For fans of JDS Uniphase Corp., the fibre-optics manufacturer with headquarters in Ottawa and San Jose, Calif., the report for fiscal 2001 provided the icing on a very delicious cake: following an uninterrupted series of positive quarterly earnings results, the corporate giant announced it was set to deliver US$67 million in pro forma profit.

There was only one fly in the ointment. Like all such calculations, JDS's pro forma numbers were not prepared in accordance with generally accepted accounting principles (GAAP), and as such they excluded goodwill, merger-related and stock-option charges, and losses on investments. Once those items were added back into the accounting mix, JDS suddenly showed a staggering US$50.6 billion in red ink - a US corporate record. Even so, many investors remained loyal, placing their trust in the boom-market philosophy that views onetime charges as largely irrelevant. The mantra was simple - operating results rule.

"That was the view at the time," says Jim Hall, a Calgary portfolio manager with Mawer Canadian Equity Fund. "It just goes to show how wrong people can be."

Since then, of course, the spectacular flameout of Houston's Enron Corp. has done much to change that point of view (though it's not a pro forma issue). Once the world's largest energy trader, the company now holds the title for the largest bankruptcy case in US history. The Chapter 11 filing in December came after Enron had to restate US$586 million in earnings because of apparent accounting irregularities. In its submission, the company admitted it had hidden assets and related debt charges since 1997 in order to inflate consolidated earnings. Enron's auditor, accounting firm Arthur Andersen LLP, later acknowledged that it had made "an [honest] error in judgement" regarding Enron's financial statements.

While the Enron saga will continue in various courtrooms for many months to come, regulators on either side of the border have responded to the collapse with uncharacteristic swiftness. Both the Securities and Exchange Commission (SEC) in the United States and the Canadian Securities Administrators (CSA) issued new guidelines on financial reporting just a few weeks after the Enron bust. In each instance, investors were reminded to redirect their focus to financial statements prepared in accordance with GAAP, paying special attention to cash flow, liquidity and the intrinsic value of acquisitions. At the same time, issuers were warned to reduce their reliance on pro forma results and to explain to investors why they were not using GAAP in their reporting.

SEC chairman Harvey Pitt moved furthest and fastest. In mid-January he announced plans to establish a private watchdog to discipline accountants and review company audits. Working with the largest accounting firms and professional organizations such as the American Institute of Certified Public Accountants (AICPA), the SEC wants the new body to be able to punish accountants for incompetence and ethics violations. As Pitt emphasized, "The commission cannot, and in any event will not, tolerate this pattern of growing re-statements, audit failures, corporate failures and investor losses."

The sheer scale of the Enron debacle has brought pro forma accounting under public scrutiny as never before, and, observers say, will provide a powerful impetus for financial reporting reform. "This will send a message to companies and accountants to cut back on some of the games they've been playing," says former SEC general counsel Harvey Goldschmid.

Meanwhile, the CSA (the forum for the 13 securities regulators of Canada's provinces and territories) expressed its concern over the proliferation of non-standard measures, warning that they improve the appearance of a company's financial health, gloss over risks and make it exceedingly difficult for investors to compare issuers.

"Investors should be cautious when looking at non-GAAP measures," says John Carchrae, chair of the CSA Chief Accountants Committee, when the guidelines were released in January. "These measures present only part of the picture and may selectively omit certain expenses, resulting in a more positive portrayal of a company's performance."

As a result, Canadian issuers will now be expected to provide GAAP figures alongside non-standard earnings measures, explain how pro forma numbers are calculated, and detail why they exclude certain items required by GAAP. So far, the CSA has provided guidance rather than rules, but the committee cautions it could take regulatory action if issuers publish earnings reports deemed to be misleading to investors.

Carchrae, who is also chief accountant of the Ontario Securities Commission (OSC), believes "moral suasion" is a good place to start. Nonetheless, he adds, the OSC intends to track press releases, cross-reference them to statutory earnings filings and supplemental information on websites, and monitor continuous disclosure to ensure a company meets its requirements under the securities act.

Although pro forma reporting finds itself in bad odour, until recently it was regarded as a useful tool that could help companies show performance when unusual circumstances might cloud the picture. In cases involving a merger or acquisition, for example, where a company has made enormous expenditures that generate significant non-cash expenses on the income statement, pro forma can be used as a clarifying document, enabling investors to view economic performance outside of such onetime events. Over the years, however, the pro forma route has increasingly involved the selective use of press releases, websites, and other reports to put a favourable spin on earnings, often leading to a spike in the value of a firm's stock. Like management discussion and analysis, such communications are not within the ambit of GAAP, falling somewhere between the cracks of current accounting standards.

"Obviously, this issue is of concern to everyone who uses financial statements," says Paul Cherry, chairman of the Canadian Institute of Chartered Accountants' Accounting Standards Board. "Our worry as standard-setters is whether these non-GAAP, pro forma items confuse or enlighten."

Regulators and standard-setters have agonized over this issue ever since the reporting lexicon began to expand with the rise of the dot-com sector in the late 1990s, a sector with little in the way of earnings that concentrated on revenue growth as a more meaningful performance indicator. New measures, such as "run-through rates" or "burn rates," were deemed welcome additions to traditional methodology because they helped determine how much financing a technology company might require during its risky startup phase.

Critics, however, argued such terms were usurping easily understood language as part of a corporate scheme to hoodwink unwary investors. Important numbers were hidden or left out under a deluge of new and ever-more complex terminology. The new measurements, they warned, fell short of adequate financial disclosure.

An OSC report published in February 2001 appears to support these claims. According to the report, Canadian technology companies have not provided investors with adequate information about how they disclose revenue, a shortcoming that may require some of them to restate their financial results.

"Initial results of the review suggest a need for significant improvement in the nature and extent of disclosure," the report states, adding that the OSC wants more specific notes on accounting policy attached to financial statements. The report also observes that revenue is often recognized when goods are shipped, not when they are sold, despite the fact that the company may be exposed to returns.

David Wright, a software analyst at BMO Nesbitt Burns in Toronto, says dealing with how technology companies record revenue is a perennial issue. The issue has gained greater prominence with the rise of vendor financing, a practice whereby companies act as a bank to buyers, lending customers the cash to complete purchase orders. If the customer is unable to pay for the goods or services subsequent to signing the sales agreement, the seller's revenue can be drastically overstated.

But pro forma still has plenty of advocates - particularly when it comes to earnings before interest, taxes, depreciation and amortization (EBITDA). Such a measure, it is often argued, can provide a pure, meaningful and reliable diagnostic tool, albeit one that should be considered along with figures that accommodate charges to a balance sheet.

Ron Blunn, head of investor relations firm Blunn & Co. Inc. in Toronto and chairperson of the issues committee of the Canadian Investor Relations Institute, says adjusted earnings can serve a legitimate purpose and are particularly helpful to analysts and money managers who must gauge the financial well-being of technology startups.

The debate shows no signs of burning out anytime soon. On the one hand, the philosophy among Canadian and US standard-setters in recent years has appeared to favour removing constraints, rather than imposing them. New rules to apply to Canadian banks this year, for example, will no longer require the amortization of goodwill in earnings figures. On the other hand, it has become abundantly clear that companies will emphasize the reporting method that puts the best gloss on their operations. And while the use of pro forma accounting has remained most prevalent among technology companies, the movement to embrace more and varied language has spread to "old economy" companies such as Enron, gaining steam as the economy stumbled. Blunn theorizes the proliferation of nontraditional reporting and the increasing reliance on supplemental filings simply reflect the state of the North American economy.

Carchrae has a slightly different diagnosis. When asked why pro forma reporting has mushroomed in recent years, he points to investors' slavish devotion to business box scores - that is, a company's ability to meet sales and earnings expectations as set out by equity analysts. Since companies can be severely punished for falling short of the Street's consensus forecast, there is intense pressure, especially in a bear market, to conjure up earnings that appear to satisfy forecasts.

As a result, pro forma terminology has blossomed over the Canadian corporate landscape. Montreal-based telephone utility BCE Inc., for example, coined the term "cash baseline earnings" to describe its operating performance. Not to be outdone, Robert McFarlane, chief financial officer of Telus Corp., Canada's second-largest telecommunications company, cited a "revenue revision" and "EBITDA deficiency" to explain the drop in the Burnaby, BC-based phone service firm's "core baseline earnings" for its third quarter ended September 30, 2001. (According to company literature, core baseline earnings refers to common share income before discontinued operations, amortization of acquired intangible assets net of tax, restructuring and nonrecurring refinancing costs net of tax, revaluation of future tax assets and liabilities and goodwill amortization.)

Meanwhile, IBM Corp. spinoff Celestica Inc. of Toronto neglected to mention the elimination of more than 8,700 jobs from a global workforce of 30,000, alluding to the cuts in its fiscal 2001 third-quarter report through references to "realignment" charges during the period.

Many statements no longer use the term "profit" at all. And while statutory filings must present at least one version of earnings that conforms to GAAP, few rules have been set down by US or Canadian regulators to govern non-GAAP declarations. Accounting bodies in Canada and around the world are charged with policing their members and assuring statutory filings include income and revenue according to GAAP, using supportable interpretations. But pro forma numbers are typically distributed before a company's statutory filing is made.

"Not to pass the buck," says Cherry, "but how can we set standards for something that's not part of GAAP?" Still, Cherry admits the use of non-GAAP terminology has become so widespread that accounting authorities are being forced to take notice. "The matter is gaining some prominence," he says, "because some of the numbers are just so different."

Despite his reservations, Cherry acknowledges "the critical point is when information is released to the marketplace," which nowadays is almost always done via a press release. The duty to regulate such releases, he says, must rest with securities bodies - an opinion shared by Edmund Jenkins, chair of the Financial Accounting Standards Board (FASB) in the United States.

Many authorities view the issue as a matter of education, believing that a high degree of sophistication must now be expected from the retail investing community. Others say the spread of non-GAAP reporting methodology, left unchecked, could distort markets, undermine investor confidence in regulatory regimes and ultimately impede the flow of investment capital. But pro forma devotees insist that introducing tough new measures to govern reporting would do little to protect consumers and encourage retail investment. Instead, new regulations might work to impede growth and limit available, useful financial information.

Blunn says many companies will likely return to more traditional reporting methods once the economy rebounds, although the professional investment community might choose to flex its muscles in the meantime. "Even if statements are not intended to confuse, they could be annoying the hell out of people," he notes, adding that in the future major institutional investors such as the Ontario Teachers' Pension Plan Board might penalize companies that produce statements that are all but impossible to comprehend. In this respect, he sees the OSC guidelines as appropriate.

Hall, who says companies use favourable reporting terminology in good times and bad, believes many income statements are growing ever more oblique, can promote inefficiency in the market and ultimately deter investment.

But he insists the fault lies in equal measure with investors, analysts and the business press, along with the companies themselves. He cites the case of phone and Internet gear manufacturer Nortel Networks Corp., based in Brampton, Ont., whose stock has plummeted along with its sales. "Through the boom times Nortel reported strong operating income," he says, "but its net numbers according to GAAP showed large losses."

In fact, Nortel's dwindling cash flow (after charges) through late 2000, along with expansion of its share float to pay for acquisitions, should have been a harbinger of the company's looming troubles. All the numbers, including dilution, were dutifully if discreetly reported by Nortel - and largely ignored by analysts and investors until their real impact became apparent with tumbling sales, a share price implosion, and the elimination of nearly 50,000 Nortel employees. With hindsight, some analysts and accountants have attributed the company's meltdown in part to the industry practice of recording revenue on reasonable expectation of payment - a practice flagged in the OSC's report. (John Roth, Nortel's former chief executive, has indicated he did not think his company was among those reviewed by the OSC.)

Thanks to all this scrutiny, pro forma reporting has lost some of its allure. BCE, for example, told investors at an earnings update late last year it would abandon its cash baseline earnings methodology in favour of the more traditional earnings per share. Rival Telus took a similar step, though no mention was made of whether it switched to earnings per share from core earnings at the behest of regulators or accounting bodies. Both companies did acknowledge, however, that growth would appear more modest using reporting that conforms to GAAP.
With plans for a new watchdog agency under way in the United States, the consensus among industry observers is that the plan has a strong chance of success. "Pitt's proposal will be close to a slam dunk, because the time is right for something like this," says Dennis Beresford, University of Georgia accounting professor and former FASB chairman. "As a result of Enron, people, including accountants, are frantically looking to do something."

For critics, the epiphany is a matter of too little, too late. They wonder why this was not done two or three years ago when all the high flyers were playing games. Those who invested their life savings in Nortel, JDS or Enron might well agree.