Pro Forma Madness

Adam Hamilton    August 17, 2001    4248 Words


As we have all learned firsthand in the last couple years, some of us through great financial pain, all is never as it seems on Wall Street.  The financial news establishment, brokerages, mainstream analysts, and others with a vested interest in the US equity markets perpetually paint a sunny and happy picture.  No matter what happens, investors are always urged and prodded to buy, buy, buy more stocks.


Since the NASDAQ crashed from its stratospheric peak in March of 2000, there has been a literal deluge of bullish propaganda spewing forth from the prominent stock market perma-bulls.  During every inch of the steep plunge, the whole excruciating slide from 5000 all the way down to the sub-2000 levels today, the retail investor has been continually warmly reassured that an economic recovery and major rally is right around the corner.  The Wall Street establishment has chased this elusive financial pot of gold like a destitute leprechaun.


While Wall Street continued to extol the virtues of US stocks, ignore stellar valuations, and persuade people never to sell, US investors watched their portfolios gorily hemorrhage in value.  The “don’t worry be happy” bubblevision band nonchalantly played on as investors’ hard-earned scarce capital was ground into the dirt and obliterated.


Because of this epidemic of supposedly objective analysts and media pundits eschewing honor and integrity in a mad rush to sell out for profits, the credibility of the Wall Street establishment is plunging to abysmal new depths.  Analysts are now being sued in droves as investors learn that extremely bullish buy recommendations on grossly overvalued companies were trumpeted right before huge and lucrative investment banking deals were signed between the analysts’ employers and the companies the analysts were supposedly objectively covering.  These filthy arrangements stink to high heaven and are absolutely inexcusable.


The financial media is just as culpable as the mainstream analysts.  Widely degenerated as bubblevision, the various financial news media outlets continually spike stories that are negative on the markets or that do not comfortably fit into the popular pantheon of bullish New Era mythology.  The financial networks are totally dependent on corporate advertisers for their revenue streams.  If they report negatively on companies or Wall Street, they are well aware that those very companies and their peers will spend far less money buying commercials.  Hence, honor and integrity in financial journalism have largely taken a back seat to outright intellectual prostitution to Wall Street and the fantasy ideal of ever-rising equity markets.  Profits have become the new financial media goal, not transparent reporting of truth.


It is no big surprise that cheerleader financial analysts and hyper-positive journalists who refuse to report the truth are increasingly being perceived in their true deceptive light by the public.  The average retail investor has been paralyzed into inaction since the NASDAQ crash by the sweet words of honey dripping from the lips of these parties up to their necks in conflicts of interest.  After over a year of non-stop catastrophic losses with scarcely a word of warning to head for safety, the Wall Street information dissemination people and organizations are rapidly plunging down into that no-man’s land of public antipathy previously reserved for smooth-talking used-car salesmen, bloodsucking lawyers, and lying politicians.


One group of financial professionals has so far largely escaped the harsh glare of the public spotlight, however.  These men and women have an enormously important role and are entrusted with the custodianship of the single most critical information stream for any investor.  Through many decades of hard and honest work, these professionals have painstakingly built up great trust with the American investor.  Tragically, they now seem ready to throw it all away and join the sold out analysts and huckster mainstream financial journalists.  They are the accountants.


When contemplating any investment, the two single most important factors to consider are valuation and cashflow.  Before deploying any scarce capital whatsoever, all investors should first analyze these two holy grails of investing.  It only makes sense to buy investments that are fundamentally undervalued and that can spin off enough cash to provide a healthy rate of return for their owners.  The realm of valuation is the domain of the analyst, but as we mentioned they have prostituted their honor for investment banking profits and have lost virtually all remaining shreds of credibility.  Wall Street analysts for the most part have violated our trust as investors and can no longer be trusted to provide clean and objective valuation analysis.


The realm of cashflow is the domain of the accountant.  Accountants prepare financial statements which are supposed to provide a materially accurate representation of the true financial picture of publicly traded United States corporations.  Investors place enormous reliance and trust on accountants to be objective and honest, to simply report solid numbers that are not tainted by the constant desires of corporate management and Wall Street to perpetually engineer results that are glowingly positive.  Accountants are trusted by investors to provide accurate earnings information that can be safely used in the complex investment decision-making process.  Over the long-term, earnings and cashflows converge into unity so accounting profits are a critical proxy for cashflow, one of the two most important factors for investing.  Accountants are the guardians of the financial statement reporting world and are commissioned to protect investors from false or misleading information flows from publicly traded companies.


Accountants have an incredibly important job, as they are often the only bulwark of defense between overzealous or even unscrupulous corporate management and the private investor.  There is an inherent asymmetry of information availability between investors and corporate management, with investors having only small scraps of publicly available information and corporate management holding all the cards.  Accountants help level that playing field. 


In addition, accountants are expected to distill highly complex economic realities into standard financial statements that even an unsophisticated investor can begin to accurately interpret after a little instruction.  Accountants have been relied upon for many decades to provide truthful financial information to investors to enable them to make prudent decisions for their capital.


Before we dive any deeper, I would like to share some relevant personal background information with you.  I am a Certified Public Accountant.  I began my career working as an auditor for one of the elite international accounting partnerships now known as the Big Five.  During my tour of duty with the elite accounting firm, my projects included performing audits of publicly traded companies.  I have spent a lot of time dealing with internal accountants such as corporate CFOs and Controllers, as well as extensive trafficking in the world of the auditor.  I believe my professional experiences grant me a unique perspective into the current accounting world of which most investors do not have the benefit.  I also have almost always held my profession in high esteem, because as a private investor I feel I can almost always trust accountants to provide good solid numbers, especially in their audited financial statements.


Once proud of my initial profession, I have become deeply disturbed by the behavior of some of my peers in the last couple years.  Rather than staying true to the noble ideals of our old profession, both internal corporate accountants and external auditors seem to have knowingly violated the trust of the investor, the ultimate and most-important consumer of their work.  Like a fiat currency, accountancy that has degenerated so far that it cannot maintain the public trust rapidly approaches worthlessness.


Unfortunately, many accountants have begun to desert their ideals in droves and bend over backwards in the pursuit of profits and personal gain.  Both corporate accountants and public accountants seem to have conspired to look the other way and allow companies to play a dangerous and deceitful game with their earnings.  This diabolical stratagem of information warfare and propaganda is known as “pro forma” earnings and is rapidly becoming rampant.


The massive Webster’s dictionary definition of pro forma is “indicating hypothetical financial figures based on previous business operations for estimate purposes”.  Pro forma financial statements are usually income statements that are based upon estimates and guesses instead of hard historical accounting data.


Pro forma financial statements do have a valid purpose, and they are used all the time internally by venture capitalists and analysts trying to financially model “What if?” scenarios.  In my old university days, we even called pro forma financial statements “what ifs”.  They are very useful for internal financial modeling or helping very sophisticated professional investors understand certain hypothetical future scenarios.  Pro formas are designed to be internal decision support tools and historically were not publicly disseminated or at least were buried deep in the bowels of a financial report footnote well after the normal proper accounting financial statements.


Today, however, pro forma financial statements are wrongfully being reported by companies in their official quarterly earnings results press releases.  What was once a tool of economic fantasy and speculation has been strangely twisted into a new financial alternate-reality.  And these same hypothetical pro forma press releases are being aggressively heralded by the Wall Street analysts and media establishment as official earnings results.  The sad net consequence is investors are being misled into accepting management estimates and guesses as rock-solid fact in lieu of financial statements prepared with proper accounting conventions.  The potential consequences of this practice for both investors and accountants could be catastrophic.


In order to gain a better perspective on the naked deception of public headline pro-forma financial statements, it is important to understand proper financial statements, known as GAAP financial statements.  The acronym GAAP stands for Generally Accepted Accounting Principles.  GAAP financial statements are expected to present to investors the economic facts of the existence and operations of an enterprise fairly, clearly, and completely.  GAAP are a group of excellent standards that have been carefully and thoughtfully developed since the 1930s based on past accounting industry experience and continual improvement.  In many ways, GAAP is to accounting what common law is to the legal fields of endeavor, a rigorous and accepted set of standards that represents the core of accumulated learning and expertise on clean accounting.


GAAP financial statements are what you will see in annual reports of companies that have been signed off on by public accountant auditors, as well as what companies are required by law to report to the United States Securities and Exchange Commission every quarter.  They are painstakingly constructed by internal accountants each quarter and once a year are carefully analyzed and validated by external public auditors.  These GAAP financial statements have to be fairly presented and materially accurate by law.  Failure to properly construct GAAP financial statements with an attempt to mislead the investor can lead to criminal charges including fraud brought by the SEC and can lead to heavy fines or even prison time for corporate management or public accountants involved.  GAAP is THE accounting standard, by practice and by law.


Since quarterly GAAP financial statements for publicly traded companies are required by the SEC, one would assume that companies would simply report their GAAP earnings results directly to investors since they have to prepare these financial statements by law each quarter anyway.  Unfortunately, this is not the case anymore for many prominent US companies, especially tech stock market darlings.  Many have resorted to nefarious strategies of outright deception and trickery by reporting hypothetical pro forma results in their press releases while at the same time stealthily filing the real, and often far different, GAAP results with the SEC.


Not surprisingly, the hypothetical pro forma earnings reported by publicly traded companies ALWAYS make their results look better than they really are per standard GAAP accounting practice.  The general fruits of headline pro forma financial statements inevitably provide a false picture of larger profits or smaller losses, making the companies’ results appear better than they really are to the average investor.  These miraculous additional profits are achieved by corporate management selectively handpicking expenses to exclude from the income statement.  Typical targets for extermination from pro formas to manage earnings results include investment losses, costs for acquisitions of other companies, and research and development expenses.


In the halcyon days before the NASDAQ bubble imploded, many prominent US companies maintained large investment portfolios.  They used extra cash provided by investors or earned from operations to buy trading stakes in other publicly traded companies.  As the stock markets were rising, these gains in the short-term investment portfolios of US companies were often included in reported pro forma earnings numbers, as they increased headline profits reported.  As the bubble has begun bursting, however, now companies deploying pro formas have often excluded their investment losses from their earnings per share reported.  They reason that investing losses have nothing to do with core business operations, so therefore they may be excluded from the pro forma reported results.  Some huge companies like Cisco Systems do not include investment gains and losses in their pro forma earnings, while others like Intel do.


A loss is a loss is a loss.  As an investor I don’t care if managers of my companies lose money through operations, investing, or any other activity.  If they are losing money consistently on any front, I want to know about it.  I know from innumerable discussions with other investors worldwide that they feel the same way and do not want losses that management is embarrassed about hidden and ignored by the headline pro forma earnings per share numbers.  Investors knowingly take on substantial risks, and they need clean, solid accounting information, not some management fantasy about how things should have been.


Another popular item for exclusion from pro formas is acquisition related costs.  When a company buys another company, it almost always pays far, far more than the book value of the assets of the company it is acquiring.  This difference is known as goodwill, basically the costs paid for a company in excess of what is reported on its balance sheet. 


In the go-go days before the bubble burst, many high-flying companies would issue stock as fast as the Federal Reserve prints fiat currency, with the issuing companies using the new stock to try to buy other companies to grow their empires, often at ridiculously inflated prices.  As it becomes clearer that most of these acquisitions are worth nowhere near what was originally paid, companies are writing off goodwill at a frantic pace.  The relatively small JDS Uniphase, for example, recently reported the biggest annual corporate loss in world history, $51 BILLION with a capital “B”, largely because of overpriced acquisitions management had made that turned sour as the stock market imploded.


Research and development is also a popular expense for management to exclude from pro forma results to cushion profits and is also a good example of other types of expenses that are often ignored for pro forma purposes.


Per GAAP accounting, there are basically two destinations for expenses.  The primary destination is the income statement, which is logical.  If a company spends money, it generally goes to the income statement as a current expense that reduces income.  If the company believes that future benefits will accrue from an expenditure, however, it can be capitalized, that is placed on the balance sheet as an asset.  An example is prepaid insurance.  If a company buys a one year insurance policy, it will probably capitalize the portion of the premium paid that will not be used up in the current month or quarter.  By turning an expense into an asset by shunting it into the balance sheet, a company can boost its profits in the near-term as that expense is prevented from flowing through the income statement until the benefit of from the expenditure is finally realized in the future.


With research and development expenses many companies try to capitalize as much as possible in order to boost quarterly earnings when the expenditures are made.  This is a key management tool for managing quarter-to-quarter earnings by strategically tweaking a sometimes large expense to push it onto the balance sheet to keep near-term income higher.  Then, in the future, they may either flush those expenses through the income statement slowly or all at once if the R&D looks like it will prove futile.  These R&D expenses are often excluded from pro forma income statements in order to make earnings look higher and more appealing to investors.


In general, any expenses that corporate management does not want to report to investors and that can in any conceivable way be divorced from operations are often ignored and excluded from pro forma financial statements when reporting headline results.  Of course, the supposedly objective financial news services dutifully report and parrot the pro forma results rather than wait for the GAAP earnings that are sent to the Securities and Exchange Commission.  Through this widespread reporting of fanciful fuzzy numbers, corporate managements’ pro formas are sometimes moving market prices dramatically.


As outgoing SEC Chief Economist Lynn Turner has sagely pointed out, pro forma earnings are effectively EBS earnings, “everything but the bad stuff”.  The SEC is well aware of the deceptive nature of pro forma earnings and will probably be forced to crack down sooner or later to bar companies from reporting whimsical pro forma estimated numbers to investors while at the same time reporting solid GAAP numbers to the SEC.  The practice just reeks of outright investor manipulation and propaganda since the same hypothetical pro forma numbers are not acceptable to the SEC.


Even more incriminating for the managements disseminating this pro forma nonsense as quarterly earnings headlines, the delta between pro forma earnings and real GAAP numbers can be vast.  One well-known example occurred recently with Computer Associates.  The company reported Q4 2000 earnings of 42 cents per share on a pro forma basis.  The market was ecstatic and bid up the stock quite dramatically on the ultra-bullish press release.  Later, in its GAAP financial statements submitted to the SEC, Computer Associates reported not a 42 cents per share profit, but a 59 cents per share LOSS in the SAME quarter.  Talk about misleading.


One of the companies that has spearheaded the pro forma and whole “creative accounting” movement all along is, the king bubble of the infamous craze.  Amazon has never made a single penny of profits in its entire existence.  So far, it has basically been a reader welfare program where investors pony up their scarce capital to subsidize the sale of books below cost to avid readers like myself.  It is a wonderful service for its customers, who pay lower than normal prices for books, but an unmitigated disaster for its investors.  Amazon has long been a leading advocate of wild and loose accounting aggressively tailored to mislead investors and paint a far rosier picture than proper GAAP accounting itself would allow.


For instance, in Q2 2001, Amazon had a GAAP loss of 47 cents per share.  Did it report this ugly number to investors?  Heck no.  Using pro forma financial wizardry, Amazon management brazenly reported only a 16 cents per share loss, conveniently exceeding Wall Street expectations.  Even worse, the folks at the helm of Amazon continually jawbone about their target date for “pro forma profitability”!  Basically, they are saying they will be profitable some day if investors allow management to get away with excluding expenses they don’t want to report.  What a farce!


Many of the large, popular market darlings are using similar pro forma tactics to obscure and overstate their earnings on a quarterly basis to meet Wall Street expectations and mask the deteriorating economic realities of their businesses.  And this latest bit of creative accounting is not even considering more conventional earnings management schemes continually employed such as establishing accounting slush funds to strategically pad profits or forcing sales into different reporting periods to manage results.  All is not as it seems on the earnings front and pro forma madness is obscuring the real profit picture for many US companies.


The bitter net result of these abhorrent and dishonorable behaviors by corporate managements manifests itself on several fronts. 


First, pro forma madness seriously degrades trust in the financial system by investors.  In our modern, highly complex, inter-related global economy, trust and confidence are still ultra-important attributes.  Without trust, deals are not consummated.  As more and more US corporations choose to abandon sound accounting for public reporting purposes, the critical investor faith in managers, analysts, the financial media, and Wall Street is waning dramatically. 


Investors are rational adults, they are willingly placing their scarce capital at risk, and they need and deserve honest, real information, not some manufactured smoke screen laid down by corporate managers, who are ultimately their employees.  Investors can handle the naked truth on earnings without embellishment.  If they can’t, they shouldn’t be investors.  Any act that continually weakens investor trust in the system is bad for stocks in general and undermines confidence that is critical for the future of the US financial markets.


Second, for the accounting profession for which I used to have so much respect, pro forma madness is destroying the public esteem and trust in accountants.  Internal corporate accountants, many of whom have achieved CPA designations, are signing off on these press releases and aiding in the creation of these fanciful pro forma results designed specifically to mislead the investor.  The CFOs and Controllers engaged in this practice are in effect selling out their own honor and that of our profession for short-term personal gain, whether it is financial via stock options or whether it is simply comfort-zone related by caving in to heavy pressure to manage quarterly earnings.  These actions are already seriously damaging public trust in the custodians of the financial statements, the accountants.  When the lawsuits start to fly as more and more investors realize they have been duped by falsely overstated pro forma earnings results, the public antipathy for the accounting profession which aided and abetted this scheme will grow dramatically.


The public auditors, while not responsible for quarterly financial statements, also bear some of the blame.  Auditors could simply refuse to audit public companies that report earnings other than the GAAP results that the auditors would be willing to sign off on.  Even though audits are not performed quarterly, public accounting firms could refuse to work for clients who report quarterly results to the public different from what they report to the SEC.  While this is not likely to happen in the money hungry Big Five, it would be a great accounting industry step forward to force accountability from its clients.  It would also help protect the public accounting firms from the blizzards of lawsuits that will be coming once the average investor understands the pro forma deceptions to which his or her capital has been wrongfully exposed.


As everyone knows who has ever had their trust violated in any way, trust is an extremely valuable yet fragile commodity.  Trust can take years and decades to build up, yet it can all be torn down in a single day through a few misleading or careless acts.  Once trust is lost, it can again take decades to rebuild, if it is ever attainable again.  The accounting profession, by being overwhelmingly silent on this pro forma quarterly earnings result garbage, is violating the crucial investor trust it has carefully earned over decades.  It is also setting itself up for a big fall and virtually guaranteeing much stricter government regulation of accounting in the future.


So what is an investor to do?


First, zealously ignore all corporate press releases on earnings, or at least dig deep and find the GAAP earnings results, not the fanciful “as if” pro forma nonsense.  If that information is not disclosed in the press releases, wait a week or two for the formal quarterly or annual GAAP numbers filed with the Securities and Exchange Commission by the company in question to see the real numbers.  You can go to, click on the “EDGAR” link, and search directly in the SEC database for the filings containing GAAP numbers by the company whose earnings you are interested in.  Although SEC filings are confusing at first, you can often search for “EPS” or “Earnings per Share” and immediately find the GAAP number you are looking for within a particular 10-K (annual) or 10-Q (quarterly) filing.


Second, be extremely skeptical of earnings results reported by the financial media.  In our fledgling Information Age, information moves spectacularly fast, at the speed of light, and all the news organizations compete to be first to report new earnings announcements.  In order to disseminate new earnings numbers as rapidly as possible, most of the mainstream financial media outlets race to report initial pro forma results as those are usually the first numbers available.  Don’t believe what you hear on bubblevision, but verify the earnings numbers against the actual GAAP results reported to the SEC.


The bottom line is all this pro forma madness has to stop.  It is bad for investors, bad for the stock markets, bad for the companies doing the earnings manipulation, and bad for the accounting profession. 


I plead with my fellow accountants who work in corporations or in public audit firms to put your foot down and not allow your employer or client to coerce you into reporting something that is patently misleading.  Investors have entrusted us with a tremendous responsibility in providing them with solid GAAP numbers, and we owe it to the investors to always provide clean materially accurate numbers with honor and integrity.


Adam Hamilton, CPA     August 17, 2001     Subscribe at