“Pro Forma” in Latin meaning “matter of form” is used in the finance and accounting world to project likely financial outcomes under different scenarios. When companies consider operating assumptions, business projects, or even business partnerships or acquisitions, management and investors need to analyze the possible financial outcomes under each alternative. The pro forma income statement projects the income and expenses under each scenario over a specific time frame and it is strongly depended on for management decision making.
Pro forma income statements are usually produced by CPAs and financial analysts with the input coming from operations, sales and finance departments. Common reasons to produce pro forma financial statements include:
Planning and Forecasting
Before the start of a new fiscal year, businesses make income and expense projections based on a variety of factors including historical figures and market data. The projections can be organized into multiple pro forma income statements, each one dependent on alternative factors and assumptions. Throughout the fiscal year, the company is able to evaluate its performance by comparing the actual income and expenses to the pro forma figures that were produced in the planning phase. If the actual figures deviate significantly from the pro forma figures, the company will know that they need to change their inputs and assumptions for the next plan or forecast.
When a company is considering a significant event such as a merger, acquisition, or expansion, management often uses pro forma financial data to predict financial outcomes under each alternative. Until there is a strong indication as to how a significant event will impact the company’s financials, it can be very risky to decide how to proceed. Typically, management and executives will spend significant time analyzing the financial impact of each decision and when they come to a consensus they will use the pro forma data to present their case to the board of directors.
Pro forma income statements are not only used for significant events but also for smaller business decisions such as introducing a new product line, offering a new service, or investing in new equipment.
External Financial Reporting
In conjuncture with a pro forma income statement presented to the public, the SEC now requires public companies to present their most recent and comparable income statement following US Generally Accepted Accounting Principles guidelines. Investors and prospective investors can use the pro forma data in combination with the US GAAP historical statement to aid in their investment decisions about the company. Companies are also required to present pro forma financial data when they make significant changes to their accounting policies. This change could be anything from adopting a new FASB accounting principal to updating a significant assumption that impacts the financial statements.
As you can see, pro forma income statements are not only useful in helping management make business decisions but also equally important in presenting financial information to the public to aid with their investment decisions. It’s no coincidence that the companies who are very good at producing accurate pro forma statements are also very good at making business decisions.