Financial Reporting Its Past Its Present Its Future

Financial Reporting: Its Past, Its Present, Its Future UAA – ACCT 650 Seminar in Executive Uses of Accounting Dr. Fred Barbee

When You Come to a Fork in the Road – Then What?

Financial Reporting Pa t s

The Third Wave Breaks on the Shores of Accounting Robert K. Elliott Accounting Horizons, June 1992, Vol. 6, Issue 2

The Great Waves of Change l Information l 1 st Technologies Wave = Writing l 2 nd Wave = Movable-Type Printing l 3 rd Wave = Computer

The Great Waves of Change l Accounting l 1 st Wave = Single-Entry Accounting l Balance l 2 nd Sheet Wave = Double-Entry Accounting l Income Statement l Statement of Cash Flows l 3 rd Wave = Triple-Entry Accounting (? )

Changes in Internal Accounting Information Managerial Accounting Information

2 nd Wave Accounting Systems l Lock in the Taylor Model l Focuses l No on tangible assets information recorded unless there is a transaction with an outside party

Current GAAP Model l Nothing accountable happens until there is an exchange. l Exchanges are bargained at arm’s length. l Exchanges are simple (cash for goods/services) l One side of each exchange is cash virtually now.

3 rd Wave Accounting Systems l Should provide measures of transformation. l Repudiate l Account the Taylor model. for information-based resources.

3 rd Wave Accounting Systems l Concerned with measuring the values created for customers. l Must enable the network, rather than lock in the hierarchy.

Changes in External Accounting Information Financial Accounting Information

Financial Accounting Model l Limits reporting entity’s accountability to financial information. l Periodic, historical, cost-basis statements.

Financial Reporting t es n re P

The Oakland Raiders Today released their January 2003 pro forma results.

l Although Generally Accepted Scorekeeping Principles (GASP) indicate that the Oakland Raiders lost the Super Bowl, their pro forma figures show that this reported loss was the result of nonrecurring items, specifically the extraordinary performance of the Tampa Bay Buccaneers defense and the somewhat lackluster performance of the Oakland offense.

The New York Yankees Today released their 4 th Quarter 2001 pro forma results. Ed Scribner, Professor of Accounting, New Mexico State University

l Although Generally Accepted Scorekeeping Principles (GASP) indicate that the Yankees lost Games 1 and 2 of the 2001 World Series, their pro forma figures show that these reported losses where the result of nonrecurring items, specifically extraordinary pitching performances by Arizona Diamondbacks personnel Kurt Schilling and Randy Johnson.

l Games 3 and 4 results, already indicating Yankee wins, were not restated on a pro forma basis.

Pro Forma and Golfing Dennis Beresford Professor of Accounting and Former Chairman Financial Accounting Standards Board

l Some of you may know that George Benson is an excellent golfer. However, on a pro forma basis I can actually out score George. For example, it’s appropriate to leave out the scores for my first four holes, I’m still warming up then and those scores certainly aren’t representative of my true ability. And my out of bounds shots shouldn’t count either – I define them as unusual and nonrecurring.

l Taking those adjustments and a little other scorekeeping creativity into consideration, I figure my pro forma average score is about 68. l And that beats the heck out of George’s generally accepted golf average (GAGA).

Pro Forma Reporting

What is Pro Forma Reporting l Companies use every trick to pump earnings and fool investors. The latest abuse: “Pro Forma” reporting.

What is Pro Forma Reporting l How Did They Value Stocks? Count the Absurd Ways

What is Pro Forma Reporting

What is Pro Forma Reporting l Denny Beresford former FASB Chair l It means anything you want it to! l In fact, the only constant is what it doesn’t mean. l Pro-forma earnings are just about anything other than the real net income of a company determined by GAAP.

What is Pro Forma Reporting l In fact, SEC’s Chief Accountant has said that companies now want to emphasize EBS instead of EPS l EPS means “Earnings Per Share” l EBS means “Earnings Before Bad Stuff”

What is Pro Forma Reporting l Pro forma is Latin for “matter of form” l Refers to statements “where certain amounts are hypothetical” l Barron’s Dictionary of Finance and Investment Terms

What is Pro Forma Reporting l Pro forma which means “as if”, has in recent years evolved into “a sophisticated term for lying about your results. Peter H. Knutson Wharton Accounting Professor Emeritus

What is Pro Forma Reporting l “A pro forma is what it would be if it were something other than what it is. l It includes everything except the bad stuff. ” Peter H. Knutson Wharton Accounting Professor Emeritus

Can you please define pro forma reporting?

What is Pro Forma Reporting l Definition l A financial statement in which the amounts stated are fully or partially estimated l Objective l To show what the significant effects on historical financial information might have been, had a transaction or event occurred at an earlier date

What is Pro Forma Reporting l Previously l Companies used pro forma reporting to adjust previously reported financial statements l So they could be directly compared with current results and provide better or more meaningful information for the financial statement reader.

More Recently. . . l Companies have expanded its use l Restructuring charges l Inventory write-downs l Impairment of goodwill or other intangible or tangible assets l Other so called one-time or non-recurring charges.

Other Pro Forma Transactions l Change l Debt in accounting principles issues l Proposed sale of securities and application of the proceeds

Other Pro Forma Transactions l Mergers and acquisitions l Disposition l Change of a portion of business in form of business organization

To illustrate. . . l Company A had a loss under GAAP of $1 per share. l However, the company effected a major restructuring during the quarter, including work force reductions and plant closings, totaling $1. 50 per share.

To illustrate. . . l These do not qualify as extraordinary items under GAAP; l However, the company believes adding back these expenses will make the statements more meaningful to investors.

To illustrate. . . l Thus, in their pro forma statements the $1. 50 per share will be “added” back. l Result: l This $0. 50 EPS. provides “a better comparison and a better baseline for analysts to model future earnings expectations. ” (The firm’s explanation!)

At some real world stuff. . .

Associated Press Analysis l The AP analyzed earnings reports of the 100 largest technology companies in Northern California. l It calculated that under GAAP, the 100 companies reported combined losses of $71 billion. l Using pro forma figures, these same companies reported a profit of $10 billion.

Corporate America’s New Math l Investors Now Face Two Sets of Numbers in Figuring a Company’s Bottom Line l Justin Gillis Washington Post Staff Writer l July 22, 2001

Pro Forma Reporting

Pro Forma Reporting l Cisco Systems, Inc. reported results for the first quarter of this year (2001) according to GAAP l Result: Quarterly loss of $2. 7 billion

Pro Forma Reporting l Cisco then did some slicing and dicing in ways they preferred – offering an alternative interpretation of its results to the investing public. l Result: Quarterly profit of $230 million.

Cisco l “One of Cisco’s most frequent accounting tactics comes up every quarter when the company directs shareholders to its unaudited pro forma earnings numbers as the best gauge of profitability. ”

Cisco l In the first quarter of fiscal 2001, Cisco reported pro forma earnings of $1. 4 billion, nearly $600 million over its net income. l In the fourth quarter, Cisco’s pro forma income of $163 million was 23 times its actual net earnings. (GAAP)

And yes. . . There have been others!

Is there anything good about pro forma?

Pro Forma? l Survey l 196 conducted by CFO. com/KPMG finance managers l 82% said their companies report some kind of pro forma in their statements l 88% believe it is appropriate to include nonfinancial measurements in growth trends www. cfo. com

Pro Forma? l Why issue pro forma results? l 45% said pro forma results help convey the company’s true financial position l 27% said they use pro forma to meet demands of analysts. l 25% admitted pro forma helps “put the best spin on the results. ” www. cfo. com

Pro Forma? l Who should provide guidance on the use of pro forma? l 65% said the formal guidance should come from the SEC rather than FASB. l 50% said FASB should not include pro forma in their study of the financial reporting system. www. cfo. com

Pro Forma? l Most believe work needs to be done on pro forma reporting l 93% believe a company should be required to reconcile pro forma and GAAP. www. cfo. com

Another Survey l Conducted by Broadgate Consultants, Inc. l 223 Fund Managers www. broadgate. com

Another Survey l 76% said pro forma information is at least somewhat useful l Many said it is extremely useful. l 67% opposed banning pro forma reporting l 91% felt that corporations should provide more detail. www. broadgate. com

What does the SEC say?

SEC: Cautionary Advice l The antifraud provisions of the federal securities laws apply to a company issuing “pro forma” financial information l. A presentation of financial results that is. . . on other than a GAAP basis raises particular concerns.

SEC: Cautionary Advice l Companies must pay attention to the materiality of the information that is omitted from a “pro forma” presentation. l SEC recommends following the guidelines developed by the FEI and others.

SEC: Cautionary Advice l Investors are encouraged to compare “pro forma” results with GAAP-based financials.

SEC: Tips For Investors l What is the company assuming? l What is the company not saying? l How do the “pro forma” results compare with GAAP-based financials? l Are you reading “pro forma” results or a summary of GAAP-based financials?

What has the SEC done?

SEC Actions. . . l January 16, 2002 l In its first pro forma financial reporting case, the SEC instituted cease-and-desist proceedings against Trump Hotels & Casino Resorts, Inc. l Misleading statements in the company’s 3 rd quarter 1999 earnings release.

SEC Allegations. . . l On 10/25/99 Trump issued a press release announcing its 3 rd quarter 1999 results. l Pro forma results differed from GAAP results l Expressly excluded a one-time charge.

SEC Allegations. . . l Release was fraudulent because it created the false and misleading impression that the firm had exceeded earnings expectations when in fact it had not.

SEC Allegations. . . l Result: Net income increased to $14. 0 million compared to $5. 3 million in 1998 l On the date of the release, the price of Trump stock rose 7. 8%.

Some Criticisms of Pro Forma Reporting

Pro Forma Criticisms. . . l Presenting the pro forma information with greater prominence than the required GAAP results l GAAP results are difficult to discern or perhaps are not disclosed in the earnings release.

Pro Forma Criticisms. . . l Adjustments or assumptions used to arrive at the pro forma results are not clearly spelled out nor easy to understand l Nature of the underlying pro forma adjustments do not warrant pro forma treatment.

Pro Forma Criticisms. . . l Companies rarely, if ever, make pro forma negative adjustments lending credence to the belief that they are looking to “spin” results rather than provide meaningful data. l Use of non-GAAP measures such as EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization)

Some Suggestions

Pro Forma Suggestions l Clearly label the data as pro forma l Present historical GAAP data in documents that contain pro forma, and do so with similar prominence l Disclose all assumptions that underlie the pro forma adjustments. The Business Monthly

Pro Forma Suggestions l List all of the material pro forma adjustments with adequate and clear explanations. l Clearly define all non-GAAP measures such as EBITDA l Review with Independent accounting firm and legal counsel prior to release to public The Business Monthly

Best Practices. . . Financial Executives Institute (FEI) & National Investor Relations Institute (NIRI)

FEI/NIRI “Best Practices” l Timing l Earnings press releases should generally be issued as soon as practicable after quarterend. l Content l Earnings press releases should include “reported” results presented under GAAP (as well as pro forma)

FEI/NIRI “Best Practices” l Forward l Looking Statements Management is encouraged to discuss, within appropriate Safe Harbor provisions the outlook for the coming quarters. l Consistency l Reconciliation between GAAP and pro forma results should be treated in similar fashion for comparable periods.

FEI/NIRI “Best Practices” l Other l Display prominently in headlines of the press release the most meaningful information. l Firms are encouraged to include telephone and web site information

FEI/NIRI “Best Practices” l Other l Management should review both the Safe Harbor language in the press release and the firm description to assure it is accurate, complete and specific to all appropriate risk factors.