Informative or misleading?

By Gary Entwistle, Glen Feltham & Chima Mbagwu

While Pro forma reporting has some restrictions, there is still a lot of reporting flexibility

There is a perception that managers are increasingly reporting non-GAAP earnings measures — colloquially referred to as pro formas — in their firms’ earnings press releases, and that these pro forma measures may potentially mislead, as opposed to inform, investors. While there are US studies of pro forma reporting, Canadian practice, until now, remained unexplored.

EXCERPTS FROM EARNINGS PRESS RELEASE Income climbs 17% to $1.7 billion, before special items, income taxes and goodwill amortization Net income for the year amounts to $390.9 million Body of release Income before special items, income taxes and goodwill amortization for the year increased 17% to $1.7 billion, compared with $1.4 billion on the same basis for the preceding year. Earnings per share before special items and goodwill amortization rose to $0.81, a 16% increase compared with $0.70 on the same basis for the previous year. After the net effect of the special items and goodwill amortization, net income for the year reached $390.9 million, or $0.27 per share, against a net income of $975.4 million, or $0.70 per share last year.

Reconciliation:
Income before special items, income taxes, and goodwill amortization	$1,674.7
Special items	(1,070.2)
Income taxes	(167.0)
Goodwill amortization	(46.6)
Net income	390.9
*underline and bold added

A recent Canadian study examined the reporting of pro forma earnings by TSX S&P 300 firms.¹ The objectives of the study included identifying the extent to which Canadian firms used pro forma earnings, the types of adjustments made to GAAP earnings, and whether the pro forma earnings were given precedence (i.e., highlighted) in the earnings press release. The study also examined the income effect of the pro forma measure, and the possible motives for pro forma reporting.

To conduct the research, the firms’ actual earnings press releases were examined (see release example below using pro forma earnings re- porting). In the release, the company reported a GAAP-based earnings measure — net income — of $390.9 million. In addition, it also reported a pro forma (i.e., non-GAAP) measure of earnings — income before special items, income taxes and goodwill amortization — of $1.7 billion, an amount 4.3 times greater than GAAP earnings.

In response to concerns about pro forma reporting, the Ontario Securities Commission (OSC) in 2002 issued Staff Notice 52-303, entitled “Non-GAAP Earnings Measures.”² This notice advised managers that pro forma earnings reporting should not have the potential to mislead investors as to the performance of the company for the period. To help reduce this potential, the OSC recommended that firms clearly reconcile pro forma to GAAP earnings and that they ensure any pro forma earnings are determined on a basis consistent with prior periods. Note in the earnings press release, management is clearly adhering to each of these recommendations.

Existing pro forma research
The existing pro forma research, all based on US data, has found mixed support for the two motives for reporting pro forma earnings — to manage expectations (and potentially mislead investors) or to inform. Consistent with the first motive, empirical evidence indicates firms that report pro forma earnings may do so to help exceed analysts’ earnings forecasts,³ to compensate for negative earnings surprises,⁴ and to focus attention away from a GAAP loss and toward a pro forma profit.⁵ Experimental research has also found that unsophisticated investors can be significantly influenced by the reporting of a pro forma result.⁶

In terms of the competing motive — to provide additional value relevant infor-mation to investors (i.e., to inform) — researchers have found that pro forma earnings are more representative of the firm’s core earnings than are comparable GAAP measures,⁷ are more closely associ-ated with the firm’s stock price,⁸ and are more predictive of future earnings.⁹

Canadian study
To extend the pro forma research into the Canadian setting, we examined the reporting of pro forma earnings by firms listed on the TSX S&P 300 index. Specifically, we read and analyzed each firm’s annual earnings press release. Our research revealed that more than four in 10 (42%, 121 of 290 firms) of Canada’s leading, publicly traded firms reported pro forma earnings in the annual earnings press release.¹⁰ We also found that a number of different descriptors for the pro forma earnings measure were used, the most common (31%) being net income excluding or before various items. Other descriptors included operating cash earnings (14%), net income from continuing operations (13%), and adjusted net income (9%). The actual term “pro forma earnings” was used in only 6% of cases.

The Canadian firms’ reported pro for-ma measures were derived using three main types of adjustments to GAAP earnings (typically income-increasing adjustments). The most common (33%) related to adjusting GAAP earnings for costs related to major business reorganization activities including restructurings, mergers or acquisitions. This was followed by adjustments for what firms described as one-time or non-recurring items (28%) such as gains or losses from the settlement of lawsuits. The third most common adjustments are accounting-motivated (19%). This includes adjusting GAAP earnings for various non-cash expenses (e.g., amortization), or for actual changes to accounting standards.

In comparing the firms’ pro forma and GAAP earnings, we found where a firm reports pro forma earnings, it is presented (i.e., highlighted) in the headline of the press release in approximately one quarter (26%) of cases. Newswire services pay special attention to these headlines. In terms of the full earnings press release, the pro forma earnings dominates (relative to GAAP earnings) the discussion of firm performance (i.e., is the focal point of discussion) in nearly two out of every three cases (65%). In examining the income affect of pro forma, in three out of four cases (75%), pro forma earnings were greater than GAAP earnings, with an average increase over GAAP earnings of 62%.

Finally, in considering the possible motives for reporting pro forma earnings, consistent with US studies, we found that Canadian firms were more likely to report pro forma earnings where its GAAP results failed to meet or exceed analysts’ earnings forecasts; this suggests that managers may be using pro forma in a strategic manner (i.e., to manage expectations or potentially mislead versus to inform). However, we failed to find evidence that firms strategically reported pro forma earnings to compensate for poor performance relative to past results, or relative to the performance of competitors in the same industry.

Conclusion
High-quality and informative earnings information is clearly of great importance to investors, and to the integrity of capital markets. To allow managers to provide such information, securities regulators, both in Canada and the US, permit managers to report proprietary (pro forma) measures of earnings in addition to earnings determined in accordance with GAAP. While there are some regulatory restrictions as to how this pro forma information is to be presented, there remains significant reporting flexibility.¹¹ Whether this flexibility is being used by managers to inform, or to mislead the market, continues to be in question.

Based on our research, a large percentage of Canadian firms (42%) report pro forma earnings. Further, this reporting takes various forms, usually results in a significantly greater earnings measure than under GAAP, and may be strategically used to manage market expectations. In future research, we plan to track these and other Canadian firms’ pro forma reporting practices over time, and to perform additional analyses to further determine the motives underlying pro forma earnings reporting.

Gary Entwistle, CA, is an associate professor and the Meyers Norris Penny Scholar in the department of accounting at the University of Saskatchewan. Glenn Feltham, CMA, is professor, dean and the CA chair of business leadership at the University of Manitoba. Chima Mbagwu is in the department of accounting at the University of Saskatchewan

Technical editor: Michel Magnan, PhD, FCA, associate dean, external affairs, Lawrence Bloomberg chair in accountancy, John Molson School of Business, Concordia University

Notes
1.  Full study is available from Gary Entwistle (entwistle@commerce.usask.ca). It was made possible by a research grant from Deloitte & Touche and the Canadian Academic Accounting Association.
2.  Staff Notice 52-306, which supercedes 52-303, can be found at www.osc.gov.on.ca/Regulation/
Rulemaking/Current/Part5/csa_20031121_52-306_revised.pdf.
3.  Bhattacharya, N., Black, E., Christensen, T., and Mergenthaler, R. (2004) “Empirical Evidence on Recent Trends in Pro Forma Reporting,” Accounting Horizons, 18 (1):27-43. Also, Doyle, J. and Soliman, M. (2002) “Do Managers Use Pro Forma Earnings to Exceed Analyst Forecasts and Avoid Losses?” Unpublished, University of Michigan.
4.  Lougee, B., and Marquardt, C. (2004) “Earnings Quality and Strategic Disclosure: An Empirical Examination of ‘Pro Forma’ Earnings,” The Accounting Review (forthcoming).
5.  Bowen, R., Davis, A., and Matsumoto, D. (2004). “Emphasis on Pro Forma versus GAAP Earnings in Quarterly Press Releases: Determinants, SEC Intervention and Market Reaction,” unpublished, University of Washington and Washington University.
6.  Elliot, W. (2003) “Emphasis and Information Display of Non-GAAP Earnings Measures: Effects and Professional and Non-Professional Investor Judgements and Decisions,” unpublished manuscript, University of Washington. Also, Frederickson, J., and Miller, J. (2004) “The Effects of Pro Forma Earnings Disclosures on Analysts and Nonprofessional Investors’ Equity Valuation Judgments,” The Accounting Review, forthcoming.
7.  Bhattacharya, N., Black, E., Christensen, T., and Larson, C. (2003) “Assessing the Relative Informativeness and Permanence of Pro Forma Earnings and GAAP Operating Earnings,” Journal of Accounting and Economics, 36 (1-3); 285-319.
8.  Bradshaw, M., and Sloan, R. (2002) “GAAP versus the Street: An Empirical Assessment of Two Alternative Definitions of Earnings,” Journal of Accounting Research, 40(1): 41-66. Also, Brown, L., and Sivakumar, K. (2001) “Comparing the Quality
of Three Earnings Measures,” unpublished manuscript, Georgia State University.
9.  Brown and Sivakumar (2001).
10.  At the time of the study, there were 297 firms listed on the TSX S&P 300 index. Data was not available for seven of these. The 290 firms had fiscal year-ending between February 1, 2001 and January 31, 2002.
11.  The SEC issued in 2001 “Cautionary Advice Regarding the Use of Pro Forma
Financial Information in Earnings Releases,” available at: www.sec.gov/rules/other/33-8039.htm. More recently, and prompted by the Sarbanes-Oxley Act, the SEC issued in 2003 updated guidance, “Conditions for Use of Non-GAAP Financial Measures,” available online at: http://www.sec.gov/rules/final/33-8176.htm.