Understanding Pro Forma Financial Statements: A Cautious Guide

Pro forma financial statements are reports that are entirely unofficial. The term "pro forma" literally means "for the sake of form." As the term implies, these statements do not truly follow any form. Instead, they are used when a company would like to hypothesize about a potential financial model. The company can use essentially any form it wishes to express this hypothesis. As a result, an investor should be very wary about considering pro forma financial statements.

Lack of GAAP Oversight

Perhaps the biggest problem with pro forma statements is that they are not required to conform with Generally Accepted Accounting Principles (GAAP). This means a company can classify various assets, liabilities and expenses according to its own system, ignoring the system put in place on the national level. It is not uncommon, then, to see a huge variance in the financial stability projected in a pro forma statement when compared to an actual quarterly financial statement published by a given company. It is important to view both documents when possible to see the areas where the company may be making changes to appear more profitable than GAAP would imply. 

Omission of Pending Liabilities

One area often left off of a company's pro forma financial statement is any pending liabilities. These are upcoming lawsuits, losses or payments the company knows it will be facing in the immediate future. Since the expenses have not hit the books yet, the company can legally leave these liabilities off of financial statements. Even where GAAP conformance is required, companies do not disclose these liabilities on the regular financial statement. However, companies must provide a record of pending liabilities elsewhere. With a pro forma statement, these pending liabilities may be entirely unmentioned. 

Overly Optimistic Hypothesis

Companies issue pro forma financial statements for a variety of reasons. One typical reason is to estimate the effect of a certain change in the company structure. For example, a pro forma statement may be supplied prior to a merger and acquisition arrangement. The statement estimates potential earnings from the change. Many companies take this opportunity to entice investors or boards of directors into voting for the change. As a result, pro forma statements can be overly optimistic. It is rare for actual financial statements to reflect the same high numbers once the change occurs. The statement should be thought of more as a "goal" than an actual "statement" in this scenario. 

Managerial Insight

Despite all the drawbacks of pro forma statements, they are still very valuable tools to see into the minds of managers in prominent positions. By evaluating the goals a manager has through a certain proposed change, you can catch a glimpse of that manager's assessment of current challenges and needs. Even if the numbers are not a technically accurate representation of the company's financial strength according to accounting principles, they still represent a picture of where the company stands and where it hopes to go in the future.