The Ability of Pro Forma Earnings to Improve Predictability and Comparability

Open Access
Author:
Interdonato, Michael Anthony
Area of Honors:
Accounting
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Jeremiah Ross Green, Thesis Supervisor
  • Orie Edwin Barron, Honors Advisor
Keywords:
  • pro forma earnings
  • street earnings
  • operating earnings
  • earnings predictability
  • earnings comparability
Abstract:
This paper seeks to determine the ability of pro forma earnings to improve predictability and comparability. The primary research question focuses on determining whether pro forma adjustments remove temporary items from reported GAAP as they are meant to do. I find that pro forma adjustments do in fact remove temporary items from reported GAAP and therefore improve their ability to predict future earnings. However, GAAP earnings also add value when predicting future earnings, which shows that these pro forma adjustments remove permanent items at times as well. The secondary research question focuses on determining when pro forma adjustments improve predictability and when they do not. I find that pro forma adjustments improve predictability of future earnings in times when companies are performing poorly, represented in this paper by times in which sales are decreasing or times in which market value is decreasing. However, they fail to improve predictability of future earnings in times when companies are performing well, represented in this paper by times in which sales are increasing or times in which market value is increasing. The tertiary research question focuses on determining how comparable pro forma earnings are when conducting ratio analysis across companies. I find that a measure of operating earnings, which removes extraordinary items, depreciation and amortization, income taxes, and interest and related expenses from GAAP earnings, is generally the best earnings measure to use when focusing on comparability of ratios across companies followed by pro forma earnings and finally GAAP earnings. As expected, because pro forma adjustments are typically made in an effort to report a more accurate EPS value, pro forma earnings are the best measure of earnings to use when focusing on comparability specifically related to earnings per share.