scandal. However, Acts such as the SOX can be used to regulate pro forma earnings reporting to enhance the reliability and accuracy of corporate disclosures (Entwistle, Feltham & Mbagwu 2006). Conclusion Managers and analysts may view the spread of deliberate non-GAAP earnings as an endeavour aimed at offering the essential difference between non-recurring and persistent components of earnings. Investors who require comprehensible, simplified and current financial reporting strongly depend on a firm’s pro forma reports. Pro forma earnings entail anticipated earnings founded on a set of assumptions. It is a firm’s financial statement that leaves out anything that managers believe obscures the exactness of its financial position. Firms used pro forma earnings to provide their shareholders with accurate information. Additionally, firms use pro forma earnings to act in response to the market place needs and to attain to meet and manage analysts’ earnings forecasts. Pro forma earnings are essential as they offer current, detailed and simplified financial information of a firm besides helping shareholders in evaluating the operating opportunities of their businesses. However, use of pro forma earnings is detrimental because it generates abnormal returns and misleads investors. However, pro forma earnings figures are value relevant because they accurately reflect a firm’s factual earning power. References Albring, S, Caban-Garcia, M & Reck, J 2010, ‘The value relevance of a non-GAAP performance metric to the capital markets’, Review of Accounting and Finance, Vol. 9, No.3, pp. 264–84. Baker, H & Nofsinger, J 2010, Behavioural finance: Investors, corporations and markets, UK, John Wiley & Sons. Berger, P 2005, ‘ Discussion of ‘Are investors misled by pro forma earnings’, Contemporary Accounting Research, vol.22, no.4, pp. 965-976. Binsted, T 2015, ‘Spotless eyes acquisitions among the resources wreck’, The Age (24 February 2015) Accessible from http://www.theage.com.au/business/spotless-eyes-acquisitions-among-the-resources-wreck-20150223-13mwre#ixzz3kYcowXDQ [ 2 September 2015]. 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