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ROYAL DOCKS BUSINESS SCHOOL - Assignment Feedback

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u1233184
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AC2040

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Relevance and quality of the research topic

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WHY COMPANIES VOLUNTARILY DISCLOSURE PRO FORMA?

Abstract
The annual statements of companies provide financial information let
users know how well companies are performing, especially external users
like investors. In order to attract investment offers, firms try to give a
good picture of its financial outlook by using non-GAAP earnings that
known as pro forma earnings. Consequently, this research provides three
findings related to the reason firms voluntarily release adjusted earnings
to the public are (1) avoiding reporting loss or reporting earning's
decrease, (2) meet analysts expectations or forecasts and (3) affect
investors perception before equity offering. Additional, this paper also
provide evidence that investors are not misled by pro forma disclosures
even these statements do not meet the acquirement of generally
accepted accounting principles (GAAP).
Keywords: non-recurring items, disclosure, pro forma earnings, GAAP,
analysts, investors.

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Content Page
Contents

Page

Abstract.......................................................................................................3
Introduction.................................................................................................5
Literature Review........................................................................................6
2.1. Determinants of disclosure of pro forma earnings.............................6
2. 2. Incomes management responds to predictions of analysist.............7
Research aim and research hypothesis.......................................................8
3. 1 Pro forma earnings encounter analysts forecast..............................8
3. 2 Pro forma earnings mislead nonprofessional investors.....................9
Methods of Data collection and Contribution............................................10
Conclusion.................................................................................................10
References list...........................................................................................11

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Introduction
Each quarter in a year, firms earnings and their financial results are
frequently supplemented by using non-GAAP as known as pro forma
accounting information (Campbell & Pitman, 2009; Zhang & Aheng, 2011).
In order to compute pro forma figures, companies GAAP earnings figures
are adjusted for non-recurring items (Alpert, 2001; Bowen, Davis &
Matsumoto, 2005). A non-recurring item means an incident that occur just
only once and does not happen again, that means the company does not
undergo during its regular business activities such as restructuring
charges or extraordinary items. Based on that, pro forma earnings are the
amount of companies profit that exclude non-recurring items cost (Matt,
2012). In 1972, SSAP6 Extraordinary Items and Prior Year Adjustments
was released and required firms to severally present extraordinary items
after Sales and Expenditure which linked to recurrent activities in earnings
announcements (Weetman, 2001). Whereas, FRS3 Reporting Financial
Performance which was issued by the UK ASB (Accounting Standards
Board) required companies to discriminate non-operating from operating
objects related to exceptional items (Ann, Stephen and Norman, 2011). It
gave a new definition of exceptional items and changed their disclosure
requirements (Acker, Horton and Tonks, 2011). In addition, under FRS3,
firms must provide more information in order to support users in
company's

historical

performance

assessment,

as

well

as

future

performance prediction. Some studies examined the economic results of

FRS3, and discovered that it enhanced the financial reporting system in
the UK. Due to the diversity of the need of different users, since 2005,
IAS1, which was published under IFRS GAAP stipulates the performance of
financial reports and non-recurring items. It allows companies to display
materials items either as a section of profit and loss account or in notes of
financial reports. Nevertheless, in comparison with FRS3, IAS1 offers not
really rigorous disclosure requirements related to non-recurring items.
According to this, firms can disclose profits prior to exceptional items and
have the opportunity in selecting the heading for these items. As a result,
these days, there is an increase in the number of companies disclosing pro
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forma earnings figures in their profit and loss statement (Frederickson and
Miller, 2002). While companies state that they disclose pro forma earnings
information to support investors having a better understanding of their
performance (Burns, 2001), others like regulators, Congress, and the
financial press argued that investors might get mislead by that kind of
information that they provide (see, e.g., MacDonald 1999; Alpert 2000;
Burns 2001b; Weil 2001d, 2001b; SEC 2001). There are many U.S
researches indicated that investors acquire the knowledge of the
difference between GAAP earnings and non-GAAP earnings and trade on
non-GAAP earnings. By using UK data of pro forma statement, the purpose
of this research is to determine whether pro forma information can meet
analysts forecast and examine how it affects to investors decisions.
Especially, this study will provide evidence about how the perception
process of investors about adjusted earnings is. That is an essential
stage

regarding

comprehending

how

pro

forma

disclosures

affect

investors assessments.
Literature Review
This section is intended to give a critical analysis of previous studies that
is related to my research's problem, debate and determine the gaps and
restrictions in our knowledge of pro forma information disclosure. Thus, it
delivers the basic foundation for my research hypothesis that I propose in
the next section.
2.1. Determinants of disclosure of pro forma earnings
The literature on causal elements of pro forma information disclosures is
important and get more concern, researching by Joerg-Markus Hitz (Feb
2010). It investigates in the list of large German firms to find out the
determinants of non-GAAP earnings report under IFRS. An incentive score
that arranges from 0 to 4 is gathered by reaching four standards in each
quarter of business. Base on that, the first potential hypothesis is
investigated: Companies that fail in planning incomes standards probable
disclose pro forma information than other companies (Heflin and Hsu,
2008). Empirical evidence also shows that year that is an imitation
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changeable has effects and takes advantage of one quarterly statement

refers to 2006. That is because the selection of the year dummy rather
than quarters control to find evidence for the application of IFRS
accounting vary from the possibility of releasing adjusted earnings. An
outstanding point in the selection of researching method is create 4
industry groups (Bassen et al., 2008) and get important figures from them
and deliver more perceptions. Results from the literature suggest that the
Incentive Score is valuable and have an implication in clarifying the
disclosure of pro forma reporting due to missing an incomes standard.
Besides, the research findings also indicate that firms that companies that
are required to apply IFRS from 2005 onwards highly tend to publish more
information of pro forma reports than ones that apply voluntarily IFRS
before 2005. However, the evidence is not adequate to conclude the
limitations on voluntary release of performance measurements of 36
companies capacity using secretive information (e.g. Heflin and Hsu,
2008, pp. 38; Kolev et al., 2008, pp. 175)
2. 2. Incomes management responds to predictions of analysist
This area research investigates whether UK companies earnings reports
satisfy

forecasts

of

experts

in

earnings

in

managing

incomes

(Athanasakou, Strong and Walker, 2009). They found that, in the period
after the end of the accounting period and prior to the publication of
results; there is the fact that most managers and analysts tend to
eliminate irregular items from profit and classification shifting from centre
costs. That can arise a lot of predictions. They do not find evidence of the
interruption in misleading predictions for the company releasing reports
on losses and profits decreases. In addition, net earnings are not
influenced by classification shifting; hence it is restricted the inspection of
auditors (Nelson et al., 2003; mcVay, 2006). Furthermore, Browns (2001)
found the evidence of remarkable efforts of the profitable company in
meeting expectations of specialists, and the disruption in the incomes
standard is not regular in companies that making losses. Moreover,
Athanasakou and others used descriptive and multivariate analysis
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methods, data tables and variables models to investigate other aspects

relating to meeting proffesionals prospects. Their results give tested
information for the relationship between nonperiodic products and
expected profits, and then found that there are about 10% companies use
classification shifting for small items just to meet experts' hopes. That is a
tremendous and essential impact for investors, however, has not

yet

provided objective reviews about if investors may attempt to use

classification shifting to impact on stock prices or not.
Research aim and research hypothesis
As mentioned earlier in literature review section, my research aims to fill
in the gap of previous studies by Athanasakou et al. (2009) in how pro
forma earnings information meet analysiss expectations and the effect to
investors decisions. In the first place, this proposal research tries to
provide the perception for showing that specialist' forecast is revised
downward by UK companies to satisfy the spacialist' expectations. This
idea, which is reaching agreement with the opinion of investors and fiscal
managers, is a fairly common practice in UK firms (Choi et al., 2006;
Brown et al., 2011). Secondly, the investigation of whether pro forma
earnings misled investor in making decisions (e.g. Johnson and Schwartz,
2002) also lead to a very curious matter to examine the effects of
adjusted earnings reports ( Frederickson and Miller, 2003). Amateurs
investors and analyzer specialists have different ways to evaluate
investment information and make decisions (Maines and McDaniel 2000).
3. 1 Pro forma earnings encounter analysts forecast
According to Bhattacharya and others (2003), there are several major
differences between the incomes forecasts of experts and stock value
variation with non-GAAP earnings, affirming that they can clarify nonGAAP information in different ways. Especially, Schipper and Lev (1991)
and Thiagarajan (1993) believe that referring to the area of acquiring
knowledge about the essential of the relationship amidst fiscal reports
items, analysts mostly express better.

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Maines and Mc Daniel (2000) suppose that due to advantages of seeking

key information, analyzer specialist can perceive exact information that is
related to issues they need to assess. Similarly, several studies provide
convincing evidence to prove that incomes information is essential to
analysts (Bouwman et al. 1987; SRI International 1987; McEwen and
Hunton 1999). Moreover, firm managers believe that analysts desire to
access information about "adjusted" incomes, and that is the reason they
decided to release financial reports (Alpert 2001; Weil 2001a).
Specialists are not entirely aware that the disclosure of pro forma
information contained incremental nature of the other particular incomes
constituents. The reason is that there are differences between the
knowledge of analysts about incomes components (Jacoby et al. 2001).
Johnson and Schwartz (2003) and Bhattacharya et al. (2003) refer 2 types
of corporation and evaluate to compare how the release of pro forma
information impact on non-professional investor and experts. Therefore, I
now would like to mention to the second hypothesis about the effect of
pro forma earnings on amateur investors.
3. 2 Pro forma earnings mislead nonprofessional investors.
Research shows that amateur investors still have several prejudice about
the significance of different fiscal report items (Maines and McDaniel,
2000),

indicating

that

amateur

investors

are

commonly

short

of

investment expertise. Investors and financial analyst use accounting

numbers to value stocks. Therefore, there is an incentive for management
to manage the earnings in order to influence the short-term stock price
performance. Experimental evidence is provided to show that non GAAP
incomes surpassed GAAP incomes. (Johnson and Schwartz, 2002). It
proves that amateur investors who acquired incomes information for both
"adjusted" and GAAP earnings reports evaluate a greater stock price than
amateurs who got a statement consisting just only GAAP information.
Firms always release non-GAAP incomes in both the headline and the first
several notes of the statement (Alpert 2000; Dignan 2001; Weil 2001a;
Johnson and Schwartz 2003) because they want to help amateur investors
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increase the possibility of accession essential information from the

beginning. Thus, I hope investors in general and nonprofessional ones in
particular should read the pro forma earnings reports from the start.
Methods of Data collection and Contribution
The main objectives of this research are to show the explanation on the
effect of pro forma incomes on analyzer specialists and non-professional
investors. I use different ways to evaluate market (Liu, Nissim and Thomas
2000; Bhojraj and Lee 2002) to find out whether investors can acquire a
greater stock price to non-GAAP corporations than GAAP corporations.
Nevertheless, there are still some limitations in my proposed research that
I have not clarified yet. Firstly, I have still not proved yet that non-GAAP
companies have a different price with GAAP companies for the same
period. Secondly, in the incomes disclosure date, there is no premium
share return for non-GAAP corporations.
Conclusion
My proposed research has an essential significance deal with both analyst
and investors who concern about pro forma earnings information of
companies. It indicates that UK firms prefer to involve incomes
expectations guidance to satisfy incomes standard (Choi et al., 2006).
Besides, firms which use non-GAAP earnings to get better communication
with general investors to avoid under-price shares and create investors
over-price shares, mostly amateurs. Future research should evaluate if
investors are able to discover the efforts of classification shifting to
support for share prices and examine the influence of how pro forma
earnings can avoid losses and profits decrease.

Word Count: 1888 words.

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Alpert, B. (2000). The numbers game: Reporting of pro forma earnings is
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Alpert, B. (2001). Maybe pro-forma earnings arent so bad after
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