On January 16, 2002, the Securities and Exchange Commission (SEC) announced that for the first time in its history, it had instituted an enforcement action involving pro-forma statements. Such statements are essentially “what-if” or “as-if” statements that show the effect of a particular assumption or a hypothetical situation on a company’s financial position (a pro-forma statement might, e.g., show how a proposed acquisition would affect a company’s income). The company cited in the SEC action—Trump Hotels & Casino Resorts Inc., chaired by well-known entrepreneur Donald Trump—was charged with making misleading statements in a press release regarding its earnings for the third quarter of 1999. According to the SEC, the numbers that the company announced for net income and earnings per share had been calculated by including positive one-time gains and excluding negative one-time charges. This violated generally acceptable accounting principles (GAAP) and created the favorable impression that the company had outperformed analysts’ earnings expectations.1
As noted in a focus box in Chapter 26, pro-forma financial reports have become quite common. Such reports are readily available on the web sites of many large companies. For example, both Yahoo! and Texas Instruments make pro-forma income statements accessible on their web sites. Pro-forma statements are not illegal unless they are intentionally used to mislead investors. Often, however, they are not prepared in conformity with GAAP and present earnings numbers that differ significantly from those calculated in conformity with GAAP. For instance, for the quarter ended December 31, 2001, Yahoo!’s pro-forma income statement showed income of $16.685 million, while its GAAP income statement showed a net loss of $8.659 million.2 A recent article in Business Week called pro-forma reports a “disturbing trend” that makes comparisons between companies “meaningless.”3
Pro-forma reports that are consistent with GAAP are an important disclosure tool, particularly for presenting the effect of changes in accounting methods. However, using them to show a company only in a positive light is a misuse that can erode the quality of earnings and the usefulness of accounting information. A clarification of what constitutes proper pro-forma reporting and the timing and circumstances of such reports seems warranted.
Notes
1. Securities and Exchange Commission, “SEC Brings First Financial Reporting Case; Trump Hotels Charged with Issuing Misleading Earnings Release,” Press Release No.2002-6, January 16, 2002, http://www.sec.gov/news/press/2002-6.txt.
2. Yahoo! Inc., “Unaudited Pro Forma Condensed Consolidated Statements of Operations,” http://docs.yahoo.com/docs/pr/4q01income_p.html (accessed August 2, 2002).
3. Nanette Byrnes, David Henry, and Mike McNamee, “Confused About Earnings?” Business Week online, November 26, 2001, http://www.businessweek.com/magazine/content/01_48/ b3759001.htm.
answer the following questions.
1. Explain the purpose and usefulness of pro-forma disclosures that are prepared in accordance with GAAP. Provide a simple example of such a disclosure relating to a change in depreciation methods.
2. What basic accounting concepts and qualitative characteristics of accounting information did Trump Hotels & Casino Resorts apparently violate or disregard?
3. What problems may arise from publishing pro-forma income statements that do not conform to GAAP?
4. What justification is commonly given for providing users of financial information with pro-forma income statements that do not conform to GAAP?
