Proper pro

forma reports
By Gary Entwistle, CA,
Glenn Feltham, CMA, and
Chima Mbagwu

Pro forma earnings reports may have their

place but make sure your company uses them
properly. By considering a few basic best
practices, this shouldn’t be difficult

anagers have the discretion to report restructuring charges) of $0.50 per share.

M alternative, ‘pro forma’, earnings meas-

ures in their company’s earnings press
releases. These pro forma measures,
which aren’t audited, are typically
determined through adjustments to
GAAP-based earnings. For example, a manager may
choose to present an alternative measure of earnings
that excludes one-time items. Consider the following
scenario. A company reports a loss for the period of
$1.50 per share under GAAP. During the period, it
wrote off under-performing assets and engaged in
restructuring activities totaling $2 per share. The man-
agers may believe that it’s more informative to discuss
the company’s performance without considering these
write-offs and restructuring charges. Consequently, in
addition to presenting the GAAP-based loss of $1.50
per share, the manager may choose to disclose a pro
forma earnings measure (earnings before write-offs and
Recently, managers’ reporting of pro forma earnings
has come under close scrutiny for two reasons. First,
there is a perception that managers are increasingly dis-
closing these alternative measures. Our recent study
supports this perception — we found that 42% and
77% of large Canadian and U.S. firms, respectively,
reported pro forma measures in their annual earnings
press releases. Second, there has been considerable
debate about managers’ intentions when reporting pro
forma measures. Do managers disclose pro forma earn-
ings to inform or mislead investors? Managers generally
claim that pro formas are used to provide information
not otherwise provided through traditional GAAP
earnings — that they are providing value relevant infor-
mation. It has been argued elsewhere that managers
have a strategic motive for reporting pro formas — to
manage investors’ perceptions of firm performance.
It’s generally accepted that pro formas shouldn’t be

C M A MA N AG E ME NT 26 June/July 2004
used to manage perceptions or to mis-
lead. Further, there is a common belief
(among managers and securities regula-
tors) that pro formas, if used properly,
can inform investors. However, guid-
ance for managers of what constitutes
best practice is disparate; that is, it’s
unclear how pro formas should be pre-
sented so that it informs rather than
misleads. By focusing on three sources
— regulation, industry guidelines, and
an analysis of more than 1,000 earnings
press releases — we attempt to synthe-
size and expand on best practice for
reporting pro forma earnings.
Sources for best practices
The first source we examined in
developing best practice is
securities regulation. To
address the concern that man-
agers may be using pro forma
earnings to manage expecta-
tions or to mislead investors,
the leading securities commis-
sions in Canada and the U.S.
recently introduced pro forma
regulations. The OSC in 2002
issued Staff Notice 52-303,
entitled “Non-GAAP Earnings
Measures”1, while the SEC in
2003 issued “Conditions for
Use of Non-GAAP Financial
Measures”2. These regulations
don’t prevent managers from
reporting pro forma earnings;
rather, they are aimed at ensur-
ing adequate transparency in
such reporting, and in reducing
(or preferably eliminating) the
possibility that investors will be misled
by pro forma earnings.
As a second source for defining best
practice, we examined financial industry
guidelines. Financial Executives
International (FEI) and the National
Investor Relations Institute (NIRI),
both important players in the financial
markets, have recently issued guidance
to help ensure the appropriate report-
ing of pro forma earnings.3
The final source used to develop
best practice is the annual earnings
press releases of large companies in
Canada and the U.S. We analyzed the
press releases of more than 1,000
Canadian and U.S. companies — those
listed on the Canada S&P/TSX 300
and the U.S. S&P 500 for the years
2001 to 2003.
Best practices
The following best practices for report-
ing pro forma earnings come from an
analysis of these three sources. These
best practices have a central purpose —
to ensure that investors will not be
potentially misled through pro forma
reporting. Note that very few of the
more than 1,000 earnings press releases
Pro forma reporting best practices
Overriding objective
Pro formas should be used to provide value-relevant
information - they should never be used to manage investor
expectations or to potentially mislead investors
Best practices
1. Explain why investors should care about the pro forma
measure (i.e., why it’s value relevant)
2. Provide a reconciliation of pro forma earnings to GAAP
earnings
3. Prepare pro forma earnings on a consistent basis, or clearly
state any change in method
4. Don’t use GAAP terminology to describe a pro forma
measure
5. Place greater, or at least equal, emphasis on GAAP
earnings as you do on pro forma
examined followed all of these best
practices. We believe that almost all the
releases we examined could have been
improved by following these practices.
The overriding objective for report-
ing pro forma earnings should be to
provide value-relevant information. For
pro forma information to be value rele-
vant, it must help predict the future
earning power of the company. In con-
trast, providing pro forma information
to manage expectations — for example,
to help meet or exceed analysts’ fore-
casts — is a strategic motive that could
potentially mislead investors.
C MA MAN A G E ME NT 27 June/July 2004
Let us discuss in turn each of the
specific best practice recommendations.
To illustrate, we will refer to Inco
Limited’s 2003 annual earnings press
release, which reflects many of these
best practices.4
1. Explain why investors should care about
the pro forma— For investors to
properly evaluate pro forma meas-
ures, they have to understand its
purpose, so it’s important that man-
agement provide investors with a
rationale for the use of these meas-
ures (i.e. how this information is
value relevant). Very few firms in
our sample (both in Canada
and the U.S.) provided an
explanation for the inclusion of
a pro forma measure. Inco
Limited’s 2003 release, howev-
er, did provide one. Their
release describes why a pro forma
measure (adjusted net earnings)
is used and states that certain
items were excluded because
“the timing or extent of such
items... do not reflect or relate
to our ongoing operating per-
formance.” They then provid-
ed a discussion of the nature of
these excluded items.
— To
2. Provide a reconciliation
understand the nature of the
pro forma measure, it’s impor-
tant that investors recognize
exactly how it differs from
GAAP earnings. Pro forma
earnings should therefore
always be accompanied by full rec-
onciliation to GAAP earnings. This
reconciliation should show all the
adjustments that are made to
GAAP-based earnings to arrive at
the pro forma measure. It’s also
important that this reconciliation be
presented in tabular form, as is done
in Inco Limited’s 2003 release. Note
that most firms in our sample that
used pro forma provided a full
reconciliation to GAAP.
3. Prepare pro forma on a consistent basis
— To allow for a meaningful com-
parison of results over time, it’s
 important that management deter-
mine pro forma earnings on a basis
consistent with prior periods, or
explain any changes in the composi-
tion of the pro forma earnings measure.
That is, for comparative purposes, the
nature of adjustments should remain
consistent across periods. For exam-
ple, Inco Limited made similar
adjustments (backing out one-time
items) to calculate its pro forma meas-
ures in 2002 and 2003. In our sample,
there is evidence that many firms
didn’t measure pro forma earnings
consistently from year to year, nor did
they adequately disclose how the
determination of the pro forma meas-
ure had changed.
4. Do not use GAAP terminology — Pro
forma earnings shouldn’t be
described using traditional GAAP
terminology, as investors may mistak-
enly believe the measure is GAAP
earnings. Such terms as net income
and earnings per share (EPS) shouldn’t
be used to refer to pro formas. While
our research found a large number of
cases in which companies used GAAP
terminology to refer to pro forma
earnings, the number declined from
2001 to 2003. (Note that, consistent
with this best practice guidance, Inco
Limited’s 2003 release did not use
GAAP terminology in describing its
pro forma measure.)
5. Place greater, or at least equal, emphasis
on GAAP earnings— GAAP earnings
are determined based on a set of
accepted accounting rules and are
subject to the annual audit process.
The principle purpose of earnings
releases has historically been, and
continues to be, the release of this
information. Therefore it’s impor-
tant that GAAP earnings receive at
least equal prominence by manage-
ment when discussing the firm’s per-
formance for the period. We suggest
that this prominence exist both in
the headline of the press release, as
C MA MA N AG E ME NT 28 June/July 2004
well as in the accompanying narra-
tive. Note that contrary to this best
practice recommendation, Inco
Limited’s 2003 release provides
greater prominence to its pro forma
measure, both by placing it prior to
GAAP earnings, and discussing it in
greater depth.
Conclusion
To ensure that financial markets oper-
ate in an efficient manner, investors
must be provided with useful (i.e. value-
relevant) information. Managers have
argued that pro forma earnings meas-
ures provide such value relevant infor-
mation to investors, allowing them to
better evaluate firm performance.
However, these pro forma earnings
measures also have the potential to mis-
lead investors. This concern has been
expressed by securities regulators, and is
consistent with our analysis of past and
current practice. Managers must ensure
that their pro forma measures will not
potentially mislead — otherwise, their
use may be prohibited through future
regulation. The guidelines presented in
this article can assist managers in ensur-
ing that the presentation of pro forma
measures in their earnings releases are
not potentially misleading. ■
Glenn Feltham, CMA, (glenn_feltham@umanitoba.ca) is
professor, Dean, and CA Manitoba Chair in Business
Leadership at the I.H. Asper School of Business,
Universtiy of Manitoba. Gary Entwistle, CA, is an
associate professor and Meyers Norris Penny Scholar in
the department of accounting at College of Commerce,
University of Saskatchewan. Chima Mbagwu is in the
department of accounting, College of Commerce,
University of Saskatchewan.
The authors would like to acknowledge the diligent
research assistance provided by Jacqueline Woods.
Funding for the full study was provided by Deloitte &
Touche, the Canadian Academic Accounting Association,
and the Social Sciences and Humanities Research Council.
Endnotes
1 Available online at:
www.osc.gov.on.ca/en/Regulation/Rulemaking
/Notices/csanotices/2002/csan_52-
303_20020107_non-gaap-earn.htm.
2 Available online at:
www.sec.gov/rules/final/33-8176.htm.
3 Available online at: www.niri.org/
irresource_pubs/alerts/EA20020117.cfm.
4 Available online at:
http://www.inco.com/investorinfo/news/defaul
t.asp?year=2004&posting_id=2276