Pro forma results: Unethical practice?

Scan Cisco's recently announced third quarter financial results and you could be confused as to whether the company made a $230m profit or a whopping $2.7bn loss.

Readers of the latest quarter's financial press release from Network Associates could be equally confused. Did the company report a loss of $24m or was it $48m?

The cause of the confusion is that more and more CEOs at public US companies are signing off on two sets of figures, one for the US Securities and Exchange Commission (SEC) using generally accepted accounting principles (GAAP) and one for public relations purposes.

Companies have started to use the phrase 'pro forma' in their financial press releases to describe their financial performance, with the resultant effect of softening any bad news caused by their sudden downturn in fortunes.

Financials that the CEOs say are pro forma invariably gloss over any problems and position the business in the best light possible.

The companies are not doing anything illegal but this pro forma reporting has caught the attention of the SEC, as well as other interested organisations.

Pro forma reporting came into existence as a way for new or merged companies to report their earnings and exclude one-time start-up or merger costs. They reflected how the core business was doing aside from those one-time charges. Nowadays, however, all sorts of companies are using pro forma results and excluding anything they say is an abnormal, non-operating expense.

Using pro forma figures was a dream come true in the late 1990s for internet companies that were burning through cash. Of course, those businesses had expenses, which were much larger than revenues, and profits were generally non-existent.

Scrambling to put together a financial statement that had something positive to say to investors, CEOs clutched at the pro forma concept as it allowed them to exclude all sorts of costs to give the business the appearance of at least being a going concern.

Amazon is a long time pro forma fan. In its latest quarter it claimed a pro forma loss of $49m that would have ballooned to $234m had the e-tailer used GAAP. It defends itself vigorously. "The pro forma numbers are how we think about our business and how Wall Street analysts follow it," said a spokesman.

Indeed, some Wall Street analysts are adding to the confusion by using pro forma figures in their earnings estimates, if companies ask them too. Observers say they kowtow to big public companies as the investment banks the analysts invariably work for also sell a whole range of services. The analysts don't want to jeopardise their employers' M&A activity, for example, by offending Cisco's John Chambers, Amazon's Jeff Bezos or Intel's Craig Barrett.

It is the spread of pro forma from its dot-com roots to other companies that caused observers to begin to worry.

In the case of Cisco, for instance, the company decided to ignore a whole swag of expenses as it scraped together a pro forma profit. Excluded were research and development costs, payroll tax on stock option exercises, amortisation of goodwill and other acquisitions-related charges, restructuring costs and other special charges, and an excess inventory charge. These costs, by the way, net of taxes, amounted to $2.93bn.

Network Associates was able to halve its loss by simply pretending that its loss making, 80 per cent-owned subsidiary, McAfee.com, does not exist. The company said it was releasing the results and not including the dot-com component. No explanation as to why.

Another problem for investors looking at the figures as a way to judge one company's performance against another is that there is no uniformity as to what expenses businesses leave out of their pro forma filings. Comparisons are difficult and time-consuming.

Helping investors is the fact that companies only get away with issuing pro form results in press releases and in the conference calls that usually follow within a few hours. In the statements they have to file with the SEC they must use GAAP, but by that time the public relations battle could well have been won.

This ludicrous state of affairs has now led two organisations - representing financial and investment professionals - to issue best practice guidelines for company-issued earnings press releases.

Financial Executives International (FEI), which represents about 15,000 senior financial professionals, and The National Investor Relations Institute, an association of more than 5,000 corporate officers and investor relations consultants, say that although pro forma results may sometimes be more analytically useful, such results should always be accompanied by clearly described reconciliation to GAAP results, which provide a critical framework for pro forma numbers.

FEI's CEO, Philip Livingston, said: "We urge companies to be very clear in disclosing the path from pro forma to GAAP results. We also urge a balanced view in presenting results - access to both the positives and negatives is critically important for users."

Momentum is growing for CEOs to ensure their CFOs return to GAAP but it may need the SEC to act. The SEC's chief accountant, Lynn Turner, has signalled the watchdog's thoughts on pro forma results. Turner calls them "EBS earnings" as in "Everything but Bad Stuff."