Wall Street finally learns to count.

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July 19 2002 10:51 AM

Falling Back Into the GAAP

Wall Street finally discovers what's wrong with "pro forma" earnings.

The release of Yahoo!'s quarterly earnings report last week may mark a milestone of sorts, a sign that American business is taking serious steps to inoculate itself against the plague of corporate scandal. Yahoo! inserted "GAAP" into the headline of its earnings news release, which for the first time highlighted actual bottom-line results rather than the fanciful numbers once fed to credulous investors. GAAP stands for Generally Accepted Accounting Principles—the sort that seemed so inconvenient during the long 1990s bull market. But conspicuous virtue is what sells on Wall Street these days, so GAAP is back, and with its return, that postmodernist form of accounting known as "pro forma" earnings is quietly beginning to expire.

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Pro forma—"as if"—was once an innocuous phrase used to make earnings reports more accurate rather than less so. When a firm made an acquisition or sold off a big unit, it would compare its latest results to pro forma results for the year-ago period—"as if" the merger or divestiture had already been in effect. Apples to apples, in other words. But during the '90s, the meaning of pro forma was stretched out of shape by many technology startups that had growing revenues, but not the profits they needed to justify their ever-climbing stock valuations. They began presenting pro forma earnings numbers that stripped out onetime, nonrecurring expenses. Often known as "operating earnings," these numbers sometimes presented a more useful picture of the firm's core finances than the net earnings calculated by GAAP rules. But as the boom gained momentum and the pressure increased to report ever-growing earnings, some companies loosened their definition of onetime expenses even more, to the point where pro forma came to mean essentially whatever the firm wanted it to mean.

Sounds like fraud, right? But it wasn't, because the companies didn't claim that their pro forma earnings were the same thing as the official GAAP earnings they reported to the Securities and Exchange Commission. The GAAP numbers also were included in the press releases, although usually they were less prominently displayed. So why did everybody focus on the pro forma earnings? Because we wanted to. It was a mass delusion in which everybody willingly participated. That's why this issue is getting relatively little attention these days, despite all the focus on reform. With pro forma, there is no convenient villain to blame. The pro forma phenomenon is simply embarrassing for all concerned—which is just about everybody.

(Federal Reserve Chairman Alan Greenspan made the point Tuesday during his testimony before a Senate panel, when he was asked about the recent accounting scandals. "Remember, it's not as though everybody should be shocked by this," he said. "I mean, we had these pro forma statements for months and quarters back when the market was roaring away, and it was the most imaginative accounting I have ever seen. …Everybody knew that was going on.")

Investors also were in on the game, the point of which was to keep the stock price heading higher. The firms that indulged in this practice would concoct their own customized definitions of pro forma, then issue guidance to Wall Street analysts, who would set the consensus earnings estimate. When the firm beat the estimate by a penny or two per share, CNBC analysts and online journalists (and, yes, I was among them) would breathlessly report a "better than expected" earnings report, whereupon the stock would rally hugely. Investors might momentarily be puzzled to read in the newspaper the next morning that the firm actually had posted a big loss. But, reading on, they would be reassured to learn that it was only a GAAP loss; the pro forma results were generally much more impressive.

Consider what happened when Yahoo! posted its fourth-quarter 2001 results six months ago. The firm's revenues had fallen precipitously from the year-ago quarter, and on a GAAP basis it lost 2 cents per share. But Yahoo! highlighted its pro forma profit of 3 cents per share, which was 2 cents higher than the consensus estimate. Pandemonium! Yahoo! shares shot up more than 10 percent that day, touching off a marketwide rally that sent the Dow Jones industrial average up 138 points.

But the same day Yahoo! released its report, the SEC began cracking down on pro forma abuse. The first wrist to be slapped was Donald Trump's: His Trump Hotels and Casino Resorts was zapped for a 1999 earnings release that trumpeted an impressive profit that excluded an $81.4 million charge but included an undisclosed, onetime $17.2 million gain. That would have been fine had the company winked at investors by calling it "pro forma." But the release omitted the phrase altogether, leaving investors to presume that the numbers bandied about were GAAP-worthy.

The Donald's firm paid no penalty, but the pro forma players felt a chill. Yahoo!'s rally was short-lived. The Enron scandal made investors suspicious of anything that smacked of accounting trickery. Three months later, Yahoo!'s first-quarter release emphasized EBITDA earnings, which are more consistently defined than pro forma earnings (though still problematic, as Daniel Gross explained). Moreover, Yahoo! renounced any future use of pro forma. With last week's second-quarter release, Yahoo! delivered on that promise and went even further, by embracing GAAP as a marketing strategy. The headline blared that Yahoo! "Delivers Year Over Year Growth and GAAP Net Income," as though GAAP were an exciting new product. Which in a way it is.

No doubt Yahoo!'s decision was made easier by the fact that it could post a GAAP profit for the second quarter. Some other firms, especially money-losing tech firms, still are posting pro forma results. But they are also proclaiming their fealty to GAAP by featuring the acronym high up in their earnings releases and by carefully explaining how their pro forma numbers were calculated. Still, Yahoo! has won little applause for its move, even while Coca-Cola is being lionized for its decision to expense stock options. No firm is going to get much credit for abandoning the pro forma charade, because the act of renunciation only draws attention to the fact that they were playing the game in the first place.

Mark Lewis is an editor at Forbes.com. You can e-mail him at mlewis@forbes.net.

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