Accounting & Tax

Lies, Damn Lies, and Pro Forma

Pro forma earnings reports may be a cause du jour of reformers, but CFOs aren't about to back down from issuing them.
Edward Teach and Tim ReasonApril 1, 2002

This past January, the Securities and Exchange Commission administered its first spanking of a company for abusing pro forma earnings figures. The culprit: Trump Hotels & Casino Resorts Inc. The sin: a “materially misleading” quarterly earnings release dating from 1999. The punishment: Go and sin no more.

Coming a month after the SEC issued “cautionary advice” about using pro forma numbers, the Trump Hotels case should cause companies to think twice before they put too hard a spin on their earnings releases. Still, despite the SEC’s tough stance–and the status of pro forma reporting as a cause du jour of accounting watchdogs–no one expects many companies to refrain from using non-GAAP earnings numbers to describe their quarterly operating performance.

Not even the SEC expects this to happen. “[The Trump Hotels] case should not be viewed as the commission saying that pro forma reporting per se is good or bad,” says Wayne M. Carlin, director of the SEC’s northeast regional office. He adds, “The SEC enforcement division doesn’t get interested in [pro forma releases] unless [companies] use them in a misleading way.” Because earnings releases are just that–press releases, not SEC filings–the SEC bases its grounds for enforcement on the antifraud provisions of the Securities Exchange Act of 1934.

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The SEC has endorsed best-practice guidelines for earnings releases (see below), which include the recommendation that companies always include GAAP results with pro forma numbers and state how they derive the latter from the former. Last November, at a Consumer Federation of America conference, SEC chairman Harvey Pitt said pro forma numbers are valuable only if their calculation is clear. What’s more, he told Reuters, “I would say in cases where pro forma statements change a loss into a profit, my view is there is an almost 100 percent chance that a company that is capable of doing that without appropriate disclosure will have defrauded or confused its investors.”


Making a small gain nearly five times larger was the effect of the October 1999 earnings release that got Trump Hotels in trouble. In that release, the company reported a pro forma profit for Q3 1999 of $14 million, excluding a one-time charge of $81.4 million, and pro forma earnings per share of 63 cents, exceeding First Call estimates of 54 cents. The release quoted then-CEO Nicholas Ribis as ascribing the better-than-expected numbers to improved operating performance.

But according to the SEC, the release failed to mention that the earnings calculation actually included a one-time accounting gain of $17.2 million, stemming from the termination of a lease agreement–the sort of nonrecurring item that pro forma earnings are supposed to ignore. Without that gain, Trump Hotels would have posted a pro forma profit of about $3 million, or 14 cents per share. The SEC considered it hardly sporting for Trump Hotels to surreptitiously include the one-time gain in the pro forma calculations while publicly excluding the one-time charge.

“In this case, the method of presenting the pro forma numbers and the positive spin the company put on them were materially misleading,” said Stephen M. Cutler, director of the SEC’s division of enforcement, in a press release. “The case starkly illustrates how pro forma numbers can be used deceptively and the mischief that can cause.” Trump Hotels’s share price rose 7.8 percent on the day of the earnings release and fell about 6 percent three days later, when an analyst revealed the one-time accounting gain.

Trump Hotels consented to the SEC’s cease-and-desist order without admitting or denying the findings. No individuals were charged, but the order noted that the company had violated the antifraud provisions “through the conduct of its chief executive officer, its chief financial officer, and its treasurer.” CEO Ribis left the company in June 2000, but CFO Francis X. McCarthy and treasurer John P. Burke are still there.

What has been the effect of the SEC’s wrist-slap on the company? “Nothing,” replies Jay Goldberg, lawyer for Trump Hotels. “It happened three years ago, it is not considered of any moment, it has not impacted on Trump’s relationship with the banks.”

Pro Pro Forma

Concern over the abuse of pro forma numbers has mounted as their use has exploded. Companies traditionally used pro forma numbers to remove the distorting effects of unusual events, such as an acquisition. Now, however, they regularly issue operating earnings that exclude a multitude of expenses, from stock-option costs to inventory write-downs. Last August, the Wall Street Journal reported that more than 300 companies in the S&P 500 now exclude some GAAP expenses from the operating-earnings numbers they publish in press releases. The overall effect is rosy indeed: for one three-month period in 2001, 60 cents of every dollar of operating earnings reported by the S&P 500 was the result of suppressing GAAP expenses.

A survey of about 200 finance managers conducted by and KPMG at last fall’s meeting of the Financial Executives Institute (FEI) found that 82 percent of respondents said their companies report some type of pro forma earnings in press releases. A similar survey released in January by the National Investor Relations Institute (NIRI) said that of the 233 companies sampled, 133, or 57 percent, reported pro forma information with prominence–or at least equal importance to GAAP measures.

Portfolio managers like pro forma, too, according to an October survey of 223 fund managers by Broadgate Consultants Inc. Nearly 76 percent of respondents found pro forma reporting at least somewhat useful, and 67 percent opposed banning pro forma numbers from earnings releases (though most of the latter wished for more detail).

Accounting professors who condemn pro forma reporting are legion, but the practice has received some good words from academe. In a study of thousands of earnings releases between 1989-97, Georgia State University professors Lawrence D. Brown and Kumar Sivakumar found that pro forma operating income was a higher-quality measure than EPS from operations and EPS before extraordinary items and discontinued operations (the latter two measures are obtained from less-timely 10-K and 10-Q filings).

“Our results should not be interpreted as suggesting that pro forma earnings are of high quality,” the professors caution. “They simply indicate that GAAP disclosures, which allow for considerable discretion in earnings measurement, are of lower quality than the self-serving, but the more timely, earnings releases by managers.”

A Bum Rap?

The SEC’s concern, of course, is that self-serving measures don’t shade into deception. Anyone who violates securities law through the misleading use of pro forma numbers can become the object of enforcement actions ranging from a cease-and-desist order to a rule 102E proceeding, which bars accountants from practicing before the SEC. “Depending on the enforcement action, there may also be civil monetary fines, which can be substantial,” says Carlin.

Pro forma earnings should always be reconciled to GAAP results in earnings releases, maintains the SEC. This recommendation is central to the SEC-approved guidelines for earnings press releases developed jointly in 2001 by the FEI and NIRI. The guidelines, which include best practices for the scope, timing, content, and consistency of releases, are available on the Internet at and

Louis M. Thompson Jr., president and CEO of NIRI, says he’s pleased with the level of compliance with the guidelines so far. Of the 133 companies in the NIRI survey that use pro forma reporting, only a dozen or so didn’t comply with the guidelines, reports Thompson. Moreover, 131 companies, or 98.5 percent, “provided some clear path of reconciliation” to GAAP.

Pro forma reporting “has gotten a bum rap,” charges Thompson. The media, he says, “seemed to emphasize that this was a phenomenon found [only] in the dot-com and tech sectors. Our survey explodes that myth, because it is used in industries across the board.” As for using pro forma numbers in a materially misleading fashion, “I don’t think it is as big a problem as the SEC has made it out to be,” says Thompson.

“I would hope that companies that use pro forma numbers are doing so to aid analysts and investors in a way that would allow them to identify useful trends,” he adds. “I would hope it wouldn’t be simply a way to make earnings [look] better. That may be taking an idealistic point of view.”