What are pro forma financial statements?
Accountants use the term pro forma financial statements to refer to financial statements prepared under a particular set of assumptions. One set of assumptions might be that some transactions, actually reported in the firm's income statement for the year under generally accepted accounting principles, had not occurred. Such assumed-away transactions might include unusual or nonrecurring revenues, expenses, gains, and losses. In these cases, firms report pro forma earnings to suggest to financial statement users what the firm views as normal, recurring earnings.
The traditional use of the term pro forma financial statements refers to projected financial statements based on some set of assumptions about the future. One set of assumptions might be that historical patterns (for example, growth rates or rates of return) will continue. Alternatively, the pro forma financial statements might reflect new assumptions about growth rates, debt levels, profitability, and so on. For example, a firm might project future sales, net income, assets, and cash flows to ascertain whether operations will generate sufficient cash flows to finance expenditures on long-term assets or whether the firm will need to borrow more. A firm might change its product lines or pricing policies and might want to estimate the impact on rates of return. A firm might project future financial statement amounts for an acquisition target to ascertain the price it should pay. This appendix describes and illustrates procedures for preparing pro forma (projected) financial statements, then shows you how to use them to value firms. In your exposure to managerial and cost accounting concepts, you will encounter the notion of a budget. A budget for an entire firm means the same thing as pro forma (projected) financial statements except that the statements projected typically have different uses and formats. Managers and analysts use pro forma financials and budgets for differing reasons, but use similar procedures to prepare them.
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