Pro Forma Earnings Reports Get New Scrutiny

Heard the one about the “pro forma” corporate golf game? You drop your five worst holes, then total your score.

As third-quarter earnings-reporting season dawns, Congress and regulators have made it clear they want companies to stop “spinning” their announcements to downplay potential bad news. And one of the principal targets of the earnings-honesty campaign is the so-called pro forma profit calculation.

The Sarbanes-Oxley corporate reform law that took effect in July requires companies that report pro forma results -- profit excluding certain charges -- to show how they compare with earnings that strictly follow U.S. accounting rules. The act also forbids companies from issuing news releases that omit “material” facts.

The Securities and Exchange Commission expects to propose a rule this month that spells out the requirements of the law.

The National Investor Relations Institute, an association of corporate investor relations officers, urged companies last week to voluntarily comply with reporting guidelines that the group said can “help restore investor trust and confidence” in the wake of the deluge of accounting scandals this year.

Among other steps, the investor relations institute said companies should lead off their quarterly earnings news releases with net income as measured by generally accepted accounting principles, or GAAP, and report any pro forma results secondarily.

“The quality of earnings releases is all over the map,” said Louis Thompson, president of the institute.

“You can certainly argue about the analytical merits of pro forma, but there has been enough abuse that it’s no longer an accounting issue -- it’s a corporate credibility issue,” Thompson said.

Earnings season starts in earnest this week with 160 of the companies in the blue-chip Standard & Poor’s 500 index expected to report.

Pro forma results, which typically omit certain write-offs and non-cash charges, often make companies appear more profitable than earnings based on GAAP.

Many companies say pro forma numbers often are the best way to track how their basic businesses are performing, unaffected by one-time gains or charges.

Analysts, too, say pro forma numbers can paint a truer picture of a firm’s operations. After mergers, for example, pro forma data help investors make meaningful comparisons as if the companies had been combined previously.

But regulators and critics say many companies have gone too far, abusing the lack of clear pro forma reporting guidelines to make their numbers look good by excluding too many expenses. Cynics joke about “recurring non-recurring charges,” which show up seemingly every quarter, and “EBBS: earnings before bad stuff.”

The SEC has been concerned about pro forma results since before Sarbanes-Oxley: In December, the agency issued an alert warning companies about misleading the public using non-GAAP numbers.

Companies already may be shifting away from pro forma reporting, at least gradually. At the end of 2001 about 48% of companies were issuing pro forma results along with GAAP numbers, but in the second quarter of this year that total fell to about 40%, according to the investor relations institute’s surveys.

Fewer than 20% of companies list pro forma results first in their news releases, Thompson said. Those companies in recent quarters have included such firms as Irvine-based semiconductor maker Broadcom Corp. and Cypress-based HMO PacifiCare Health Systems Inc.

“We’ve always provided reconciliation with GAAP numbers, both verbally and in charts, but it’s important to show the results that investors and analysts really care about, which in our case is pro forma,” said Suzanne Shirley, vice president of investor relations at PacifiCare. “Analysts want an apples-to-apples look at the ongoing operations.”

She said she would be willing to list GAAP numbers first, though no decision has been made about the company’s third-quarter release.

Broadcom did not return calls seeking comment.

Other firms, including Walt Disney Co., have shifted within the last year to reporting GAAP earnings first, listing pro forma results later in their releases, even before the investor relations institute’s initiative.

“It was an evolution consistent with calls in the public arena to display the information this way,” Disney spokesman John Spelich said.

Chuck Hill, research director at Boston-based earnings tracker Thomson First Call, said companies have gotten more forthright in their quarterly earnings reports -- to a point.

“That problem is improving but not as fast as it might. I would think in this scandal-plagued environment that companies would be bending over backward to help the investment community,” Hill said.

He said stock analysts share the blame because many have been shoddy “gatekeepers.”

Case in point: In its quarterly report issued Oct. 4, Alcoa Inc.’s write-off for shutting down a smelter should “at least have been questioned by the analysts,” Hill said. “Hey, guys, that’s part of doing business. Business may be slow right now because of the economy, but you’re still in the aluminum business.”

Alcoa led its earnings release with profit excluding the smelter write-off, though the company immediately thereafter reported results with the write-off included.

Hill also said the investor relations institute guidelines could go further, specifically urging companies to spell out “step by step” any differences between pro forma and “as reported” earnings.

“There’s nothing wrong with adjusting GAAP numbers. A lot of times it’s desirable,” Hill said. “But when you leave the trail from GAAP to pro forma, it’s your obligation to show exactly how you got from Point A to Point B.”

He said that currently, for example, a company might report 50 cents a share in net income for a quarter, but 60 cents in operating profit, excluding a total of 10 cents a share from an asset sale, a restructuring charge and an inventory write-down. But if the company doesn’t break out the three write-offs individually, analysts and investors can’t adjust the results as they see fit, Hill said.

He hopes the SEC addresses this loophole, which he said it left open in its December alert.