Advantages and Disadvantages of Pro-Forma Earnings over Net Profit after Tax - Example

Pro-forma Pros and Cons Name Date Course Table of Contents Table of Contents 2 Executive Summary 2 Introduction 3 Discussion 4 Why firms choose to announce Pro-forma earnings 4 Advantages and disadvantages of Pro-forma earnings over net profit after tax 6 Perception of the stakeholders regarding the Pro-forma earnings 9 Personal opinions 10 Conclusion 12 Bibliography 13 Executive Summary Pro-forma earnings are a financial transaction that is prepared within the organization and it provides information about the earning when no complications were experienced. Firms usually choose the Pro-forma reporting in order to provide a forecast for the future. The use of Pro-forma earnings has its advantages as well as disadvantages. The advantages of Pro-forma earnings over net profit over tax include ability to forecast the financial growth and development of the company. It also enables the firm to determine how manage change. The likely profits that an organization can earn can also be estimated using Pro-forma earnings. Its main disadvantage is the high levels of manipulation it is exposed to. Pro-forma earning can also mislead the investors and stakeholders through provision of inaccurate information. Some useful cost information is also left out when Pro-forma earnings are used. The perception of the stakeholders is mixed due to its advantages and disadvantages. Since Pro-forma earning lacks regulations, it should be prohibited to avoid exploitation of stakeholders and investors by the companies. Introduction The Pro-forma earnings involve earnings that which excludes the specific unusual events or transactions that may include litigations and restructuring costs. It is usually intended to report the earnings of an organization if the fiscal period was more in line with the normal expectations. Pro-forma earnings are common when the organization did not experience any unusual complications during its operations (James & Michello, 2010). The Pro-forma earnings are also considered as the core of operating earnings. It is also common without the nonrecurring losses or earnings. Most of the organizations use the Pro-forma earnings for providing the investors with a better outlook of the core business operations. The Pro-forma earnings usually exclude the nonrecurring business events since they are not expected to occur again in the future years. The Pro-forma earnings can exceed or fall short of normal earning reports. In the financial community, the Pro-forma earnings are considered controversial. The main reason being the Pro-forma earnings do not follow the generally accepted accounting principles. In most cases, the Pro-forma earnings are not audited. The Pro-forma earnings depend on the business ethics since it lacks auditing (James & Michello, 2010). It is therefore difficult to verify the Pro-forma earnings since some of the organizations lack solid business ethics. Other companies also use the Pro-forma earnings for providing misleading information to the investors. The Pro-forma earnings are common in some sectors while in other sectors it is not common. The use of Pro-forma earnings has its advantages as well as disadvantages. The paper discuses the pros and cons of Pro-forma earnings. Discussion Why firms choose to announce Pro-forma earnings Most of the companies choose to announce the Pro-forma earnings as compared to using the Australian Accounting Standards. This can be attributed to various factors including the benefits of announcing the Pro-forma earnings. The Pro-forma earnings mainly provide a forecast for the future earnings. This has made its use common among the small organizations and new business organizations. The ability to obtain the future financial outlook is useful to all the organization and hence it’s continued use among different organizations (Joo, et al, 2014). The companies that are growing and trying to predict the future needs find the use of Pro-forma earnings relevant. This is because it enables the companies to develop strategies that can be used for growth and expansion. Other organizations use the Pro-forma earnings to project their earnings in the next two to three years. The information plays an essential role in enabling the organization to make informed business decisions. Firms also choose the Pro-forma earnings due to the potential benefits that it has on the stakeholders. The Pro-forma earnings provide the investors with information about the growth and potential of the organization. The investors can use the information to make investments decisions. The Pro-forma earnings are therefore commonly used by firms to attract the investors. The upcoming and growing firms are usually keen on attracting investors and hence the use of the Pro-forma earnings (Joo, et al, 2014). Various firms have been able to attract investors and experience a high level of growth and development as a result of using the Pro-forma earnings. The Pro-forma earnings usually exclude the irregular items or activities that took place within the organization. This includes the sale of assets and divisions or losses due to acts of nature. It therefore provides the organization with an opportunity to conceal some of the information that may scare away the investors. The use of Pro-forma earnings is important to organizations in determining the amount of money made from the usual activities (Brown, et al, 2012). Determining the amount made from the ordinary business activities is useful to a firm. The sustainability of an organization depends on its ability to make money from the ordinary activities. The projection of the future income of the organization can be carried out through the use of the Pro-forma earnings. Most of the alternative methods of financial reporting focus on the historical records and past financial information of the organization. The Pro-forma earnings however focus on the future and hence its use by different firms. The Pro-forma earnings are useful to firms during the process of planning and control. It provides an important basis for comparison and analysis. Financial operations within an organization can be planned through the use of the Pro-forma earnings (Brown, et al, 2012). The Pro-forma earnings are important to the firms during the process of minimizing risks. The financial characteristics of a proposed business plan can be obtained through the use of the information from Pro-forma earnings. All the assumptions about the financial and operating characteristics can be obtained through the use of the Pro-forma earnings. Advantages and disadvantages of Pro-forma earnings over net profit after tax Advantages One of the main advantages of Pro-forma earnings over net profit tax is in terms of strategic planning. The pro-forma earnings provide useful information about the future of the organization. The future financial information is important to the company in ensuring that strategies are developed to improve on its growth and development. Based on the future predictions, the organization can come up with new strategic goals and objectives (Zhang & Zheng, 2011). The performance of the organization against the expectations can be compared when the Pro-forma earnings is used. The Pro-forma earning provides information about the future asset management, debt to equity ratio and financial soundness of the organization. Such information is required by an organization during the process of developing strategic goals. The Pro-forma earnings are thus useful in providing guidance to an organization about its future outlook. When dealing with smaller or new organizations, the Pro-forma earnings is important in developing the strategic goals. Long term current assets as well as the long term liabilities are usually provided when the Pro-forma earnings are used. This provides the smaller organizations with the opportunity to plan for its activities. Unlike the net profit after tax, the Pro-forma earnings are useful in the identification of the strengths, weaknesses, threats and opportunities (Zhang & Zheng, 2011). Through the SWOT analysis, an organization is in a better position to identify the areas that needs to be developed. Using the Pro-forma earnings enables the planners within an organization to understand the expected resources that may be used to meet the needs of the organization. Unlike the net profit after tax, the Pro-forma earnings enable the organization to make specific predictions about its future. A bigger financial picture is obtained through the use of the Pro-forma earnings as compared to the net profit after tax (Brown, 2012). The Pro-forma earnings provide the external stakeholders with a wider picture of how the company intends to make profits. Detailed information is also provided through a Pro-forma earnings and it can be used by the investors to make investment decisions. The Pro-forma earnings are useful to an organization during the process of highlighting the impacts of changes that an organization intends to make. Any organization has to make changes from time to time since change is brought about by the internal as well as the external factors. The ability of an organization to manage change is important as it ensures the organization is able to continue with its operations without many interruptions. The impacts of activities such as mergers and acquisitions can be understood by an organization through the preparation of Pro-forma earnings. The consequences of refinancing debt can be understood through the use of Pro-forma earnings (Brown, 2012). The Pro-forma earnings play an essential role in providing the organization with adequate information about control and management of the business. It therefore enables the managers to make effective business as well as financial information. The Pro-forma earnings are more beneficial to organization as compared to the net profit after tax. Disadvantages The Pro-forma earning has some disadvantages which have made more organizations prefer the use net profit after tax. As compared to the net profit after tax, the Pro-forma earnings are mainly best estimates. The estimates are usually made with the assumptions that the company continues operating at status quo. The Pro-forma earnings are mainly a projection after the completion of a planned transaction (Joo, et al, 2014). This means that the estimates may be wrong and it may end up impacting negatively on the future operations of the company. The net profit after tax however provides actual financial information of the company which makes it more reliable. Errors may be made when preparing the Pro-forma earnings. Any error may end up affecting the operations of the whole organization. When preparing the Pro-forma earnings, there are no standard guidelines or rules that govern the process. This may impact negatively on the stakeholders or external investors. The organization may manipulate the figures in order to attract the investors. The use of false information is common in some of the organizations that intend to attract the investors. The Pro-forma earnings may therefore provide misleading information to the investors which may see them losing their money in case of losses (Joo, et al, 2014). The lack of standards or regulation means that the Pro-forma earnings are dependent on the business ethics of the organization. Lack of ethics within an organization may contribute to the manipulation of the investors leading to the wrong business decisions. The information provided in the net profit after tax is more realistic and reliable as compared to the Pro-forma earnings. The Pro-forma earnings are subject to a lot of manipulation by the organizations in order to make the image of the company look good. Various items are usually left out of the Pro-forma figures and this includes depreciation, goodwill, restructuring and amortization. Other items that are left out includes interests, taxes, loses at affiliates, one-time expenses and stock-based employee pay (Brown, et al, 2012). Excluding the important items affects the ability of the organization to represent the actual earning potential of the company. This has negative impacts on the accuracy of the projection of the company. The one-time cash expenses are also excluded from the Pro-forma as it is considered irrelevant. This further negatively influences the accuracy of the financial information. The one-time cash expense in the real sense is a particular sum of money that has left the organization and should therefore be considered as an expense. Poor decision making process can result from the Pro-forma which may end up affecting the financial position of the organization. The unsold inventory in some instances is usually taken off the balance sheet when the Pro-forma reporting is used (Brown, et al, 2012). This is unrealistic in the real business environment and it may affect the planning process within the organization. In most cases, the investors have to scrutinize the information in the Pro-forma in order to determine its legitimacy. This involves establishing the information that has been left out in the pro-forma. The Pro-forma therefore lacks credibility among stakeholders which affects its use. Perception of the stakeholders regarding the Pro-forma earnings The perception of the stakeholders regarding the Pro-forma earnings is mixed. However, some of the stakeholders re in support of the Pro-forma and they consider it relevant. This is common in the telecommunication industry as well as the organizations that are undergoing growth and development. The nature of doing business in some of the sectors makes the Pro-forma earning more relevant to the stakeholders in providing the financial information. The stakeholders in such sectors perceive the Pro-forma as the most accurate source of financial information. Some of the telecommunication companies rarely make any net operating profit since they are constantly writing down huge depreciation costs (James & Michello, 2010). In such cases, the only way to establish financial information of the company is through the use of a pro-forma. The investors are also able to see the actual cash profits of the organization with the exclusion of the non-cash charges. The perception of the stakeholders is positive in the sectors that it highlights a clear view of the operations of the company. The perception of the stakeholders is also influenced by the high levels of business ethics in some of the organizations. However the perception of other stakeholders regarding the pro-forma earnings is negative. This is mainly attributed to the weaknesses that are associated with its use. Some stakeholders have negative perception since some companies use the pro-forma earnings to provide inaccurate information aimed at attracting the shareholders. The lack of standards during the preparation of the pro-forma is also of concern among the stakeholders and it has contributed to negative perceptions. Personal opinions Firms should be prohibited from reporting using the pro-forma earnings. This is due to the absence of standards as well as mechanism of regulating the information provided to the investors. The pro-forma earnings provide a short cut for rogue organizations to attract investor using false information. A lot of stakeholders have ended up losing their money or investments as a result of relying on the information provided to them in the pro-forma earnings. The investors and shareholders are usually the greatest losers when false information is provided by the company through the pro-forma (James & Michello, 2010). Some of the investors and stakeholders may not have adequate knowledge on the issues of finance. When presented with the pro-forma, it is easier for such investors to make the wrong decisions with the belief that the company is likely to perform well. Currently, the issues of ethics in business are highly regarded. However, this has not deterred some rogue companies from exploiting the investors and shareholders. The lack of policies as well as standards means that the investors and stakeholders have to depend on the goodwill of the managers at the organizations. This increases the chances of exploitation of investors and shareholders. This is an indication that the use of the pro-forma earnings does not serve the interest of all the stakeholders. It mainly serves the interest of the organizations and hence its inability to address the challenges that the investors and shareholders may face. The information provided in the pro-forma may not be reliable since some of the costs are usually excluded. The exclusion of costs makes it difficult for the stakeholders and investors to determine the actual performance of the organization. Some of the costs that are usually excluded have negative impacts on the expenses of the organization and it may end up affecting its operations. Such weaknesses in the use of the pro-forma may impact negatively on the investors and it should therefore not be used. The chances of manipulation of the pro-form are too high and this is likely to affect the stakeholders as well as the shareholders (Zhang & Zheng, 2011). The lack of regulations gives rogue companies an opportunity to by-pass some of the important aspects of accounting. The use of the pro-forma earnings contributes to the lowering of accounting standards as it is prone to manipulations. The levels of professionalism when using the pro-forma is also low in most of the organizations. Although the pro-forma earning has benefits to the organizations, in most cases, it is used for the purposes of portraying a good financial image of the company among the shareholders and investors. The use of the pro-forma earnings should therefore be prohibited due to the negative impacts that it has on the stakeholders. Conclusion In conclusion, it is evident that the pro-forma earnings have financial information about an organization. The information provided is important in forecasting the financial position of the organization. It is evident that the pro-forma earning has its pro and cons. The main advantage of the pro-forma earnings is use in developing strategies. The organization can use the information to develop strategies that can be used to enhance growth and development. It is evident that the information can be used by the organization to determine the means that an organization can use to finance its operations. It is evident that the main problem associated with pro-forma is high levels of manipulation. The information can be manipulated by the company to attract investors. It also leaves out useful financial information including different types of costs. The use of pro-forma earnings has attracted mixed views among the stakeholders. It is evident that its use is relevant in some of the sectors as compared to other sectors. The use of pro-forma in the telecommunication industry is relevant due to the nature of business operations. Personally, the use of pro-forma should be prohibited due to its negative impacts that it has on the investors and shareholders. Bibliography James, K, L, & Michello, F, A, 2010, Pro forma versus GAAP reporting: An examination of differences in investor perceptions, Journal of Finance and Accountancy, 2, 1-16. Joo, J, H, et al, 2014, The effect of Industry Business Cycles on the Information in pro-forma Earnings: Evidence from US REITs. In the 2014 America Accounting Association Financial Accounting and Reporting Section Mid-year Meeting. Brown, N, C, et al, 2012, Investor Sentiment and pro-forma earnings disclosures, Journal of Accounting Research, 50(1), 1-40. Zhang, H, & Zheng, L, 2011, The valuation impact of reconciling pro-forma earnings to GAAP earnings, Journal of Accounting and Economics, 51(1), 186-202. Brown, N, C, 2012, The timing of quarterly pro-forma earnings announcements, Journal of Business Finance & Accounting 39(3-4), pp. 315-359. Read More