Accounting 201   

What is pro forma reporting, and why is it used?

Among the controversial subjects now afflicting corporate governance--in addition to conflicts of interest and stock options, which I wrote about in my last two columns--is something called "pro forma" reporting of earnings.

This is worth exploring to illuminate why newspaper and other companies resort to it and how it might help or hinder one's understanding of a company's financial health.

Now, all companies are required to report their financial results according to generally accepted accounting principals, or GAAP. Under these disciplines, all expenses for write-offs and write-downs of investments, employee buyouts and other nonrecurring expenses, as well as gains from the sale of assets and the like, are applied against earnings in a company's profit-and-loss statement.

Pro forma treatment of earnings, on the other hand, entails a company saying: "This is what would have happened if none of these things had happened." The idea is to show how the continuing businesses of a company are performing without regard to some additional things that may have cost real money but were out of the ordinary and not expected to happen again.

Companies resort to pro forma earnings for two reasons: One, to make themselves look better; and two, to satisfy Wall Street's interest in how the continuing businesses will perform in the future regardless of niggling accounting charges in the past.

Controversy arises when companies get aggressive about what they consider nonrecurring or extraordinary expenses. In a notorious example, one firm (not a newspaper company) declared that painting its fleet of trucks was an extraordinary expense. A company's independent auditor is supposed to approve these decisions, but as we've seen with Enron and other cases, that does not always work. Another problem is that in their earnings reports, a lot of companies put more spin on pro forma as opposed to GAAP earnings. This obscures the fact that, say, when a company writes off an investment it is really saying: "We made a dumb mistake, and now we are paying for it."

I recall with fondness a meeting between Wall Street analysts and Capital Cities Communications, back when this company operated mainly newspapers and television stations (it was later absorbed by Disney). John Sias, a senior executive, gave a presentation about a publishing investment the company had made (not a newspaper) and told about the challenges of making the investment pay off. He summed up by saying: "What we're trying to decide is whether we have a turkey on our hands."

Such candor is rare, which is why I've remembered it all these years. More typically, a company will extol the great opportunities an investment presents, right up to the day it is written off or otherwise discarded.

But pro forma reporting can be useful for investors. For example, pro forma can point out how much the sale of an asset inflated earnings according to GAAP. I mean, if the New York Times Co. really wanted to have a bang-up year, all it would have to do is sell the Boston Globe or another of its newspapers.

For newspaper companies, this year in particular, pro forma reporting is important in understanding financial performance. A change in accounting rules that took effect January 1 no longer requires companies to deduct from earnings amortization of goodwill from acquired properties over a period of years. (Basically, goodwill is the difference between the value of hard assets acquired and the purchase price.)

Most newspaper companies have been active acquirers of newspapers, which means in past years they have had to charge substantial amounts of goodwill against earnings. The theory under the old rule was that the goodwill inevitably declined in value. Under the new rule, if a company can demonstrate that its acquired properties have not declined in value (newspapers typically never decline), it need not charge amortization against earnings.

This change put the publicly owned newspapers in a position of comparing apples and oranges. In the second quarter, for example, reported per-share earnings for newspaper companies soared 58 percent based on existing accounting rules for this year and last. But if last year's earnings are refigured to take out amortization charges--in other words, to apply this year's accounting rules to last year's performance--per-share earnings would have risen 11.2 percent. In this instance, pro forma results provide a truer picture of financial performance.

All of these accounting issues come down to how honestly companies report their financial performance. The more information properly presented, the better for shareholders.