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The Starting Line: SEC pores over pro forma

What began as a way to discount aberrant events has come under fire as a method used to put a good face on bad numbers.

The U.S. Securities and Exchange Commission is investigating several companies for possible deception through the use of pro forma financial results, the SEC's chief accountant said this week. The big question is whether the SEC can make a dent in the pro forma practice.

A spokesman for the commission said it has been monitoring the issue for some time, and that the number of companies under investigation "changes by the day." Companies found to have deceived investors could face censures or fines from the agency.

The use of pro forma results in earnings reports has become a hot topic in accounting and investing circles. What began as a way for companies and analysts to discount aberrant events has come under fire as a method used to deceive the public about what's really going on with a company's bottom line.

Pro forma earnings--often a favorite for technology companies--are those that exclude certain items, typically one-time charges for things like a merger or a restructuring. Although those results do not follow the Generally Accepted Accounting Principals (GAAP) standard that companies are required to use with SEC filings, they are commonly reported in press releases and often form the basis for analysts' predictions and estimates.

According to Merrill Lynch, technology earnings would be 25 percent lower if companies included nonoperating items and one-time charges--items excluded from pro forma results.

The biggest issue surrounding pro forma results is the fact that each company can interpret them differently. There are no standards. Some companies don't count payroll taxes on stock options, but others do. If a company wants to "spin" its results, it can omit many items that other companies would usually count as normal expenses.

Analysts say it could be difficult for the SEC to actually prosecute companies for abusing pro forma numbers.

"There's nothing wrong with the proper use of pro forma numbers," said Gary Lutin, an investment banker who has worked with the New York Society of Securities Analysts (NYSSA) on this issue. "They used to illustrate what were called 'normalized' numbers. Pro forma had been used generally among professionals as a means of adjusting aberrant (numbers)--essentially taking the noise out of numbers."

Lutin added that the SEC will have to resist the temptation of more regulation. The key will be to end the abuses, but not the practice of pro forma earnings entirely.

"It's not possible to regulate against lying and cheating; it's not possible to regulate against irresponsibility," Lutin said. "What we all rely on is responsibility of directors and executives of a company. There's no need for additional regulations. Regulations already say don't lie and cheat."

Pro forma changes everything
It's no wonder that companies love pro forma results. The difference between pro forma results and those based on GAAP can be startling.

Take Red Hat, for instance. The Linux company reported first-quarter results Tuesday in a press release titled "Red Hat Achieves Positive Cash Flows From Operations and Shows a Profit for the First Time in First Quarter."

But further down in the press release, the company revealed that "on a reported basis," it had a net loss of $27.6 million, or 16 cents per share.

The adjusted results excluded amortization of goodwill and intangibles, stock-based compensation, and merger-and-acquisition costs. And it was the pro forma number that analysts were looking at. News reports talked about Red Hat matching analyst expectations of a break-even quarter. (Red Hat is not under investigation by the SEC.)

Though that may seem confusing, analysts say that in many cases, these types of exclusions are fine because eliminating them gives a better picture of a company's day-to-day operations.

"Looking at pro forma numbers typically allows a more accurate (description) of the cash movements within the company," said Derek Brown, an analyst at WR Hambrecht. And many of the excluded items, such as goodwill and other noncash charges, are "an accounting phenomenon," said Michael Cristinziano, an analyst at Gerard Klauer Mattison.

Everyone is doing it
There are other reasons behind the popularity of pro forma numbers. For one, companies want to stay in line with what their competitors are doing.

"If you're a new entrant in an industry where competitors are valued on a cash basis, you'll do it too," said John Corcoran, the Internet and digital new media analyst at CIBC World Markets. "You don't want to be the only one putting out a 50 cent per-share net loss, while your rivals are reporting 8 cent pro forma profit."

The same holds true for the analysts. "There are 45 people who follow AOL. You can't have 10 looking at one thing and 10 looking at something else," Corcoran said.

But what has sparked concern among Wall Street watchdogs such as Lutin is the abuse of pro forma numbers to show, as SEC chief accountant Lynn Turner put it, "everything but bad stuff."

Lutin said that while the cash results may be useful to analysts, many companies are using the practice to try to put a good face on bad numbers.

"It's hard to imagine that either a company CEO or CFO or analyst, in presenting the term 'pro forma profit' to a broad public audience, doesn't know that that is misleading and that the average public investor is going to assume that profit means profit," he said.

One company that came under fire for those types of releases was Lutin and the NYSSA held a series of public meetings to discuss that company's financial reports.

Amazon eventually switched to reporting both pro forma and GAAP results in its press releases, a move Lutin applauds.

And recently, Financial Executives International, backed by the National Investor Relations Institute, issued a set of "best practices" that calls for companies to report both pro forma and GAAP results in their press releases.

What's important, Corcoran said, is for analysts and investors to make sure they realize the difference.

"We look at everything. It's not simply, 'Gee, they'd like to be analyzed based on these three financial metrics, but on these other ones they look terrible.' We use every metric we can," he said.