“Management Earnings Forecasts: A Review and Framework” by D. E. Hirst, L. Koonce and S. Venkataraman explained the antecedents, characteristics and consequences interlinked with earnings forecasts. Antecedents are characteristics that are prevalent prior to the consequence such as the existing environment/firm specific characteristics; and consequence is the outcome from antecedents and characteristics. Characteristics are the choices the management has deciding on how the report will be issued.
The article guides the reader giving explanations of why management decides to release earnings forecasts, interactions of the three variables and its findings and how these findings may impact one period to another. Studies have found that management may issue forecasted earnings to reduce difference of opinions and/or information with the shareholders, to avoid litigation risks when the entity needs to make bad news disclosures and when managers have equity-based compensation tied to extend their wealth.
Case Summary According to the case, “Management Earnings Disclosure and Pro Forma Reporting” by Mark T. Bradshaw and Jacob Cohen states that companies too often exclude information that negatively impacts the company’s earnings per share on their pro forma reports prior to releasing the financial statements that is in accordance with generally accepted accounting principles which is based on companies who have released such reports and the response to such reporting by the regulators.
According to the case, pro forma reporting was originated by the SEC to provide earnings comparability for investors for differing time periods based on a “what if” analysis, meaning, what would have happened if this transaction had occurred and what would’ve been its impact on later reporting periods (Regulation S-X 1982). However, multiple incidents have shown that companies abuse the system. Proxim and Cisco, Inc. , both released their pro forma reports prior to their financial statements being released where both of the companies excluded the research and development costs, restructuring charges, mpairment/amortization of goodwill, which resulted in an overall positive net income with net income per share, whereas the financial statements in accordance with GAAP resulted in a loss with loss per share for both of the companies.
Managers who are trying to disclose bad news about the company are more likely to issue earnings forecasts in order to avoid litigations (Skinner 1994, 1997). In addition, Trump Hotels and Casino, Inc. DJT) also excluded a onetime charge while including a onetime gain of $17. 2 million, exceeding the analysts’ estimates of $0. 54 per share to $0. 63 per share on their pro forma reporting (Burns 2002). The Securities and Exchange Commission (SEC) responded to their incautious reporting and DJT acknowledged the findings and consented to unyielding commitments if similar violations were to take place again. The DJT incident was the first time the commissions took action against abusing pro forma reporting.
Financial forecast data rating agencies such as Standard & Poor’s (S&P) recommended for companies to include in their operating earnings such as restructuring charges, write-downs of assets, stock-option expenses and research and development costs and furthermore S&P suggested companies to exclude from operating earnings the following four categories: 1) goodwill write-downs 2) charges for litigation 3) gains and losses on asset sales and 4) expenses related to mergers and acquisitions (Leisman and Weil 2001).
Although S&P made recommendations, Proxim, Inc. , still excluded restructuring charges, research and development costs while Cisco Systems, Inc. , also excluded restructuring, stock option exercise and research and developments costs on their pro forma reports, one of the reasons might be based on the belief that stock prices will fluctuate with high volatility, for example, when Rainforest Cafe announced earnings per share that was lower than expectations the stock price plummeted by 40% on a single day (Sloan and Skinner).
Although managers may want to convince the investors their company’s value by providing pro forma reports that is plausible, they may want to consider the fact that this is only short term credibility because according to Hirst et al. (1999) only when the prior forecast is accurate do they consider future forecasts.
The choices aren’t clear-cut on why the management continues to release misleading pro forma reports, the incentives behind them may be bonuses tied to stock prices or on the other hand management may want to release pro forma reports that is symmetrical to financial statements to reduce the asymmetry of information between managers, analysts and shareholders (Ajinkya and Gift 1984; Verrecchia 2001).
It would be best for management to issue accurate pro forma reports to maintain creditability with the shareholders and the analysts because in the long-run the investors will depend on the entity’s reports for accuracy thus creating creditability which is the fundamental foundation of any business.