Managers of many companies frequently provide a pro forma earnings amount in conjunction with their annual or quarterly earnings calculated in accordance with GAAP. Managers claim that pro forma earnings numbers more fairly reflect a company's
performance. Required: 1 . Explain the meaning of the term "pro forma earnings". 2 . Discuss the advantages and disadvantages of reporting pro forma earnings numbers.
1 . Pro forma earnings are the regular GAAP earnings number with certain revenue, expense, gains, or losses excluded. The exclusions are made on the premise that earnings measured in conformity with GAAP do not fairly reflect the company's performance. Pro forma earnings may be viewed as representing management's view conception of permanent earnings.
2 . The key issue regarding pro forma earnings is whether the number helps financial statement users better understand a company or whether it represents an attempt to disguise poor financial results. Research on pro forma earnings has demonstrated that both answers may be correct.
For some companies, the pro forma earnings number may be a more accurate reflection of the entity's economic performance than GAAP net income. In this case, the pro forma earnings number allows managers to provide additional useful information to the financial statement user.
Pro forma earnings numbers can also be controversial as they may represent management's biased view of permanent earnings. Managers may use pro forma earnings to hide poor operating performance.
Pro forma earnings may represent an extension of the choices available to managers in reporting GAAP earnings. A trustworthy manager that provides reliable GAAP earnings can be expected to reveal even more useful information through the means of pro forma earnings. Similarly, a deceitful manager will provide unreliable GAAP earnings and deceptive pro forma earnings. The dilemma is distinguishing between the reliable manager and the deceitful manager.
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