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What is Pro Forma?

definition

The Latin term pro forma — meaning “as a matter of form”” — is often used in finance to refer to a certain method of creating financial statements.

🤔 Understanding pro forma

Pro forma, a Latin term, refers to something that is done as a formality or “as a matter of form.” Companies use pro forma financial statements to share financial information with investors and creditors while using certain projections or assumptions about what might happen in the future. Businesses can use pro forma statements to highlight certain things that might appeal to investors. This can be a valuable tool for start-up companies that don’t have a financial history to highlight. Pro forma financial statements ignore certain one-time and unusual items, and are thus not presented in compliance with generally accepted accounting principles (GAAP). The Securities and Exchange Commission (SEC) regulates these pro forma financial statements and prohibits businesses from using them to give misleading or false information.

example

Imagine that fictional publishing company ABC Books is creating a pro forma income statement. ABC Books has a deal in the works with a major book retailer, which will almost certainly skyrocket their income. Even though the deal hasn’t happened yet, ABC Books might include the expected extra income on their financial statements to attract the attention of potential investors.

Takeaway

A pro forma financial statement is like a caricature…

It’s a pretty good representation of a company’s financial situation, but not as accurate as a photograph. The company uses the pro forma financial statement to highlight certain aspects to draw the attention of investors.

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Tell me more...

What is a pro forma financial statement?
What is the history of pro forma?
What is the purpose of pro forma reporting?
What are the benefits of pro forma accounting?
What are some problems with pro forma accounting?
What is a pro forma invoice?

What is a pro forma financial statement?

Pro forma financial statements are income statements, balance sheets, or cash flow statements that use pro forma reporting to highlight or eliminate certain information for investors. Companies use hypothetical information to craft these statements to give extra information about their financial situation.

An income statement is a financial statement that reports the profit a company has generated over a period of time, while a balance sheet shows a big-picture view of a company’s finances, including assets, liabilities, and shareholders’ equity. Finally, a cash flow statement is a summary of cash and cash equivalents flowing in and out of the company.

Traditionally, companies use generally accepted accounting principles (GAAP) to provide accurate information to investors. The Financial Accounting Standards Board (FASB) sets forth these principles and requires publicly traded companies to use them in the creation of their financial statements. This is not the case with pro forma financial statements.

When a company releases a pro forma financial statement to highlight certain financial aspects of the business, the U.S. Securities and Exchange Commission (SEC) requires that the company also release a financial statement using GAAP.

What is the history of pro forma?

Pro forma financial statements became commonplace in the 1990s. Dot-com companies sometimes used pro forma financials arguably to mislead investors and show smaller losses than generally accepted accounting principles (GAAP) would have shown.

The U.S. Securities and Exchange Commission (SEC) requires companies to report financial results using GAAP. In response to the misuse of pro forma financials, in 2001, the SEC cautioned companies that GAAP-based financial statements were still a requirement for all publicly traded companies and any companies found to be using pro forma financials to intentionally obscure legitimate financial results will receive punishment. The SEC also warned that investors should be cautious when reviewing pro forma statements. Pro formas are still used by many businesses today.

What is the purpose of pro forma reporting?

The purpose of pro forma reporting is to sidestep generally accepted accounting principles (GAAP) to show financial results based on certain assumptions or projections. Companies typically use pro forma reporting to draw investors’ attention to certain aspects of their financials or to downplay the significance of other elements that might appear to be unfavorable.

At its core, pro forma reporting is meant to provide benefits to investors and give them a more accurate picture of a company’s operations and financial situation. Because of the limited regulation for this type of accounting, the information depicted in pro forma reporting is not always done with the best interests of the investors in mind — Which is why investors should pay just as much attention, if not more attention, to the financial statements created using generally accepted accounting principles.

Companies might also use pro forma accounting internally to plan future business decisions. When companies create pro forma financial statements, they make certain assumptions based on the effects of future business decisions. If a company is considering alternative future business decisions, they might use internal pro forma financial statements to compare the long-term results of each choice. For example, a company considering taking on additional debt to grow the company might prepare pro forma statements to estimate the long-term consequences of that decision and whether it would potentially result in an increase in profits.

There are also situations where the U.S. Securities and Exchange Commission (SEC) requires a company to file a pro forma financial statement, such as in the case of an error in a previous report or a significant change within the business (perhaps due to an acquisition). For those situations, the SEC has outlined certain information the company should include:

  1. An introductory paragraph explaining the purpose of the pro forma statement and a summary of what the pro forma statement shows

  2. A condensed pro forma balance sheet and income statement showing both historical information and the pro forma adjustments

  3. The pro forma adjustments that result from the change in the company, along with any necessary explanatory notes

What are the benefits of pro forma accounting?

Pro forma financial statements allow companies to share with potential investors information that might not appear on a traditional income statement or balance sheet. It will enable companies to remove a balance from a financial statement that might appear to be unusually unfavorable due to one-time expenses.

For example, let’s say a company is restructuring. In the fiscal year that the company is carrying out the restructure, they incur several necessary expenses. In the long run, the company expects that the restructure will reduce company costs and increase profits. But in the current year, the restructure has been expensive, and they haven’t seen the financial return yet.

A company in this situation could use pro forma reporting to give investors a better idea of what’s really going on. Their financial statements will still reflect the factual information about the state of their finances, while also providing an idea of what the company’s finances look like without these one-time expenses.

Pro forma financial statements can also be beneficial when it comes to starting a new business. In the first years of business, it’s common that costs are high and profits are low. But despite potentially bleak numbers, new companies need a way to convince investors that their business is worth investing in. These start-up business owners can use pro forma reporting to show potential investors projections of the revenue they expect to see after they get off the ground.

What are some problems with pro forma accounting?

Companies should be using pro forma financial statements to give investors a more accurate view of what is going on in the company. These financials can show investors things that might not appear using the generally accepted accounting principles (GAAP). For example, companies can use pro forma financials to show the outcome of future or in-progress activities.

However, not all companies use pro forma financials to provide clarity to their investors. In some cases, companies can use pro forma statements to mislead investors and show only the information that is favorable for the company.

Companies have used pro forma financials in the past to elevate their profits by removing evidence of financial losses like unsold inventory, amortization, and depreciation. Businesses can also be overly optimistic about future revenues and profits, causing them to inflate pro forma statements unintentionally.

While the U.S. Securities and Exchange Commission has confirmed that there are situations where pro forma reporting can be beneficial, they’ve also cautioned companies against using this type of reporting to mislead investors. Additionally, the SEC has warned investors to question incomplete financial records and has encouraged them to pay special attention to GAAP-based financial reporting.

What is a pro forma invoice?

A pro forma invoice is a preliminary bill that the seller of a good or service would send to the buyer. The pro forma invoice acts as an estimate or a quote, not as the official invoice. The pro forma invoice isn’t part of the negotiation process — a seller would typically send this invoice after they have agreed to a price with the buyer.

A pro forma invoice provides the buyer with as precise an estimate as possible. The invoice includes not only the price of the good or service, but also typically lists the price of any additional fees, commissions, taxes, or shipping costs.

A pro forma invoice is a common feature in a sale where the seller doesn’t require payment until after the buyer has received the goods or services. They’ll get their official bill later, but the seller provides a pro forma invoice so the buyer knows how much they’ll owe.

For example, let’s say a caterer has booked a large job doing the catering for a fundraising event in town. The caterer doesn’t require customers to pay their bill upfront, but the organization putting together the event has requested an invoice for their records to ensure they are staying on budget. In this case, the caterer might send a pro forma invoice, which contains a thorough estimate of the total cost. Then, at the end of the event, the caterer will provide the official invoice for the customer to pay.

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