Pro Forma

What Is Pro Forma?

Pro forma, a Latin term that means “for the sake of form” or “as a matter of form”, is a method of calculating financial results using certain projections or presumptions.

 Pro forma financials are not computed using standard generally accepted accounting principles (GAAP) and usually leave out one-time expenses that are not part of normal company operations, such as restructuring costs following a merger. Essentially, a pro forma financial statement can exclude anything a company believes obscures the accuracy of its financial outlook and can be a useful piece of information to help assess a company's future prospects.

Understanding Pro Forma

The presumptions about hypothetical conditions that occurred in the past and/ or may occur in the future are used to project the most likely outcome for corporate results in reports known as pro forma financial statements. For instance, a budget is a variation of a pro forma financial statement as it anticipates, based on certain assumptions, the inflow of projected revenues and the outflow of funds for a defined future period, usually a fiscal year.

Essentially, pro forma statements present expected corporate results to outsiders and often feature in investment proposals. A pro forma income statement is a financial statement that uses the pro forma calculation method, mainly to draw potential investors' focus to specific figures when a company issues an earnings announcement. Companies may also design pro forma statements to assess the potential earnings value of a proposed business change, such as an acquisition or a merger.

Investors should be aware that a company’s pro forma financial statements may hold figures or calculations that are not in compliance with generally accepted accounting principles (GAAP). Sometimes, pro forma figures differ vastly from those generated within a GAAP framework, as pro forma results will make adjustments to GAAP numbers to highlight important aspects of the company's operating performance.

Types of Pro Forma

In financial accounting, pro forma refers to a report of the company's earnings that excludes unusual or nonrecurring transactions. Excluded expenses could include declining investment values, restructuring costs, and adjustments made on the company’s balance sheet that fix accounting errors from prior years.

In managerial accounting, meanwhile, accountants design financial statements prepared in the pro forma method ahead of a planned transaction such as an acquisition, merger, change in capital structure, or new capital investment. These models forecast the expected result of the proposed transaction, with emphasis placed on estimated net revenues, cash flows, and taxes. Managers are then able to make business decisions based on the potential benefits and costs.

History of Pro Forma

Pro forma financials in the United States boomed in the late 1990s when dot-com companies used the method to make losses appear like profits or, at a minimum, to reveal much greater gains than indicated through U.S. GAAP accounting methods.

The U.S. Securities and Exchange Commission (SEC) responded by cautioning that publicly traded companies report and make public U.S. GAAP-based financial results as well. The SEC also clarified that it would deem using pro forma results to grossly misconstrue GAAP-based results and mislead investors fraudulent and punishable by law.

Important

Using pro forma results to grossly misconstrue GAAP-based results and mislead investors is deemed by the U.S. Securities and Exchange Commission (SEC) to be fraudulent and punishable by law.

Pro Forma Example

Today, there are several places where you can find a boilerplate template for generating a pro forma financial statement, such as the income statement, including Excel spreadsheets that will automatically populate and calculate the correct entries based on your inputs.

Still, you may want to know how to create a pro forma income statement by hand. The steps are:

1. Calculate the estimated revenue projections for your business, a process called pro forma forecasting. Use realistic market assumptions and not just numbers that make you or your investors feel optimistic. Do your research and speak with experts and accountants to determine what a normal annual revenue stream is, as well as asset accumulation assumptions. Your estimates should be conservative.
2. Estimate your total liabilities and costs. Your liabilities include loans and lines of credit. Your costs, on the other hand, will include items such as lease expense, utilities, employee pay, insurance, licenses, permits, materials, taxes, etc. Be sure to put a great deal of thought into each expense and keep your estimates realistic.
3. To create the first part of your pro forma, you’ll use the revenue projections from Step 1 and the total costs found in Step 2. This portion of the pro forma statement will project your future net income (NI).
4. Estimate the cash flows. This portion of the pro forma statement will identify the net effect on cash if the proposed business change is implemented. Cash flow differs from NI because, under accrual accounting, certain revenues and expenses are recognized prior to or after cash changes hands.

Here’s a real-life example of a pro forma income statement, courtesy of Tesla Inc.'s (TSLA) unaudited pro forma condensed and consolidated income statement for the year ended December 31, 2016.

Source: U.S. Securities and Exchange Commission.

What is a pro forma financial statement?

Pro forma financial statements incorporate hypothetical amounts, forecasts, or estimates, built into the data to give a "picture" of a company's profits if certain nonrecurring items were excluded. These are often intended to be preliminary or illustrative financials that do not follow standard accounting practices. Basically, companies use their own discretion in calculating pro forma earnings, including or excluding items depending on what they feel accurately reflects the company's true performance. As pro forma forecasts are hypothetical in nature, they can deviate from actual results, sometimes significantly.

What does the phrase pro forma mean?

From Latin, pro forma translates literally into "for the sake of form."

What's the difference between pro forma and GAAP financials?

There are no universal rules that companies must follow when reporting pro forma earnings. This is why it is important for investors to distinguish between pro forma earnings and those reported using generally accepted accounting principles (GAAP). GAAP enforces strict guidelines when companies report earnings, but pro forma figures are better thought of as "hypothetical" earnings, computed according to the relevance of certain events or conditions. For this reason, investors must examine not only the pro forma earnings, but also GAAP earnings, and never mistake one for the other.

What is a pro forma invoice?

A pro forma invoice is a preliminary bill of sale sent to buyers in advance of a shipment or delivery of goods. The invoice will typically describe the purchased items and other important information, such as the shipping weight and transport charges. A pro forma invoice requires only enough information to allow customs to determine the duties needed from a general examination of the included goods.

Can you compare pro forma statements from different companies with one another?

Maybe, but it is not advised. Because companies' definitions of pro forma will vary along with their internal methods for forecasting and making assumptions, you must be careful when comparing pro forma figures between different companies. If you are not aware of how the companies define their pro forma figures, you may be inadvertently comparing apples to oranges.