Earnings Management - Accounting Red Flags
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Richard J. Wayman

Pro Forma EPS

The words "pro forma" indicate that assumptions were used to derive whatever number is being discussed. Used correctly, pro forma earnings are a good way to compare "apples to apples." For example, if a company doubled its size with an acquisition, investors would want to know how much of the sales and earnings growth was generated by the core business (also referred to as "organic growth") and how much came from the new acquisition. Companies normally use pro forma sales and earrings to compare the core results and avoid the distortion caused by comparing the combined results to the historic results of the original (smaller) company. Likewise, if a company sold a division, it would use pro forma data to compare the results of the remaining business.

Recently, however, pro forma earnings have been used as a way for companies to divert attention from their actual GAAP earnings to a semi-fictional number management thinks will please Wall Street. Amazon is the pro forma poster child because it raised pro forma reporting to a high art. Most recently, it announced that it "earned" a pro forma $0.09 per share in Q4 of 2001. But the GAAP number was $0.01 (and I even think that number is suspect). In the past Amazon has tried to focus attention on pro forma earnings that excluded expenses that could be considered necessary and which should have been used to calculate EPS. If there is a large difference between pro forma EPS and GAAP reported EPS, this should be a big flag to investors of the need to dig into the financial statements because it generally indicates that the company is trying to divert attention from "real" earrings.