Updated July 13, 2023
Introduction of Pro-Forma Earnings
Pro-forma earnings are those earnings that are calculated using certain projections or estimations, or presumptions about the future prospects of the company, which may not be in compliance with the generally accepted principles of accounting & which are used for securing bank finance or using internally for the purpose of decision making by the management.
Explanation
- Pro-forma means “as a matter of form.”
- Pro-forma earnings are estimated using recurring events occurring in the entity on a year-on-year basis & thus, it ignores the non-recurring events such as any restructuring made, disposal of any plant of the organisation, etc.
- Both positive and negative non-recurring events are ignored for the purpose of presentation.
- Thus, we can say that such a statement does not comply with the generally accepted accounting principles.
- The non-inclusion of exceptional items in Pro-forma earnings is that we cannot project exceptional events in the future.
- Thus, pro-forma earnings can be referred to as earnings in the normal situation of the company (i.e., the demand for sales remains the same).
- Also, the company has to specify proactively that pro-forma figures are unaudited.
Examples of Pro-Forma Earnings
Different examples are mentioned below:
Johnsons INC
Pro-Forma Statement of Operations (unaudited)
For Three-Months Ended December 31, 2019
| Particulars | December 31, 2019 | ||
| Reported Figures ($) Millions | Adjustments ($) Millions | Pro-Forma Figures ($) Millions | |
| Sales | 1,95,458 | – | 1,95,458 |
| Non-operating income | 45,000 | -45,000 | – |
| Total Revenue | 2,40,458 | -45,000 | 1,95,458 |
| Cost of Goods Sold | 1,01,508 | – | 1,01,508 |
| Gross Profit (A) | 1,38,950 | -45,000 | 93,950 |
| Operating Expenses | |||
| Employee Benefit Costs | 15,000 | 1,350 | 16,350 |
| Sales, General & Administrative costs | 12,500 | – | 12,500 |
| Stock compensation | 1,850 | -850 | 1,000 |
| Depreciation on tangible assets | 14,523 | – | 14,523 |
| Amortisation of intangibles | 16,800 | -16,800 | – |
| Loss due to dismantling of assets | 35,000 | -35,000 | – |
| Loss due to earthquake | 3,500 | -3,500 | – |
| Foreign Exchange loss | 1,456 | -1,456 | – |
| Shifting of factory (relocation expenses) | 986 | -986 | – |
| Other expenses | 4,500 | -2,250 | 2,250 |
| Subtotal expenses (B) | 1,06,115 | -59,492 | 46,623 |
| Pro-forma earnings (A-B) | 32,835 | 47,327 | |
Explanation:
- The company has excluded the non-operating income from its pro-forma earnings figure due to its non-recurring nature. Companies can earn a discount due to higher-order on procurements or settlement claims with vendors, etc.
- The company has added $ 1350 million on a net basis to the employee cost on the submission that the number of employees will increase in the near future.
- It has excluded $ 850 million in stock compensation, assuming that these are non-recurring.
- Further, loss due to the dismantling of assets is excluded due to the assumption that the company will not dismantle the assets in the future.
- Loss due to earthquake cannot be recurring in nature & hence, excluded.
- Foreign exchange gain or loss depends on foreign dealings & thus; the company does not want to project on uncertain events.
- Further company has assumed that 50% of other expenses are non-recurring in nature.
- On a gross basis, you can observe that due to such adjustments, the company has managed to increase its Pro-forma earnings from $ 32835 million to $ 47327 million even if its total revenue has been reduced by $ 45000 million.
Uses of Pro-Forma Earnings
- Pro-forma earnings represent the normal scenario of company performance over the period.
- Investors can look upon the company in a better position.
- The management can use Pro-forma earnings internally for the sake of decision-making.
- The management can also see the effect of change in a single assumption & can decide accordingly.
- The exclusion of non-recurring events helps investors understand the core business process & normal process of the company in a clean environment.
- Pro-forma earnings can also be presented to a financial institution for securing bank finance or cash credit facilities.
- Companies can also attract investors in the company by certifying the assumptions used in the preparation of Pro-forma statements. This increases the confidence of the investors.
- It helps compute the projected EPS after a merger deal or for analyzing the merger situation on the company’s share price.
- Investors also use pro-forma earnings to analyze the risk involved in the company’s business.
Benefits of Pro-Forma Earnings
Some of the benefits are given below:
- It represents the normal scenario of the company since exceptional situations are already excluded during preparation.
- This can also be viewed as a budgeted or target statement to be achieved by the organization.
- It ensures the minimum performance guarantee by the company in future years.
- Sometimes, it may happen that no exceptions have occurred & Pro-forma results may happen to be actual results of the company.
- It helps companies to identify the introduction or deletion of a product line into the business.
- In the long run, the company can also use these statements as back-projection to identify where the assumptions used at that time were appropriate.
- Pro-forma earnings are presented in Pro-forma financial statements. Thus, an estimation is made for both earnings as well as expenses.
The disadvantage of Pro Forma Earnings
Some of the disadvantages are given below:
- The biggest disadvantage is why a company would show the negative prospects of its operations in the future. This business reduces the sensitivity with respect to figures reported in the pro-forma financial statements.
- We can say the management can easily manipulate the pro-forma earnings to show only the positive side of earnings.
- Such earnings negate the existence of exceptional events that may occur in the future. Thus, few companies exclude exceptional events even if they have evidence of the exception occurring today.
- There is no accounting standard specified for the computation of pro-forma earnings. Thus, the computation is free at the discretion of the management.
- Even if investors may appoint a third party to certify the figures, such a third party can also provide reasonable assurance on the assumptions used in calculating pro-forma earnings.
- Another disadvantage is that companies don’t need to report Pro-forma earnings every year & you may not get continuous reports every year.
- The actual earnings are always lower than the pro-forma earnings due to the exclusion of non-recurring expenses & inclusion of normal revenue.
Conclusion
Pro-forma earnings represent the assumptions used to arrive at the figures. These assumptions reflect the basis of the figures. A few assumptions also reflect the mentality of the management in arriving at the figures. Therefore, it may differ from the actual performance of the company. Also, any regulation mandates Pro-forma statements & there is no specific format of presentation & thus, the presentation may vary from one company to another.
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