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In legitimate cases, pro forma financial statements take out one-time charges to smooth earnings. However, companies can also manipulate their financial results under the guise of pro-forma financial statements to provide a picture that is rosier than reality.
Let's take a closer look at what pro-forma financial statements are, when they are useful and how companies can use them to dupe investors.
What Are Pro-Forma Earnings? Pro-forma earnings describe a financial statement that has hypothetical amounts, or estimates, built into the data to give a "picture" of a company's profits if certain nonrecurring items were excluded.
Pro-forma earnings are not computed using standard GAAP and usually leave out one-time expenses that are not part of normal company operations, such as restructuring costs following a merger.
Such an expense can be rightfully viewed as a one-time item that does not contribute to the company's representative valuation. Essentially, a pro-forma financial statement can exclude anything a company believes obscures the accuracy of its financial outlook, and it can be a useful piece of information to help assess a company's future prospects.
Every investor should stress GAAP net incomewhich is the "official" profitability determined by accountants, but a look at pro-forma earnings can also be an informative exercise.
Pro forma earnings figures are inherently different for different companies. There are no universal guidelines that companies must follow when reporting pro forma earnings, which is why the distinction between pro forma and earnings reported using GAAP is very, very important.
GAAP enforces strict guidelines that companies must follow when reporting earnings, but pro forma figures are better thought of as "hypothetical," computed according to the estimated relevance of certain events and conditions experienced by the company.
Basically, companies use their own discretion in calculating pro forma earnings, including or excluding items depending on what they feel accurately represents the company's true performance.
For example, net income does not tell the whole story when a company has one-time charges that are irrelevant to future profitability. Some companies therefore strip out certain costs that get in the way. This kind of earnings information can be very useful to investors who want an accurate view of a company's normal earnings outlook, but by omitting items that reduce reported earnings, this process can make a company appear profitable even when it is losing money.
We like to call pro forma the "everything-but-the-bad-stuff earnings. Because traders and brokers focus so closely on whether the company beats or meets analyst expectations, the headlines that follow a company's earnings announcements can mean everything.
And, if a company missed non-pro-forma expectations but stated that it beat the pro-forma expectations, its stock price will not suffer as badly; it might even go up - at least in the short term.
Problems with Pro Forma Despite the positive reasoning behind pro-forma statements, there are many ways in which pro-forma earnings can be manipulated. Items often left out of pro forma figures include the following: The theory behind excluding non-cash items such as amortization is that these are not true expenses and therefore do not represent the company's actual earnings potential.
Amortization, for example, is not an item that is paid for as a part of cash flow. But under GAAP, amortization is considered an expense because it represents the loss of value of an asset. See What is the difference between amortization and depreciation?
One-time cash expenses are often excluded from pro forma because they are not a regular part of operations and are therefore considered an irrelevant factor in the performance of a company's core activities.
Under GAAP, however, a one-time expense is included in earnings calculations because, even though it is not a part of operations, a one-time expense is still a sum of money that exited the company and therefore decreased income. Sometimes companies even take unsold inventory off their balance sheets when reporting pro-forma earnings.
Of course it does, so why should the company simply be able to write it off? It is bad management to produce goods that can't be sold, and a company's poor decisions shouldn't be erased from the financial statements.
The Securities and Exchange Commission SEC will investigate companies suspected of trying to deceive investors in the pro-forma modification of earnings. Read more about how companies are regulated in Compliance: The Price Companies Pay. This isn't to say companies are always dishonest with pro-forma earnings; pro forma doesn't mean the numbers are automatically being manipulated.Instead of saying an income statement, you say it's a pro-forma income statement.
Sometimes they might say, it's a projected or a forecasted statement, but it takes the same exact skills that. Pro-forma financial statements are also prepared and used by corporate managers and investment banks to assess the operating prospects for their own businesses in the future and to assist in the.
Review the Capstone Project Assignment Directions for additional information. Write the Financial Plan for your organization ( word maximum). Create the accompanying spreadsheet(s) and address the following in your plan: Using Excel, create a three-year Pro Forma income statement for your organization (or product/service)%(2).
A pro forma financial statement is a report prepared base on estimates, assumptions, or projections. In other words, it’s not an official GAAP statement issued to investors and creditors to relay information about past company performance.
How Do You Create a Pro Forma Income Statement To create a pro forma income statement, work from your current Income statement and try to predict the future changes. Sit down with an income statement from the current year. Capstone Project- MGT A pro forma income statement is a projection of future business profits and losses.
It allows the business to make operational changes that could affect the actual outcome before the projections are reality.