In the late 1990s, certain firms emphasized pro forma earnings in their press releases over GAAP earnings figures. Managers sometimes offer these numbers to the media claiming they represent a truer picture of future earnings than standardized GAAP earnings. But in the post-2000 period, with the subsequent market crash, economic recession and high-profile accounting scandals, standard setters and policymakers were concerned with the practice because the pro forma numbers given by companies were non-standard and ad hoc. “A debate raged between managers, regulators and the financial press about the integrity and the motivations of pro forma reporting,” co-author and SMU Cox Accounting Professor Neil Bhattacharya says.  His paper “Who Trades on Pro Forma Earnings Information?”, written with Ervin Black, Theodore Christensen and Richard Mergenthaler, reveals that less sophisticated investors, primarily individuals, trade on pro forma numbers, therefore raising issues for public policy.

At the time of this debate on pro forma numbers, anecdotal evidence and rhetoric was the only support available versus any rigorous empirical analysis. Bhattacharya explains, “We couldn’t find any real research about it. So we published a first paper in the Journal of Accounting and Economics in 2003.” Pro forma numbers, being called by managers “a current earnings number,” is different from GAAP earnings numbers. Companies started issuing these earnings figures because of non-recurring items that are not relevant to earnings in future periods, they claimed. Bhattacharya continues, “So managers claimed that for future forecasting (offering information for trading), GAAP is not good and the market should focus on pro formas.” According to Bhattacharya, “The difference with pro forma numbers is that it’s a free-for-all, with managers adding to and subtracting from GAAP figures.” Managers claimed that they were voluntarily providing another metric that was better. But regulators and other academics tackling the issue wondered if this was just “spin.”

In their most recent paper, Bhattacharya and his co-authors studied the market reactions surrounding pro forma earnings announcements between January 1998 and December 2003. They found that market reactions were almost exclusively attributable to less-sophisticated, individual investors. They used trade sizes as a proxy for investor sophistication—smaller trades indicate the smaller, less-informed investors, while larger trades reflect the larger sophisticated investors. This is a well-accepted convention in academia.

So what should be done about the practice of firms issuing pro forma earnings information? “We are not pushing a policy prescription. We find that mostly the individual or naïve investor trades on pro forma information. What’s suspicious is that sophisticated investors are not using pro forma earnings numbers; they’re going by street earnings from analysts.” This raises an important policy question: Since the sophisticated investors—those who know the market mechanisms and financials much better—are not trading, are pro forma figures value-relevant information?

The study finds that not only are sophisticated investors absent, but that only smaller investors are trading en masse, which is worrisome to Bhattacharya. With baby boomers retiring and trying to manage their own 401(k)s and IRAs individually, that leaves a good deal of retirement funds at risk. “If one of the explicit goals of standard setters and regulators is to protect the interest of the individual investor, they should be concerned by some of this evidence,” Bhattacharya notes.


Listening to the Street

Findings show that the sophisticated institutional traders tend to rely more heavily on street earnings analysis than GAAP figures. Bhattacharya explains, “We know that GAAP figures have ‘noise’ and it tries to maintain conservatism. While this is probably more reliable, it may not be best for future forecasting.” The market believes the street numbers are more relevant for forecasting future earnings, but they don’t place much value on managers’ numbers that are volunteered, i.e., the pro forma numbers.

An earlier paper by Bhattacharya and his colleagues found that in the late ’90s it was the technology and dot-com firm that were mainly pushing out pro forma numbers. Smaller firms were reporting pro formas more so than large firms. If you’re an IBM, there is so much publicly-available information, that it serves no purpose for the manager to offer pro forma numbers when you’re heavily analyzed anyway. According to Bhattacharya, firms that report pro formas generally have less than two or three analysts tracking these firms, while blue-chip firms such as IBM are typically followed by 15 to 20 analysts.


Future for Pro Formas

Pro forma reporting increased from 1998 to mid-2000, and then declined after the stock market crash. They came back up but again dropped off dramatically in the third quarter of 2003 after Sarbanes-Oxley, which required explicit reconciliation between pro forma and GAAP earning figures. Pro formas have been on the rise again since 2003.

New regulation effective January 2003, Regulation G, will improve the standardization of pro forma statements. Bhattacharya explains, “Now we might see more genuine pro forma numbers. There may be some good managers who were trying to honorably provide value-relevant information in the past, but most of the bad ones outweighed the well-intentioned ones in our study period.” The authors plan future research and will collect more data between 2004 and 2006 to determine whether Reg G is accomplishing its goals. “So we may see an increase in pro formas if managers are trying to offer numbers that are better for forecasting; the regulations’ effort to standardize pro forma reporting may help the cause of the well-intentioned managers,” Bhattacharya summarizes.

Firms will have choices about how to show their pro forma figures and implement Reg G. Bhattacharya and colleagues will comb through thousands of press releases again to compare pre- and post-Reg G periods. They will see if the market reacts differently to these new and improved pro formas, and find out whether the market (especially sophisticated investors) find them more believable. “If Reg G provides a path toward better reporting of pro forma earnings, we’ll see institutional interest in the post-period,” he says. This will be good information for the SEC, as it has requested independent research to help determine whether  Reg G is beneficial.

“Who Trades on Pro Forma Earnings Information?”, by Neil Bhattacharya, Ervin Black, Theodore Christensen and Richard Mergenthaler, was published in The Accounting Review, May 2007.

 
Written by Jennifer Warren.