SEC Warns About Earnings Pro Formas

As the year 2001 winds to a close amidst uncertainty created by a weaker economy, the Securities and Exchange Commission has issued a strong warning to public companies, and cautioned investors, regarding the potential dangers of pro forma (non-GAAP) presentations of financial results in earnings releases. See SEC Release No. 33-8039 (December 4, 2001) and "Pro Forma" Financial Information: Tips for Investors, at www.sec.gov/rules/other/33-8039.htm and www.sec.gov/investor/pubs/proforma12-4.htm, respectively.

Public companies have increasingly used non-GAAP presentations in recent years to focus investor attention on certain aspects of quarterly and annual results that they believe to be critical to a proper understanding of those results, to eliminate non-recurring elements as a means of enhancing period-to-period comparability and for other reasons. While conceding that pro forma financial information can serve useful purposes, the SEC warned that it can also mislead investors when it is inadequately explained, when it is actually used to impede comparability or when it omits material elements in an effort to obscure or recast GAAP results. The SEC also pointedly reminded public companies that misleading use of pro forma financial presentations could result in violation of the antifraud provisions of the federal securities laws.

In its warning to public companies, the SEC commended earnings press release guidelines jointly published earlier this year by Financial Executives International and the National Investor Relations Institute. The SEC encouraged public companies to consider and follow the recommendations in the FEI and NIRI guidelines before determining whether to issue pro forma results and before deciding how to structure a proposed pro forma statement. Among other things, the FEI and NIRI guidelines state that:

• Earnings releases should always include GAAP-based financial results. Pro forma information should only be included as a supplement if it clarifies both results for the period and future prospects.

• GAAP results provide a critical framework for pro forma results, although the pro forma results may be more analytically useful. It is important to provide the pro forma results in the context of their GAAP framework.

• Pro forma results should always be accompanied by a clear reconciliation to GAAP results, preferably in a tabular format.

• Reconciliation between GAAP and pro forma results should be treated in similar fashion for comparable periods. In other words, elements of the reconciliation should not be presented in one period without including similar elements in pro forma results of comparable periods.

The guidelines also recommend that discussion of significant factors affecting results in the period be included in the press release as well as in the Management's Discussion and Analysis section of the company's Form 10-Q or 10-K for the period. The guidelines characterize as a "best practice" the inclusion in the press release of a framework or outline for the more detailed analysis in the MD&A. The guidelines are available in full at www.fei.org/news/FEI-NIRI-EPRGuidelines-4-26-2001.cfm.

At the same time that it issued its warning to public companies, the SEC issued a cautionary alert to investors urging them to read the full GAAP financial statements of companies in which they intend to invest and to apply "appropriate and healthy skepticism" to pro forma numbers in press releases. The advisory urges investors to ask themselves:

• What is the company assuming? The SEC warned of tricky assumptions used to turn a GAAP loss into a pro forma profit, including an assumption that a proposed transaction has actually occurred or that a cost or charge has not.

• What is the company not saying? The SEC also warned in particular of pro forma omissions of information, especially those addressing only one component of a company's financial results - for example, earnings before interest, taxes, depreciation and amortization (EBITDA). Such information can be misleading unless the company clearly describes what transactions are omitted and how the numbers might compare to other periods.

• How do the pro forma results compare with GAAP-based financials? The SEC cautioned investors to demand a clear, comprehensible explanation of how pro forma results differ from GAAP financials and to make sure they understand the differences before investing.

• Are you reading pro forma results or a summary of GAAP-based financials? The SEC warned that there is a big difference between pro forma results and GAAP-based summary financials and that investors should know what they are reviewing.

The SEC's latest warnings are clearly a shot across the bow for public companies heading into the upcoming reporting season. Pro forma presentations in earnings releases are not illegal, but they may pose serious risks if not properly presented in the context of GAAP-based financials. Companies that present pro forma results that do not conform to the FEI and NIRI guidelines may be heading into dangerous waters.

December 12, 2001