A new study documents that investors are being led astray by what companies report as their pro forma earnings.
Pro forma earnings have been widely criticized because companies have had wide latitude to define them as they see fit. While there has been much anecdotal evidence that companies have abusing that freedom, the new study is the first to measure systematically how much pro forma earnings have misled investors.
In theory, at least, pro forma earnings are intended to exclude one-time charges that have no real bearing on the long-term profitability of a company. In that sense, pro forma earnings canpaint a more accurate picture of a company's true profitability than earnings calculated according to conventional accounting standards.
But there is a strong incentive for companies to classify expenditures as one-time even when they are recurring. Doing so could make a company appear to be delivering outstanding profits to its shareholders and to be exceeding the expectations of Wall Street analysts.
To study how companies have responded to that incentive, Russell J. Lundholm, an accounting professor at the University of Michigan, and two of his graduate students, Jeffrey T. Doyle and Mark T. Soliman, turned to Thomson Financial's Institutional Brokers Estimates System, which recently became part of Thomson Financial's First Call database.
They focused particularly on the more than 150,000 earnings reports issued from the beginning of 1988 to the end of 1999 in which companies excluded expenditures from their pro forma earnings. (Their research is circulating in academic circles as a working paper at http://papers.ssrn.com/sol3/papers.cfm?abstract-id(equal sign)303563.)
The researchers first looked for correlations between these companies' exclusions and their cash flows over the subsequent three years.
If the companies had been correct in classifying their excluded expenditures as nonrecurring, then there would have been no correlation. In fact, however, there was a very strong one: on average, US$1 of exclusions in a given report of pro forma earnings was associated with a total of US$1.34 less cash flow over the subsequent three years.
The researchers next searched for correlations between these companies' exclusions and the performance of their stocks over the next three years. On average, they found, the stocks of companies that had the largest exclusions significantly lagged behind those companies with the smallest ones.
These results suggest that we should be skeptical of all expenses that companies exclude from their pro forma earnings. But the researchers did identify one exception: expenses that fall into the category known as ``special items.'' These include restructuring charges, asset write-downs or losses on the sale of assets.
Professor Lundholm speculates that this category is relatively immune from abuse because such expenditures are readily identifiable and tend to receive much publicity. Most of the abuse, in other words, takes place in other parts of companies' financial statements.
Investors can benefit by training themselves to avoid companies that exclude large expenses from their pro forma earnings.
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