The pro forma method is sometimes used by publicly traded companies to prepare financial statements. When utilizing the pro forma method, companies frequently deviate from Generally Accepted Accounting Principles (GAAP) to present things in the most advantageous light. This can be misleading for the uninformed investor.
Under the pro forma method, financial statements are adjusted in a calculated effort to highlight certain points and overlook others. For example, pro forma earnings numbers exclude various charges the company may not want investors to see. The pro forma method is often applied to income statements, balance sheets and statements of cash flow. When financial results are reported using both pro forma and GAAP, GAAP-based financial statements provide a clearer picture of a company’s financial health.
The SEC requires most publicly held companies to files statements using specific accounting conventions, known as Generally Accepted Accounting Principles (GAAP). Because of the consistency it requires, GAAP makes it easier for investors to track the reported earnings of a company from quarter to quarter and year to year. GAAP-based financial statements also enable investors to more accurately compare the stock of one company with that of another. Because of SEC requirements for publicly traded companies such as Amazon.com, many investors naturally expect that the financial statements they release will be in compliance with GAAP. But while such companies do prepare the necessary statements to meet SEC requirements, the statements presented to investors are often prepared using the pro forma method.
Publicly traded companies understand that disappointing earnings can cause the value of a company’s stock to plummet. In order to avoid this result, many companies emphasize pro forma results and deemphasize those in compliance with GAAP. Some companies even neglect to report GAAP results, preferring the pro forma method exclusively. Because of the potential of the pro forma method to mislead investors, the Securities and Exchange Commission (SEC) issued a warning about the pro forma method of accounting. While the SEC warns against pro forma statements, it does not ban their use.
Financial statements prepared using the pro forma method may be based on assumptions that are not in accordance with GAAP, with the end result being that the statements themselves do not present an accurate financial picture. Pro forma statements tend to highlight the most positive information, often failing to account for costs or charges that may be of interest to investors. Examples of eliminated charges include depreciation, unsold inventories, amortization, stock-based compensation and acquisition-related expenses. Interest expense and taxes are sometimes even left out.
If you see the phrase “pro forma” on any financial statements you are reviewing, look for a footnote or explanation of what is and is not included in the pro forma figures. In some cases, a reconciliation between GAAP and statements prepared with the pro forma method are provided so you can see what the changes have been. If the company is publicly traded and GAAP-based statements have not been provided, you can download a free copy of the company's GAAP-based financial statements that were filed to meet SEC requirements from the SEC's website.