In January 2001, I wrote an article about the spreading use of pro-forma accounting and, more specifically, the use of pro-forma reporting in earnings releases. The bottom line: a growing number of US companies, particularly acquisitive technology companies, were pushing beyond the original intent of pro-forma reporting. Instead of simply excluding from their pro-forma earnings the cost of goodwill amortization or charges taken for large restructurings, companies were excluding – or including – a host of questionable items that many observers argued were not one-time or non-operational events. Even worse, some were providing sloppy or misleading disclosure of their pro-forma results.
At the time, there was plenty of hand-wringing but little agreement about what exactly should be done to try to stem or improve pro-forma reporting and who should do it. A year, it seems, can make quite a difference.
Over the last several months, there has been a tremendous shift in attitudes towards accounting, both inside and outside the financial community. The latest recession has certainly had a lot to do with the change (even financial gimmickry cannot hide plunging earnings). Another factor is the widespread distrust of analysts who recommended buying the very stocks now hovering on the brink of delisting. And finally, there is the fallout from the demise of Enron and Global Crossing amid questionable-to-illegal accounting procedures.
All of this has led to a deepening crisis of confidence among investors and a lack of patience when it comes to pro-forma or as if results. It has also pulled the subject of accounting from the backwaters of the financial pages, where it tended to draw the same amount of attention as the latest prices for pork bellies and native steer, and dropped it down on page one.
International contagion
The new limelight has yielded a number of results, from new guidelines to working groups dedicated to sorting out accounting abuses (see below, Milestones). But just as pro-forma accounting is coming under increased scrutiny in the US, corporate America’s appetite for pro-forma reporting seems to be spreading across the Atlantic, with large cap, established companies, including Nokia and Vivendi, releasing pro-forma results.
According to Edinburgh-based Company Reporting, an independent financial research company, of the 400 or so large and mid-sized UK companies the firm sampled from 1999 to 2001, the proportion issuing pro-forma accounts increased by 50 percent, from 6 percent to 9 percent. The results showed that the incidence among larger companies jumped even more dramatically.
Nearly all of the instances of pro-forma accounts appeared in annual reports, rather than earnings releases, and most were used to address major events such as purchases or disposals of businesses or companies, according to Company Reporting.
In the UK, financial statements fall under the Accounting Standards Board’s mandate, which in the early 1990s produced a standard for reporting the profit and loss account and, specifically, instances where management issues an alternate per-share profit. But the jurisdiction doesn’t extend to earnings news releases.
‘We can only say, if you’re doing this near the financial statements, you must explain the differences and make sure the alternate figure is not more prominently displayed. That’s as far as we can go. We can’t stop companies from putting out pro-forma statements. The UK Financial Services Authority doesn’t have the powers that the SEC does,’ says Allan Cook, technical director at the Accounting Standards Board.
The situation is similar in continental Europe, where pro-forma accounts in regulatory filings are not unusual. But as in the UK, few have embraced pro-forma earnings releases. One reason is that unlike Americans, the European investing public isn’t as maniacally focused on earnings releases, let alone quarterly results, which are anyway less prevalent in Europe.
‘Normally we don’t do it,’ says Wouter van de Putte, IR Manager at Royal Philips Electronics. ‘Sometimes we discuss pro-forma figures internally or externally if we’ve done an acquisition, but it doesn’t appear in presentations or press releases. In some instances, an analyst may ask for pro-forma information, and we may give them specific figures. We do know others use pro-forma reporting, especially in the US, but as of now, we don’t see any need to do so.’
European regulators, wary of the trends that tend to drift over from the US markets, are keeping an eye on pro forma. At both the Committee of European Securities Regulators (CESR) and the International Organization of Securities Commissions (Iosco), the issue is receiving more attention than publicly acknowledged.
Says one insider familiar with the discussions, ‘Within the CESR, there is a permanent working group on accounting issues. The subcommittee on enforcement is working on a survey of the rules in each member state of the CESR [EU-countries, plus Norway and Iceland]. Pro-forma reporting is one of the items. Iosco is also dealing with pro forma or so-called non-Gaap earnings measures. Its technical committee has several standing committees working on different issues concerning securities regulation, and is considering a public statement on guidelines for pro-forma reporting in earnings releases.’
Back on the farm
In the US, the debate over pro forma is far more advanced given its prevalence and abuse. The remedies being discussed or implemented have, for better or worse, grown in large part out of the Enron disaster. Since the Houston-based energy trader’s demise, investors have been punishing companies for opaque accounting practices. This has prompted companies that once dictated the terms of their disclosure to provide investors with more information.
‘I think more companies are using pro forma. But there is more disclosure of how it’s calculated. The recent statements from GE and IBM about disclosing more detail of their accounting are also a positive that comes in the wake of Enron,’ says Eric Von der Porten, manager of Leeward Investments, a hedge fund in San Carlos, California.
Another development expected to improve the way companies employ pro forma is FASB’s long-awaited rule change: as of January 1, 2002, companies no longer have to amortize goodwill, including goodwill recorded in past business combinations. In effect, the rule-maker has removed one very large reason for companies to issue pro-forma results.
‘The recent FASB rules regarding goodwill amortization should significantly close the gap between reported operating earnings and net earnings, since the primary variable for many companies has been large non-cash expenses related to the amortization of goodwill. We’ve always taken a very conservative approach by amortizing our acquisition-related goodwill over a three-year period, which has significantly affected our net income results due to the large non-cash expense,’ explains Cnet Network’s vice president of investor relations, Robert Borchert.
Von der Porten, who has been a vocal critic of pro-forma abuses in the past, agrees that the change in goodwill amortization rules will apply some pressure to help create positive change. ‘I think there was a tendency for companies to exclude lots of other things,’ he suggests. ‘Without that big charge, it’s more glaring when you’re excluding many little things.’
One sign of the rule change’s significance is that US fiber optics giant Corning recently announced it would stop issuing pro-forma results. According to Katherine Dietz, vice president of IR, the company no longer sees the need for pro forma now that it won’t have to account for goodwill amortization. ‘Our definition of pro forma was very straightforward. When they got rid of goodwill, we didn’t find the need to use it. Before we started using pro forma, we would always break out extraordinary items like restructuring costs. So now what we’re doing going forward is reporting the Gaap number, then saying, this number includes such and such charge for restructuring.’
Standardizing non-Gaap
The removal of goodwill amortization reduces the gap between pro-forma and Gaap earnings, but it will probably not, even in the long run, stop companies from issuing non-Gaap earnings, Corning notwithstanding. This is especially true for those companies in Europe following international accounting standards that still have to contend with goodwill amortization. But it is also true for US companies trying to remove from their results what they view as non-operating expenses.
Andrew Kramer, the director of investor relations at Chelmsford, Massachusetts-based Sycamore Networks, hopes some bad apples won’t spoil it for everyone. ‘I think the biggest key to Gaap versus pro forma is being able to provide reconciliation so investors understand what you’ve taken out and what you are or aren’t including,’ he says. ‘That’s very important. As long as the reconciliation is clear and transparent, pro forma is very useful.’
But no matter how well disclosed and employed, a company’s pro-forma results remain slave to each company’s own interpretation of the very broad accounting methodology. This has led some to call for a standardization of these measures, whether they’re called operating earnings or pro-forma earnings, with the most notable initiative coming from Standard & Poor’s (see below, Milestones).
‘The response has been both broader than we expected and generally, very positive,’ says David Blitzer, chief investment strategist and director of quantitative services for Standard & Poor’s. ‘We’ve heard from a few companies, some of the big investment banks and staff at the SEC, and we also got informal feedback from the House Financial Services Committee. The response across the board is that people agree there needs to be a standard. But no-one wanted to step up and put the issue on the table.’
Not everyone is applauding the plan, however. ‘It’s a nice idea on the surface to standardize everything, but it doesn’t work in real life. Until FASB defines these items better than they do now – asset sales, for example, and restructuring – it’s too hard to say what should be excluded or included. If you try to standardize it anyway, analysts are going to make adjustments no matter what, so you’re just adding another layer from which analysts will make adjustments,’ says Chuck Hill, director of research at First Call.
As Hill points out, some companies use the term restructuring and apply it to a slowing or failed business unit, such as an internet division that imploded. Others use it in reference to a business line they’re exiting as part of clear change in business focus. The latter is the proper usage, according to Hill.
Despite his pessimism over standardization, Hill says he does hold out hope that improvements can come. But he’s putting his bet on the rule-makers: ‘The fact is, with the pro-forma issue, we’re talking about earnings that people use to value the stock, and that will always take analysis. But can we make progress with FASB? Hopefully.’
For his part, Blitzer, believes that in the post-Enron climate, the will is there to set up a standard that removes the disparity in collected earnings figures.
He may be right: in March, Merrill Lynch announced it is telling its analysts to use a variety of ways – and a standard is in development within the firm – to better review companies’ financial performances rather than relying on the companies’ pro-forma numbers.
For now, Standard & Poor’s proposal is just that. Blitzer says the firm will institute the plan once it has all the data it needs and there is final agreement on the definition of operating earnings. Regardless of whether or not companies comply, Standard & Poor’s will be able to calculate the figure from SEC filings.
But Blitzer also points out that nothing is a cure-all for Enron-like disasters: ‘Based on what I’ve seen in the press about Enron, it looks like fraud, not analytical issues. If someone wants to, they can report Gaap fraudulently. Nothing we’re doing would enable people to prevent what happened at Enron.’
Milestones
April 2001 – Financial Executives International (FEI) and the National Investor Relations Institute (Niri) issue joint guidelines for pro-forma reporting, calling for greater transparency and reconciliation of Gaap and pro-forma numbers (see www.niri.org).
November 2001 – Standard & Poor’s announces its intention to standardize the way it defines operating earnings, a measure similar to pro-forma earnings in that certain items are included or excluded which would otherwise not be allowed under Gaap. Under the proposal, items such as stock option expenses, for example, would have to be included in operating earnings, though many companies now exclude this item in their pro-forma numbers.
December 2001 – The SEC, which had embraced the FEI/Niri guidelines, issues ‘cautionary advice’ to companies. The commission notes that touting misleading pro-forma financial metrics in earnings news releases that lack proper disclosure on the methodology behind the metrics could result in civil fraud lawsuits. Echoing the FEI/Niri guidelines, it advises companies to provide ‘clear and comprehensible explanations of the nature and size of the omissions’ so as not to mislead investors (Canadian regulators issue similar guidelines soon after).
January 2002 – The SEC discloses it had slapped Trump Hotels & Casino Resorts with its first enforcement action for improper use of pro-forma earnings in a third-quarter 1999 earnings release. According to the SEC, the company failed to disclose that an unusual $17.2 mn gain allowed it to beat Wall Street estimates. The SEC signaled a wider crackdown on the use of pro-forma results.
February 2002 – SEC officials publicly call on FASB to quickly improve accounting standards in order to close loopholes. Accounting rule-maker FASB, as well as the International Accounting Standards Board, have task forces working on a host of performance accounting issues, including pro-forma earnings.
