The strange, self-contained world of pro forma financial statements…

We recently discussed the CSA’s current consultation paper on reducing the “regulatory burden” on reporting issuers. Among much else, the paper floats the possibility of removing the requirement to prepare pro forma statements as part of a business acquisition report filed under Canadian securities regulations. Well, in a nutshell, if that part of the reporting “burden” can’t be removed without causing detectable damage to anyone’s understanding of anything, then nothing can.

It had been a while since I spent much time looking at pro forma statements, but recently after a professional change of scene I’ve been encountering them more often again. For the uninitiated, these are a regular component of those business acquisition reports, or of other filings made in connection with significant corporate transactions. In the words of National Instrument 51-102: “The objective of pro forma financial statements is to illustrate the impact of a transaction on a reporting issuer’s financial position and financial performance by adjusting the historical financial statements of the reporting issuer to give effect to the transaction. Accordingly, the pro forma financial statements should be prepared on the basis of the reporting issuer’s financial statements as already filed.”

So, if calendar-year reporting entity A acquires entity B in May 2017, it might present a pro forma consolidated balance sheet and income statement showing how things would have looked if the transaction had taken place on December 31, 2016 and on January 1, 2016 respectively (the different assumptions applying to the two statements reflect the different preparation mechanics). In broad terms of course, this just amounts to adding the historical statements of A and B together and adding the minimal entries necessary to  make it “work” in accounting terms (bringing in an estimate of the purchase price, eliminating the share capital of the acquired entity and suchlike).

As with any aspect of financial reporting, the only ultimate point of doing anything that relates to the past is to provide a basis for forming expectations about the future.  This premise becomes a bit strained for pro forma financial statements because the separate historical information of the two entities only provides a limited basis (if any) for anticipating what might become of the combined entity (it’s commonly pointed out that a large percentage – perhaps more than half – of business combinations fail to meet management’s expectations for them, for one reason or another). If entity B had in fact been owned by entity A for any portion of 2016, then of course it might have done things differently in any number of key respects, with material consequences for the financial statements.  The trouble is though that if you try to incorporate those kinds of what-might-have-beens into a pro forma statement, your “historical illustration” may rapidly become highly subjective and unreliable. Wary of this possibility, Canadian regulators generally limit pro forma adjustments to the following:

• those directly attributable to the specific acquisition transaction for which there are firm commitments and for which the complete financial effects are objectively determinable, and
• adjustments to conform amounts for the business or related businesses to the issuer’s accounting policies.

The first item would likely encompass (for instance) contracted legal fees that are directly incremental to the transaction, but not planned savings to be made from economies of scale, from eliminating duplicated functions, from new marketing initiatives and suchlike. The irony in that comparison, of course, is that the acceptable pro forma adjustment reflects a one-off expenditure of no ongoing predictive value; for most readers, the adjustments that are unacceptable would likely be of greater interest in evaluating the transaction’s merits and possibilities, regardless of the uncertainty attaching to them.

Given all the conceptual limitations, it’s no surprise that the average set of pro forma financial statements kicks off with about a page of caveats, typically including language along the lines of….

• The unaudited pro forma consolidated financial statements may not be indicative of the financial position that would have prevailed and operating results that would have been obtained if the transactions had taken place on the dates indicated or of the financial position or operating results which may be obtained in the future. The unaudited pro forma consolidated financial statements are not a forecast or projection of future results. The actual financial position and results of operations of the company for any period following the closing of the acquisition will vary from the amounts set forth in the unaudited pro forma consolidated financial statements and such variation may be material….

…which would surely cause anyone to wonder whether pro forma financial statements accomplish enough to make the exercise worthwhile. In theory, a company might address the anticipated benefit of a major acquisition by providing a careful narrative explanation of the expected incremental impact, by setting out the possible impact on one or more key performance measures, or by other means. In each such situation, investors can choose how much weight to put on the company’s assertions about the acquisition, and how much weight to put on the things it leaves unaddressed. But by mandating a particular form of pro forma statements as a necessary element of full, true and plain disclosure in various designated situations, securities regulations implicitly assert that these pro forma statements in the way they’re constituted are a vital reference point for investors. But considered rationally and logically, it’s just plain that they’re not. As such, the whole thing might often end up feeling like an abstracted, self-defined game, more than a meaningful exercise in communication.

Still, if you have any involvement in securities filings, or in public company reporting beyond just the periodic financial statements, it’s a game you’ll likely find yourself playing at some point, and very likely feeling defeated by. For now at least…

The opinions expressed are solely those of the author.