Does Pro Forma Reporting Bias Analyst Forecasts?

ABSTRACT

Standard setters put much effort into the development of ‘better’ financial reporting standards, that is, standards that more accurately capture the economic substance of business activities. However, the more sophisticated accounting treatments caused by new standards, and the growing complexity of business activities as such, has made financial reports more difficult to understand. In response to this situation, some companies use pro forma reporting, which means that certain complex items required by financial reporting standards are excluded. This study adopts a user perspective and investigates how pro forma reporting affects analysts' judgments in an experimental setting. On the basis of psychological theory, our hypothesis suggests that analysts' judgments will be affected by differences in the way company performance is presented. Our results show that analysts who received both pro forma and Generally Accepted Accounting Principles (GAAP) information made significantly higher earnings per share (EPS) forecasts than those who received GAAP information only. It is argued that positive framing and higher levels of anchor explain this result, which suggests in turn that analysts' EPS forecasts can be manipulated by alternative ways of presenting company performance. Some possible implications of this finding for standard setters are discussed.

Acknowledgements

Both authors contributed equally to this work, the order of authorship is arbitrary. Helpful and valuable comments from Salvador Carmona and two anonymous reviewers are gratefully acknowledged. The first author wishes to thank the research foundation of Jan Wallander and Tom Hedelius for financial support.

Notes

¹Ordinary net profit, calculated according to Generally Accepted Accounting Principles (GAAP), is adjusted for items that are in some sense ‘unusual’. This could include restructuring charges, write-downs and impairments, research and development expenses, merger and acquisition costs, stock compensation expense, goodwill amortization, etc. (Bradshaw and Sloan, 2002).

²Bradshaw and Sloan (2002) reported this empirical result on the basis of a comparison between GAAP earnings and pro forma earnings as registered by analyst tracking services. Thus, they do not use the companies' pro forma earnings measures. However, the analyst tracking services base their pro forma measures on companies' specifications of what is referred to as non-recurring or non-cash expenses.

³Quotations from the speech are included in Bhattacharya et al. (2003, pp. 286–288).

⁴These results reported in Frederickson and Miller (2004) and Elliott (2006) also agree with those of a recent study based on archival data by Allee et al. (2007).

⁵According to the descriptive statistics in Elliott (2006), analysts who received the press release emphasizing pro forma earnings gave slightly higher earnings performance ratings than analysts who received GAAP information only (31.94 compared to 28.82 on the 100-point scale). The pro forma earnings press release with reconciliation caused analysts to give significantly higher earnings performance rankings compared to the press release including GAAP information only.

⁶Elliott (2006) reports a case in which the GAAP loss of $1.02 is transformed into a pro forma profit close to zero ($0.01).

⁷Analysts' stock price appraisals could be expected to be preceded by analyst forecasts of a particular valuation attribute, such as earnings. Furthermore, the appraisal will involve subjective risk considerations. In the case of investment decisions, analysts do not typically make such decisions. The analysts' earnings performance ranking (Elliott, 2006) is likely to be the dependent variable that comes closest to the analyst's primary real-world task of making earnings forecasts.

⁸In a study based on archival data, Doyle et al. (2003, p. 159) reported that some of the items excluded from pro forma reports (denoted ‘special items’) are unrelated to future cash flows from operations, whereas other excluded items (denoted ‘other exclusions’) have a pronounced negative relation with future cash flows from operations. It is possible that analysts use the reconciliation to learn more about the type of items affecting the pro forma reporting. If there are a lot of ‘special items’, this might be a reason for viewing the company more positively than if the items were part of the group of ‘other exclusions’.

⁹The complete research instrument can be obtained from the corresponding author.

¹⁰There were also additional questions prompting the participants to make subjective probability forecasts with respect to the likelihood of higher sales, lower costs, improved income or a stronger financial position, as well as indicating their confidence in the forecasts concerned.

¹¹As suggested by one of our reviewers, an alternative procedure would involve splitting the sample into three subgroups so that the participating analysts were categorized as limited, moderately or highly experienced (n = 19, 13, 16). Such a procedure was also adopted. A Kruskal–Wallis test showed that the subgroups did not show significantly different reactions to the types of financial report. Nor were the differences between the limited and highly experienced analysts significant.

¹²We thank an anonymous referee for suggesting this design.

¹³We thank an anonymous reviewer for helpful comments on the implications of our results for standard setters.