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THE DAY AHEAD: An ode to pro forma earnings

COMMENTARY--As we start to wrap up earnings season, it's time to pay our respects to those beloved pro forma figures.

You know the ones--the earnings that always headline quarterly results--the ones that exclude everything but the kitchen sink. The ones that exclude billion-dollar inventory screw-ups, payroll taxes on stock options, warrants that are used instead of cash, venture capital losses (but not gains), goodwill and even the occasional charitable foundation donation.

Simply put, pro forma earnings are hypothetical, but Wall Street plays along anyway. These fuzzy math creations thrive because there are no real accounting guidelines to govern them. Have something that could really hurt your bottom line? No worries. Just exclude it in the pro forma results.

Wall Street's love affair with pro forma earnings are partially to blame for JDS Uniphase's (Nasdaq: JDSU) upcoming $40 billion goodwill write-off and Cisco Systems' (Nasdaq: CSCO) $2.5 billion inventory write-off. Pro forma earnings are also the reason companies can claim to beat estimates (once they exclude all the bad stuff) and look good despite big losses.

Amazon (Nasdaq: AMZN) gives you a few different earnings figures and then a lengthy reconciliation with generally accepted accounting principles to show how much money it really lost. PurchasePro's (Nasdaq: PPRO) weaker-than-expected earnings excluded strategic marketing expense amortization of equity-based compensation and goodwill. And that's just a few examples out of thousands.

Maybe it's old-fashioned, but there are a few folks hankering for the days when the bottom line was the bottom line. Only on Wall Street do you get such a distortion of reality as the pro forma earnings result.

Tad LaFountain, a networking analyst at Needham & Co., says the pro forma earnings movement is distorting all the measuring sticks Wall Street uses. And he's right.

Pro forma earnings prove that Wall Street is completely devoid of anything that resembles reality.

Think about it. LaFountain said he uses pro forma figures to describe his golf game. On a pro forma basis, he can hit a drive 250 yards in one swing. Including charges, it takes two swings.

Seems absurd doesn't it? Well it is. Apply Wall Street's pro forma rationale to other aspects of your life. On a pro forma basis, my earnings (also known as my paycheck) look a lot better. Of course my pro forma figures exclude taxes on my paycheck, that trip to the pub (a strategic marketing expense) and a one-time write-off for my higher-than-expected electric bill this month.

I think I'll also use pro forma figures for my mile-run time. On a pro forma basis, I can run a 4-minute mile, excluding a write-off for the fact my knee has been reconstructed and a one-time charge for my overall lack of conditioning. My net time, including charges, is 8 minutes on a good day and 10 minutes on a bad one.

Maybe I'm just jealous of Wall Street. I just want a pro forma life too.

The biggest problem with pro forma earnings are that they hide management miscues way too much. Cisco goofs on inventory, but it gets a free ride with an inventory write-off. In the real world, that would be an expense. JDS Uniphase goofs by buying SDL with its overpriced stock, and then the floor falls out leaving it with more goodwill than God. If JDS would have issued more of its overpriced stock in the glory days and collected cash, the company could have been sitting on a mountain of dough right now. JDS guessed wrong, but luckily it can write it off.

Life in pro forma land goes on because Wall Street thinks it's a victimless crime. After all, it's just accounting mumbo jumbo isn't it?

Not completely. The victim is the guy who bought stock based on bogus measuring sticks endorsed by investment bankers, analysts, the press and even accounting standards organizations. You may even be that victim--the person who bought CMGI well above $100 for instance. Many of those bygone bubble valuations were based on pro forma numbers that should have been generously labeled fiction.

"The victim is the guy who buys this nonsense hook, line and sinker," LaFountain said.

Chuck Hill, director of research at First Call, said the pro forma earnings movement got wacky when Internet companies excluded whatever it took to look good. Then tech companies in general got into the act, using "highly valued stock to pay huge amounts over book value," Hill said.

From there, the accounting gurus blessed the write-off of goodwill expense. Based on a rule likely to pass July 1, goodwill expenses will go the way of the dinosaur. Hill said the next logical step was for companies to push the limits.

Companies said "let's see what else we can exclude from the pot," said Hill, who added that a lot of the pro forma earnings out there are troubling.

Hill is confident that Wall Street will eventually sniff out bogus pro forma figures. "There's a hell of a lot of confusion," he said. "Hopefully there will be a wake-up call."

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