Does Pro Forma Reporting Bias Analyst Forecasts?

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Does Pro Forma Reporting BiasAnalyst Forecasts?Patric Andersson a & Niclas Hellman ba Centre for Economic Psychology , Stockholm Schoolof Economics , Swedenb Department of Accounting and Managerial Finance ,Stockholm School of Economics , SwedenPublished online: 29 Jun 2007.

To cite this article: Patric Andersson & Niclas Hellman (2007) Does Pro FormaReporting Bias Analyst Forecasts?, European Accounting Review, 16:2, 277-298, DOI:10.1080/09638180701390966

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Does Pro Forma Reporting BiasAnalyst Forecasts?

PATRIC ANDERSSON� & NICLAS HELLMAN��

�Centre for Economic Psychology, Stockholm School of Economics, Sweden and � �Department of

Accounting and Managerial Finance, Stockholm School of Economics, Sweden

ABSTRACT Standard setters put much effort into the development of ‘better’ financialreporting standards, that is, standards that more accurately capture the economicsubstance of business activities. However, the more sophisticated accounting treatmentscaused by new standards, and the growing complexity of business activities as such, hasmade financial reports more difficult to understand. In response to this situation, somecompanies use pro forma reporting, which means that certain complex items requiredby financial reporting standards are excluded. This study adopts a user perspective andinvestigates how pro forma reporting affects analysts’ judgments in an experimentalsetting. On the basis of psychological theory, our hypothesis suggests that analysts’judgments will be affected by differences in the way company performance ispresented. Our results show that analysts who received both pro forma and GenerallyAccepted Accounting Principles (GAAP) information made significantly higherearnings per share (EPS) forecasts than those who received GAAP information only. Itis argued that positive framing and higher levels of anchor explain this result, whichsuggests in turn that analysts’ EPS forecasts can be manipulated by alternative ways ofpresenting company performance. Some possible implications of this finding forstandard setters are discussed.

European Accounting Review

Vol. 16, No. 2, 277–298, 2007

Correspondence Address: Niclas Hellman, Ph.D., Assistant Professor, Department of Accounting

and Managerial Finance, Stockholm School of Economics, Box 6501, 113 83 Stockholm, Sweden.

E-mail: [email protected]

0963-8180 Print/1468-4497 Online/07/020277–22 # 2007 European Accounting AssociationDOI: 10.1080/09638180701390966Published by Routledge Journals, Taylor & Francis Ltd on behalf of the EAA.

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1. Introduction

There is a general international trend towards increasingly complex accounting.

Pro forma reporting, that excludes some of the complex GAAP-required items,1

offers a way of demystifying complex accounting disclosures to allow for better

communication of a company’s ‘core earnings’ (Bhattacharya et al., 2004). Pro

forma reporting started in the USA in the mid-1990s (Bhattacharya et al.,

2003), and has since been adopted by many companies, including large non-

US companies such as Nokia and British Telecom.

The pro forma adjustments generally lead to improved results (Bradshaw and

Sloan, 2002),2 and critics of pro forma reporting claim that it is simply a way of

increasing profits to make a company look more attractive to analysts and inves-

tors. Doyle et al. (2003) report that expenses excluded by the calculation of pro

forma earnings are negatively related to future cash flows, which indicates that

the items excluded from the pro forma statement are in fact relevant to analysts

and investors. If the users of accounting information do not accept the complex

GAAP reports, but rely on simplified and improved pro forma numbers, their

judgment may be biased. However, experimental research (Frederickson and

Miller, 2004; Elliott, 2006) indicates that professional users (i.e. financial ana-

lysts) are able to ‘see through’ the pro forma adjustments, and their judgment

does not become biased. The main purpose of the present study is to test

whether this finding also holds for settings in which there is substantial difference

between (negative) pro forma and (positive) pro forma earnings. Thirty-six

Swedish financial analysts in an experimental setting were given fourth-quarter

earnings releases for an anonymous listed company, and were asked to forecast

the next year’s earnings per share (EPS) according to Swedish GAAP. One

group of analysts was given GAAP information only, while another group

received both pro forma and GAAP information. The results show that the ana-

lysts who were given both pro forma and GAAP information made significantly

higher EPS (according to GAAP) forecasts, compared to the analysts who

received GAAP information only. If an alternative (non-GAAP) presentation

of a company’s performance draws attention away from GAAP numbers in

such a way as to make sophisticated users change their judgment, as our

results suggest, this represents a potential threat to the public’s trust in account-

ing, in that managers may modify the pro forma reporting in an opportunistic

way. We suggest that standard setters should be concerned about the proliferation

of pro forma earnings and about their presentation and use by various parties.

2. Pro Forma Reporting

2.1. The Phenomenon

The Latin phrase ‘pro forma’ refers to a fictive situation as if certain things either

had, or had not, happened. In the case of pro forma profits, the idea is to present

the net profit figure as if certain events leading to ‘unusual’ items had not

278 P. Andersson & N. Hellman

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occurred. Pro forma income statements are included in companies’ quarterly

earnings releases. They often precede the income statement according to

GAAP, and it is common for the written text in the earnings release to emphasize

the pro forma figures. One feature of pro forma reporting is that the unusual

item adjustments persist throughout the whole income statement and affect the

bottom line profit and the EPS calculation. Thus, putting more emphasis on

EBITDA (earnings before interest, taxes, depreciation and amortization) or

non-recurring items in the earnings release is not enough to qualify as pro

forma reporting.

Bhattacharya et al. (2003) examine the use of quarterly pro forma reporting

among US companies between 1998 and 2000. They note that pro forma report-

ing increased dramatically during this period and that the pro forma announcers

were particularly common in the service and high-tech industries. However,

although many companies did go in for pro forma reporting, its occurrence

was still fairly infrequent. Of 1,149 earnings releases in the sample, only 11%

of the companies reported pro forma earnings for four or more quarters during

the relevant period and very few of these cases occurred in consecutive quarters

(ibid., p. 296). In an earlier study, Bradshaw and Sloan (2002) reported that pro

forma profits were significantly higher than GAAP profits, and that the largest pro

forma profit overstatements occurred in the fourth quarter.

Hitherto, pro forma reporting has been subject to little regulation. In 2003, the

Securities and Exchange Commission (SEC) issued a regulation requiring com-

panies reporting on a pro forma basis to disclose a quantitative reconciliation of

the differences compared to GAAP (SEC, 2003). The empirical results presented

in Bowen et al. (2005) suggest that SEC’s recommendation in 2001 regarding pro

forma reporting was already helping to reduce the emphasis on pro forma earn-

ings in 2002. The International Financial Reporting Standards (IFRS) do not

include an adequate standard on the presentation of IFRS financial statements.

On the basis of a review of 65 large European companies who implemented

the IFRS in 2005, Ernst & Young (2006) report:

The widespread use of alternative, non-IFRS measures in companies’

results announcements and presentations suggests that . . . there is a gap

between IFRS and what managements believe is necessary in order to com-

municate to the markets information which enables underlying perform-

ance and sustainable cash flows to be assessed.

(Ernst & Young, 2006, p. 4)

In Sweden, the new listing rules on the Stockholm Stock Exchange require

companies to include three specific GAAP-measured items (turnover, net

profit and earnings per share) at the beginning of their earnings releases

(Stockholmsborsen, 2003).

Does Pro Forma Reporting Bias Analyst Forecasts? 279

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2.2. Why do Companies Report Pro Forma Profits?

Over the last decade, the International Accounting Standards Committee/Board

(IASC/IASB) and the Financial Accounting Standards Board (FASB) have both

issued a variety of complex standards, and the overall collection of standards is

now very extensive under both IFRS and US GAAP. A possible explanation for

the tendency towards pro forma reporting could be that managers and financial

analysts together are seeking to create a simpler and more comprehensible

mode of financial reporting. Harvey Pitt, the former SEC chairman, suggested

in a speech in 2001 that the increasing use of pro forma reporting should be

seen in relation to the growing complexity that is making it more difficult for

users to understand companies’ financial reporting according to GAAP:3

Investors anxious for current, simplified and comprehensible financial

reporting are today more likely to rely on a company’s ‘pro forma’ disclos-

ures than the same company’s meticulously prepared, mandated GAAP

financial disclosures.

(Pitt, 2001)

The argument that pro forma reporting satisfies the need of investors and analysts

for simplified reporting geared to the core earnings has received support in

market-based accounting research. Bradshaw and Sloan (2002, p. 64) conclude

that investors display a growing preference for the modified versions of profits

reported by the analyst tracking services compared to the profits reported accord-

ing to GAAP. Moreover, earnings response coefficients and regression R 2’s are

both higher for pro forma profits than for GAAP profits (Bradshaw and Sloan,

2002, p. 65; Bhattacharya et al., 2003, p. 316). As regards the use of pro

forma information for forecasting purposes, Bhattacharya et al. (2003) regressed

the revision of analysts’ one-quarter-ahead earnings forecasts on forecast errors

based on different earnings metrics. Their results suggest that pro forma earnings

have significantly greater explanatory power than earnings according to GAAP

(ibid., p. 309), which suggests that analysts regard pro forma earnings to be

more informative than GAAP earnings.

However, the use of pro forma reporting also involves some risks connected with

management’s behaviour and the quality of financial reporting. In preparing the pro

forma income statement, the items that are excluded in the GAAP counterpart are

referred to as ‘unusual items’, ‘non-core business items’, ‘non-cash items’, etc.

The managers’ official argument for this procedure is that it helps external stake-

holders to compare the underlying earnings capacity across companies. However,

the common anecdotal story is that managers seek to manipulate the external stake-

holders’ view of the company by excluding such items. As pro forma reporting is

highly dependent on management’s opinion of what is classified as ‘unusual’ or

‘non-core’, there is a substantial risk that the pro forma reporting will be


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manipulated in such a way as to allow the company to meet earnings projections.

This issue, as to whether or not managers behave opportunistically, has been

examined on the basis of archival data, and the results are mixed. Bhattacharya

et al. (2004, p. 36) report that a very large proportion of the pro forma companies

in their sample actually change the definition of pro forma earnings from one

period to another, which suggests manipulative behaviour. In a similar vein,

Doyle et al. (2003) examine the predictive value of expenses that are excluded

from pro forma earnings, and find that although some expenses (‘special items’)

are generally unrelated to future cash flows, the so-called ‘other exclusions’ are

very predictive of future negative cash flows (ibid., p. 148). Bowen et al. (2005)

investigate the factors associated with the emphasis placed on pro forma earnings

compared to GAAP earnings. They conclude that managers are using specific

emphasis in the earnings press release as a disclosure tool that has an influence

on investors. In a comparable study, on the other hand, Bradshaw and Sloan

(2002) examined management discussions in earnings releases, and they report

that although managers have stepped up their efforts to emphasize pro forma

profits, the empirical results do not give any indication of the relative displacement

of GAAP earnings in the earnings announcements (ibid., p. 63). In a similar vein,

Johnson and Schwartz (2001) show that the magnitude of the market premium

for pro forma firms is unrelated to the specific characteristics of the pro forma

disclosures, and argue that investors are not misled by pro forma profits.

If managers do in fact modify pro forma reporting in an opportunistic way, as

some of the above research findings suggest, then there is a potential threat here

to the public’s trust in accounting. FASB (2002) has also expressed concern that

pro forma reporting may undermine the quality of financial reporting. However,

there would be less of a problem if investors were able to ‘see through’ any

attempt at exaggerating earnings. This question has been subjected to experimen-

tal research, and is also the focus of the present paper. Thus, we will now leave

the pro forma phenomenon as such, and will consider instead whether or not this

type of reporting affects the judgments made by its users.

2.3. The Impact of Pro Forma Reporting on Analyst Judgments

An important issue connected with pro forma reporting concerns the extent to which

it influences the judgments and decisions of investors, financial analysts, forecasters

and other actors in the financial market. Up to now, to the best of our knowledge,

two experimental studies have investigated this issue empirically. Frederickson and

Miller (2004) conducted an experiment involving two groups of participants: 46

MBA students (who acted as proxies for non-professionals) and 34 experienced

analysts. The participants’ main task was to study a particular case, appraise

the fair value of the company’s stock and then to provide an explanation in

writing of the reasoning behind their judgment. They were given background infor-

mation and an earnings announcement from a hypothetical technology-oriented

company in the medical sector. The announcement was manipulated so as to


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report GAAP earnings only in one version and both pro forma and GAAP earnings

in the other. Apart from different levels of annual percentage increase (8.8% as

against 0.8%), the pro forma earnings were slightly higher than the GAAP earnings

($1.68 as against $1.24 per share). The case was mailed to the analysts, but was

given to the students in small groups. On a basis of evidence from psychological

research on decision-making and expertise, Frederickson and Miller (2004) hypoth-

esized that non-professionals would predict higher stock prices when using

announcements including both pro forma and GAAP earnings than they would

do if the announcements only included GAAP earnings. As regards the financial

analysts, Frederickson and Miller formulated an explorative research question

instead of a formal hypothesis about the effect of pro forma reporting on analysts’

judgments, since earlier research had generated mixed evidence regarding the ten-

dency for accounting experts to be the victim of cognitive bias (e.g. Shanteau, 1989;

Smith and Kida, 1991; Maines, 1995). Frederickson and Miller (2004) found, in line

with their hypothesis, that the 22 MBA students who were exposed to pro forma

plus GAAP earnings announcements made higher stock price appraisals than did

the 24 students who received GAAP information only. However, this effect

could be explained by differences in the valuation models applied and by uninten-

tional cognitive effects, rather than by the non-professionals relying on pro forma

earnings information because they perceived it as being informative. Regarding

the explorative research question, it was found that the appraised stock prices

given by the participating analysts were similar regardless of the experimental

conditions. In other words, the analysts were not influenced by the presence of

pro forma reporting. Frederickson and Miller (2004) suggested that this finding

was due to the tendency on the part of the participating analysts to rely on

well-defined valuation models.

Elliott (2006) casts further light on the effects of pro forma reporting, investi-

gating two issues: (1) whether it is the presence of pro forma information or the

particular emphasis of such information that affects non-professionals; and (2)

the extent to which the judgment of analysts and non-professionals is affected

when there is a quantitative reconciliation between the GAAP and pro forma

earnings calculations. On a basis of behavioural research showing that salient

information tends to capture people’s attention regardless of its usefulness,

Elliott hypothesized that non-professionals would arrive at a different judgment

when the emphasis was on pro forma earnings. She also predicted that a specifi-

cation of the pro forma adjustments (the reconciliation) would reduce the effect

of pro forma reporting on the judgment of non-professionals, whereas it would

not affect the judgment of analysts. To test these hypotheses Elliott conducted

an experiment involving 89 MBA students (representing non-professional inves-

tors) and 55 experienced analysts. The participants read a press release regarding

a hypothetical company in the technology sector. The release consisted of finan-

cial information for the first quarter of the last two years. The participants were

asked to rate the company’s earnings performance (on a 100 points scale ranging

from very weak to very strong) and then to decide on the amount of money to


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invest in the company (ranging from $0 to $5,000). The press release was

manipulated as regards the presence of pro forma information, the emphasis on

pro forma information and the presence of a reconciliation of the differences

between the GAAP and the pro forma measures. The GAAP earnings were nega-

tive and the pro forma earnings slightly positive, respectively (i.e. a loss of $1.02

as against a profit of $0.01 per share). Elliott found that non-professionals tended

to rate earnings performance higher and to invest more money when they were

exposed to the press release emphasizing pro forma earnings. This tendency

was weaker when the same group read the press release that included a reconci-

liation. The analysts revealed no significant difference in judgment between the

press release emphasizing pro forma earnings and the other that included GAAP

information only. However, contrary to her hypothesis, Elliott (2006) reported

that analysts who had examined a press release involving a reconciliation gave

higher ratings to earnings performance and were willing to invest more money

in the company concerned than the analysts who were confronted by press

releases giving GAAP information only or those putting more emphasis on pro

forma earnings than on GAAP earnings. In her view, this somewhat paradoxical

finding could be explained by the tendency of the analysts to regard pro forma

earnings as more reliable and less misleading when reconciliation was present.

In sum, earlier studies provide consistent empirical evidence that pro forma

reporting does not seem to have any effect on analysts’ judgments, while the

judgments of non-professional investors may be so affected.4 However, the evi-

dence should be considered in light of the following factors which, in our view,

limit its validity and reliability. First, Frederickson and Miller (2004) rely on a

case in which pro forma earnings do not differ substantially from GAAP earnings.

The difference per share was $0.44, corresponding to about 1.7% of the mean

stock price appreciation made by the analysts. Bigger discrepancies could have

consequences for the analysts’ judgments. Elliott’s (2006) case material included

a somewhat bigger difference ($1.03 per share), but then there was also a ten-

dency towards higher analyst rankings for earnings performance in the GAAP

press release compared to the case of the pro forma earnings press release.5

Further, neither Frederickson and Miller (2004) nor Elliott (2006) analysed the

case of pro forma profits and GAAP losses in pro forma reports,6 although

such combinations are not uncommon in practice, according to the results of

studies of pro forma reporting based on archival data:

. . . the mean GAAP earnings is a net loss of 14.7 cents per share, while the

mean pro forma earnings is a net income of 8.5 cents per share. This result

is consistent with the notion expressed in the popular press that most items

excluded from GAAP income to arrive at the pro forma number are

expenses that decrease income. Moreover, it is consistent with the results

of prior academic research examining actual pro forma press releases . . .

(Bhattacharya et al., 2004, p. 32)


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Secondly, prompting analysts to estimate fair stock values for a company

(Frederickson and Miller, 2004) or to decide on the amount of money they are

prepared to invest in a firm (Elliott, 2006) is an indirect way of capturing these

actors’ predictions, and such interventions are problematic in the context of

task realism and differences in individual attitudes to risk.7 Moreover, when per-

forming the tasks the participants may have considered the general condition of

the stock market and the economy at the time when they were taking part in the

experiment. For example, the analysts participating in the study described in

Frederickson and Miller (2004) were asked to evaluate the financial information

of a technology-oriented company for the year 2001. It is plausible that,

consciously or unconsciously, their judgment was affected by the poor state of

the stock market in 2001. Thirdly, the participants of the two studies were not

being monitored when they were performing the tasks, which mean that

there is some uncertainty as to whether the participants acted in line with their

instructions. The possibility that they employed decision-aids or that the

responses were produced by someone else, cannot be safely ruled out. Fourthly,

the material used in the two studies involved fictitious firms in the technology

sector. Consequently, the results might not allow for generalizations about

other industries, associated with different financial characteristics. It is these

factors that motivated the writing of the present paper.

2.4. Rationale and Contributions of the Present Paper

Our paper proceeds from prior research on the effects of pro forma reporting on

the judgments made by financial analysts. Basing our argument on psychological

theory, we suggest that financial analysts will be affected by exposure to a com-

bination of negative GAAP earnings and positive pro forma earnings. This is not

an unusual combination in practice, as we have already noted. Given a substantial

discrepancy between GAAP and pro forma earnings, we suggest that the forecast

of earnings made by analysts confronted by pro forma and GAAP information

will be higher than those made by analysts who receive GAAP information only.

Moreover, earlier studies have relied on dependent measures that raise ques-

tions about reliability and validity. In an attempt to increase the external validity

of the dependent variable, we employ another measure based on earnings fore-

casts. By asking analysts to provide earnings estimates for the coming year we

hope to eliminate confounding factors such as individual risk propensity, incen-

tives and task realism that are present in prior research (Frederickson and Miller,

2004; Elliott, 2006). We also seek to improve the reliability of the whole under-

taking by conducting a monitored experiment with the analysts rather than the

non-monitored experiments of analysts reported in Frederickson and Miller

(2004) and Elliott (2006). Finally, following Elliott’s (2006) suggestion, our

case concerns an authentic but anonymous firm working in an established indus-

try rather than in the technology sector.


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In summary, our paper investigates how analysts’ earnings forecasts are

affected in a situation where the discrepancy between pro forma and GAAP earn-

ings is substantial and involves a pro forma profit and a GAAP loss. Further, we

hope to improve the validity and reliability in relation to earlier studies. Another

aim of the paper is to investigate whether the presence or the absence of pro

forma information affects the strength of the confidence that analysts place in

their earnings forecasts. This aspect of the subject has not been addressed in Fre-

derickson and Miller (2004) or Elliott (2006).

In contrast to earlier studies, the empirical material for the present paper con-

sists of the responses of European (or, more precisely, Swedish) financial analysts

rather than of US analysts. However, we feel that this divergence will not con-

taminate our results, as empirical evidence indicates that Swedish and US ana-

lysts are not too dissimilar. Using questionnaire data, Olbert (1994) reported

no significant differences between Swedish and US analysts when it came to

the frequency with which they used fundamental analysis for stock valuation pur-

poses, how often they used p/e ratios for stock valuation purposes, how often

they used earnings per share as a forecast variable, or how highly they ranked

profit and loss statements as a source of information. Any disagreement

between the findings of our study and those of earlier research may not thus

depend on differences in the nationality of the participants.

In the next section we will describe the theoretical foundation for our hypoth-

esis, namely that analysts can be expected to make higher EPS (according to

GAAP) forecasts if they receive pro forma and GAAP information compared

with their receipt of GAAP information only.

3. Theory and Hypothesis Development

Pro forma reporting is related to certain constructs appearing in research on cog-

nitive psychology and behavioural decision-making. In particular, this type of

reporting is associated with the notion of framing, which refers essentially to

the way decision situations are represented or perceived by decision-makers

(Tversky and Kahneman, 1981; Kahneman and Tversky, 1984). In an oft-cited

article, Kahneman and Tversky (1979) found that participants’ preferences dif-

fered depending on whether the alternative was framed as a win or a loss situ-

ation. Similarly, people tend to evaluate choices differently when the amounts

concerned are expressed in different currencies or in terms of nominal as

against real values (Soman, 2004). Evidence of the impact of framing on

human judgment has also been documented by Camerer (2000), using field

data. Similarly, pro forma reporting can be expected to create framing effects,

given that the discrepancy between pro forma earnings and GAAP earnings is

obvious or is at least perceived as discernible.

Tversky and Kahneman (1974) found that people tend to rely on a variety of

heuristics when making their judgments. One heuristic assumes that individuals

consider initial values (anchors) and then adjust their judgments from this base.


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On the whole, individuals tend to make insufficient adjustments, leading in turn to

biased judgments (Chapman and Johnson, 2002). This anchoring heuristic is very

relevant in forecasting tasks such as the prediction of future earnings (cf. Ayton,

1998). Psychological research has shown that if you give someone a number – it

may or may not be informative – this will have a remarkable impact on the way

they respond to a question requiring a numerical answer, since, consciously or

unconsciously, subjects will anchor their responses to that number (Chapman

and Johnson, 2000). If people are confronted by more than one anchor, they

may try to consider all the values or they may stick to the one which they

guess to be the most relevant (Whyte and Sebenius, 1997). It seems likely that

their judgments will vary more than if they had only been offered a single

anchor. As regards pro forma profits, analysts who get both adjusted and

GAAP-based information (i.e. two anchors) will probably arrive at completely

different estimates compared to those of their peers who only have access to

EPS based on GAAP (i.e. a single anchor). Thus, starting from the psychological

concepts of framing and anchoring, it is reasonable to assume that pro forma

earnings will have a considerable impact on the predictions of financial analysts.

There are two objections to this line of argument. First, previous studies

(Frederickson and Miller, 2004; Elliott, 2006) of pro forma seem to suggest

that no influence exists. As noted above, there are some weak points. In particu-

lar, there is some doubt as to whether these studies were able to stimulate framing

and anchoring effects. It should be remembered that they employed experimental

material where the discrepancy between pro forma and GAAP earnings per share

was $0.44 (Frederickson and Miller, 2004) and $1.03 (Elliott, 2006), respect-

ively. From a cognitive psychological point of view, the two types of earnings

measures could be perceived as fairly similar. Anchoring research generally

relies on experimental tasks in which the anchors differ substantially

(Chapman and Johnson, 2002), as they do for example in Whyte and Sebenius

(1997) – between $8 and $12. Thus, previous pro forma studies may have

relied on measures that were not psychologically dissimilar. In this context, it

should be noted that there was a tendency towards greater impact of the pro

forma information on the analysts’ judgments in Elliott’s (2006) study compared

to the study made by Frederickson and Miller (2004). This tendency may perhaps

be related to the somewhat bigger difference between the anchors in Elliott’s

(2006) study.

A second objection is that analysts are experts, and should thus be less suscep-

tible to judgmental bias. Analysts have acquired extensive knowledge and devel-

oped methods for analysing accounting information (Bouwman et al., 1987).

However, research has found mixed evidence regarding the so-called expertise

argument. Smith and Kida (1991) reviewed a great many studies that investigated

whether professional auditors are victims of heuristics and bias. Their review

suggests that auditors do tend to be victims, but that tendency is weaker when

they face tasks that are job-related and familiar. Shanteau (1989) came to the

same conclusion. On the other hand, Smith and Kida (1991) could not rule out


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the possibility that some audit decisions were associated with anchoring and

adjustment. It should be noted that auditors’ tasks differ from those of financial

analysts, which suggests that tendencies observed in one profession may not

necessarily apply to another. Further, there is a body of research showing that

expert judgment is fragile, even in the case of accustomed tasks (e.g. Camerer

and Johnson, 1991; Andersson, 2005; Tetlock, 2005). For example, despite con-

siderable experience, managers tend to be the victims of anchoring effects

(Lovallo and Kahneman, 2003). Anchoring has also been claimed to partly

explain overreactions and underreactions in analysts’ earnings forecasts (Amir

and Ganzach, 1998). Moreover, length of experience is also weakly related to

performance (Ericsson and Lehmann, 1996). Thus, even if financial analysts

are regarded as experts, they may still be sensitive to framing and anchoring

effects.

Despite the conflicting evidence as to whether or not experts are victims of

judgmental heuristics, previous studies (Frederickson and Miller, 2004; Elliott,

2006) have argued that analysts will not be influenced by pro forma information,

due to their expertise. Elliott (2006) for example found that analysts were not

affected by the emphasis on pro forma earnings and attributed this to their invest-

ment-related expertise and familiarity with the task. However, one manipulation

in Elliott’s experiments with her analyst subjects (the manipulation involving a

quantitative reconciliation between pro forma and GAAP information), yields

statistically significant results that are inconsistent with her hypothesis, thus

casting some doubt on the expertise argument that is used to support both of

the hypotheses related to analysts. Elliott attributed this inconsistency to a

greater perceived reliability regarding pro forma earnings as compared to

GAAP, when reconciliation is added. An alternative interpretation could be

that this manipulation stimulated framing and anchoring effects.8

Thus, we dispute the expertise argument and argue that the impact of pro forma

earnings is related primarily to the psychological theory of anchoring. In testing

this theory, the anchors used should not be too similar, in other words there needs

to be a marked difference between pro forma earnings and GAAP. One real-

world example of this could concern firms that are reporting pro forma earnings

at the same time as GAAP losses. Such firms also tend to give greater emphasis to

pro forma earnings in their press releases, compared with other companies

(Bowen et al., 2005, p. 1013), which motivates an emphasis on pro forma earn-

ings in the case design. In light of the above, the following hypothesis was

formulated.

H1: Earnings releases including both pro forma and GAAP-based infor-

mation will be associated with forecasts of higher EPS than earnings

releases that include GAAP-based information only.

As well as testing this hypothesis, we also look at whether pro forma reporting

affects the amount of confidence that financial analysts place in their forecasts,


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an issue that has not been explored in previous studies. Intuitively, one would

expect that the conflicting information in earnings releases based on pro forma

and GAAP statements would inspire less confidence than earnings releases

based on GAAP alone. On the one hand, research shows that access to additional

information makes people more confident, even though the additional infor-

mation does not necessarily lead to more accurate predictions (Oskamp, 1982).

On the other hand, judgment research in financial accounting suggests that the

effect of providing professionals with additional information can be mixed (cf.

Maines, 1995). In view of these rather imprecise findings, we decided to

include a research question about the effects of pro forma reporting on confi-

dence, rather than formulating a hypothesis on the issue. For this reason, we

will also look into the level of confidence associated with earnings releases

including both pro forma and GAAP-based information and compare this with

the level of confidence associated with earnings releases including GAAP infor-

mation only.

4. Methodology

4.1. Rationale for the Chosen Experimental Approach

To test our hypothesis (H1), we decided to adopt an experimental approach. This

scientific method, which is commonly used in (Anglo-American) accounting

research (cf. Libby et al., 2002), enables a reliable evaluation of causes and

effects in controlled environments. For the purpose of the present paper, such

an approach made it possible to observe analysts’ forecasting behaviour under

exposure to two types of earnings releases, namely, GAAP-based or pro forma

information. Further, given the experimental approach, it was possible to

ensure that all analysts had equal access to the information (except in so far as

it was manipulated for experimental purposes) and to control for any contami-

nating factors. For instance, if analysts had responded on different occasions,

the possibility cannot be ruled out that their judgment might have been affected

by the vagaries of the daily (business) news. Similarly, incentives arising from

institutional circumstances also tend to distort analysts’ forecasts (e.g. Hunton

and McEwen, 1997). Another factor, which hampers the findings presented in

Frederickson and Miller (2004) and Elliott (2006), could be that the analysts

may employ a variety of decision aids or, may simply hand over the task to

someone not fully qualified to deliver responses on their behalf.

Further, the experimental approach has advantages lacking in other research

methods such as interviews or the econometric analysis of archival data, as it

allows for the separate examination of effects associated with the financial report-

ing. First, in real-life listed companies do not publish two separate earnings

releases that are sent to two groups of analysts. Second, in making their earnings

forecasts many analysts tend to take note of their colleagues’ estimates, so that

their own estimates do not deviate too far from these (Trueman, 1994). Third,


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some analysts may possess private information enabling them to make more

reliable earnings forecasts.

4.2. Participants

Thirty-six financial analysts (29 of them males) who had enrolled in an executive

education programme in advanced finance were asked to make their own evalu-

ation of an earnings release. Their mean age was 34.8 years. The main occupation

of around 81% of them concerned corporate analyses and stock investment, while

the rest of them were engaged in stockbroking and giving financial advice. Their

average experience of the tasks concerned was 6.1 years.

4.3. Study Material

The study material consisted of two types of earnings release. One type included

accounting data based on pro forma and GAAP calculations, while the second

type involved GAAP-based accounting data only. The two types will be referred

to below as the pro forma report and the GAAP report, respectively. Following

the field, both types of earnings releases have been based here on figures from

a real-life listed company, but the identity of the company has been concealed.

This procedure guaranteed both realism and an ecologically valid task.

Both types of earnings releases opened with a brief summary of sales, income

before tax, earnings per share and dividends. See Table 1 for details.9 A few brief

sentences then described the business and market conditions of the company con-

cerned. These sentences were identical in the two types of earnings release. After

this brief summary, the pro forma report went on to present the pro forma income

statement, the GAAP income statement and the balance sheet. The GAAP report,

in contrast, proceeded to the GAAP income statement and the balance sheet only.

Regardless of the type of earnings release, both the income statements and the

balance sheet all spanned three successive years. Differing as regards their

content, the GAAP report ran to three pages and the pro forma report to four.

4.4. Experimental Design and Task

The type of earnings release represented the independent variable. Thus, this

between-groups measure had two levels: GAAP report and pro forma report.

The study material was followed by a two-page questionnaire prompting the

participants to make an individual assessment of the financial status of the

company. First, participants were asked to predict EPS according to GAAP for

the current year, indicating their predictions on an 11-point scale ranging from

250 SEK to 50 SEK with a midpoint denoting zero earnings. Note that this

approach to measuring the effects on judgment of pro forma information

differs from the approach adopted in earlier studies on the subject (Frederickson

and Miller, 2004; Elliott, 2006). In our view, asking participants explicitly to


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predict EPS guarantees greater external validity, since it avoids some of the pro-

blems associated with other approaches (see Sections 2.3 and 2.4). Second, after

noting their responses, the participants indicated their level of confidence on a 6-

point scale ranging from ‘very unsure’ to ‘very sure’. There were then seven

empty lines where the participants could comment on their predictions.

Largely, the purpose of these lines was to check the extent to which the subjects

had observed and interpreted the content of the independent variable (cf. Libby

et al., 2002). Third, the participants were asked to evaluate the degree of

realism in the material and whether the information given was sufficient as a

basis for economic forecasting. These questions represented an attempt to

measure the external validity of the study material. Finally, there were questions

about demographics, the motivation for participating in the study and the time

devoted to the experiment.10

Table 1. Summary of the contents of the study material: GAAP and pro forma earningsreleases

GAAP earnings release Pro forma earnings release

Page 1: Introductory summary Page 1: Introductory summary†Sales fell by 11% to 53,358 (59,746)

million.†Sales (pro forma) fell by 16% to

49,342 (58,640) million.† Net income was 26,892 million,

which was a strong improvementcompared over previous year(211,022 million).

†Net income (pro forma) was 3,258million, which was a strongimprovement compared to theprevious year (22,102 million).

†Earnings per share were 222.46,compared to 234.50 in the previousyear.

†Earnings per share (pro forma)increased to 10.47, compared to26.11 in the previous year.

†The board suggests dividend (3.00);unchanged from the previous year.

†The board suggests dividend (3.00);unchanged from the previous year.

Page 2: GAAP consolidated incomestatement

Page 2: Pro forma income statement

†Gross margin: 17,482 million. †Gross margin: 16,578 million.†Operating income: 23,626 million. †Operating income: 4,014 million.†Income before financial items:26,892 million.

†Income before financial items: 3,258million.

†Net income: 24,970 million. †Net income: 2,317 million.

Page 3: GAAP consolidated balancesheet

Page 3: GAAP consolidated incomestatement

†Total assets: 62,186 million. †See column to the left.†Stockholders’ equity: 22,478 million.†Long-term liabilities: 19,446 million. Page 4: GAAP consolidated balance sheet†Current liabilities: 12,379 million. †See column to the left.

Note: The two earnings releases were written in Swedish and all amounts in the two reports were given

in Swedish kronor (SEK). On 18 February 2007, 100 SEK corresponded to about $14.22 or E10.82.


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Before running the experiment, the study material was pre-tested on four Ph.D.

students specializing in accounting and financial analysis. On the whole, they felt

that the instructions were clear and that the contents of the study material were

realistic.

4.5. Procedure

The two types of earnings release were randomly distributed among the partici-

pants at a lecture on advanced finance. The participants were instructed to make

an individual examination of the study material, and then to answer a question-

naire. As an incentive they were each given the reward of their choice: one

cinema ticket or three lottery tickets worth approximately $10 (64% chose the

lottery tickets), if their completed questionnaire were drawn.

A total of 16 participants read the GAAP report, while 20 studied the pro forma

report. The majority of the participants (61%) said that they felt motivated to

undertake the task. On average, it took about 19 minutes to complete the task

and to answer the questionnaire. Despite exposure to different parts of the

material, the two groups did not differ significantly when it came to the (self-

reported) time devoted to the task.

5. Results

For the participant groups as a whole the average EPS forecast was 25.83 SEK

(SD ¼ 12.96). Table 2 shows clearly that the two types of earnings releases

yielded substantially different EPS forecasts. Participants examining the GAAP

report predicted a lower EPS (M ¼ 213.13 SEK) than those who were given

the combined report of pro forma and GAAP-based information (M ¼ 0.00

SEK). Note that the forecasts submitted by this second participant group were

more widely dispersed and covered a greater range (40) than those made by

Table 2. Descriptive statistics regarding EPS forecasts and the confidence in such forecasts

Type of earnings release

GAAPinformation

(n ¼ 16)

Pro formaand GAAP information

(n ¼ 20)

Mean EPS forecast (SD) 213.13 (7.04) 0.00 (13.76)Median EPS forecast (Min: Max) 210 (220: 0) 10 (230: 10)Mean confidence in EPS forecast

(SD)2.25 (1.24) 2.70 (1.26)

Median confidence in EPS forecast(Min: Max)

2 (1: 5) 2 (1: 6)

Note: The EPS forecast was measured on an 11-point scale ranging from ‘ 2 50 SEK’ (1) to ‘50 SEK’

(11), while confidence was rated on a 6-point scale ranging from ‘very unsure’ to ‘very sure’.


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the group receiving GAAP-based information only. A statistical test (Levene’s

test for equality of variances) revealed that the dispersion differed significantly

between the groups (F ¼ 12.22, p , 0.001). The measure of EPS forecast was

recoded as a variable, which had 11 points reflecting the 11 possible forecasts

(i.e. 250, 240, 230, etc.). This variable was then used in the statistical analyses.

Independent samples t-test (based on the assumption of unequal variance)

showed that the mean difference of 21.31 (SD error ¼ 0.35) was significant

(t(29.4) ¼ 23.70, p , 0.001, Cohen’s d ¼ 21.24). A non-parametric test (i.e.

Mann–Whitney U) confirmed this result. There was thus support for the hypoth-

esis that earnings releases including both pro forma and GAAP-based infor-

mation lead to higher forecasts of EPS than earnings releases involving

GAAP-based information only.

The participants also rated the confidence they felt in their own EPS forecasts.

Across the participant groups as a whole the mean level of such confidence was

2.50 (SD ¼ 1.25), which meant that the average participant felt ‘rather uncertain’

about his or her forecast. As Table 2 shows, those who were given the GAAP-

based report were slightly less confident than those given the combined pro

forma and GAAP report (mean ¼ 2.25 vs. 2.70). Independent samples t-test

showed that the mean difference of 20.45 (SD error ¼ 21.30) was not signifi-

cant (t(34) ¼ 21.07, n.s., Cohen’s d ¼ 20.36). Non-parametric tests (i.e.

Mann–Whitney U) also confirmed that there was no significant difference

among participant groups as regards confidence. Non-parametric correlation ana-

lyses were also run for each participant group, and these showed that confidence

was unrelated to EPS forecast (rs ¼ 20.04 and 20.08, n.s.).

It should be remembered that the participants were able to comment on and

motivate their EPS forecasts. This information would indirectly reflect the way

they had interpreted the study material. In all, nine of the participants who had

read the GAAP report and seven of those who had read the pro forma report

chose to take up the offer. The former group seemed concerned about three

issues: (1) the shortage of information, (2) the management of costs, and (3) the

assumption of market development. Comments from the group looking at pro

forma earnings were difficult to classify since they took up so many different

issues. One participant for instance, talked about the expected market development,

while another discussed the possibility of the company repurchasing its own stock.

And, interestingly, only one participant wrote that he knew little about pro forma

reporting, which perhaps suggests that most (at least of the participants receiving

the pro forma report) were familiar to some extent with this phenomenon.

It could perhaps be expected that financial analysts of varying experience

would react differently to the two types of financial report. To test this assump-

tion, the sample was divided into two groups: 21 less experienced participants

(with less than the 4.8-year median) and 15 of their more experienced colleagues

(with more than the 4.8-year median). These two groups then allowed compari-

sons to be made within the two experimental groups, that is, those confronted by

GAAP reports as against pro forma reports. The nine participants with less


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experience and the seven with more experience who all received the GAAP

report predicted more or less the same level of EPS (M ¼ 212.22 as against

214.29). Similarly, there was no substantial difference between the predictions

of the 12 less experienced and the 8 more experienced participants who were

given the report combining both pro forma and GAAP-based information

(M ¼ 23.33 as against 5.00). The application of non-parametric tests (i.e.

Mann–Whitney U), which was motivated by the limited numbers in the two

length-of-experience subgroups revealed non-significant differences only.11

In order to make a simultaneous evaluation of the effects of the experimental

manipulation (GAAP as against pro forma) and level of experience (less vs.

more), a multiple regression model was tested with EPS forecast as the dependent

variable (MS ¼ 8.24, F(2) ¼ 6.43, p , 0.001). The model had a significant pre-

dictor, which was the experimental manipulation (standardized beta ¼ 0.52,

t ¼ 3.49, p , 0.001) and a non-significant predictor, which was the level of

experience (standardized beta ¼ 0.14, t ¼ 0.95, n.s.). Accounting for about

24% of the variance concerning the EPS forecasts, the regression model gave

further support for the hypothesis.

Finally, after they had made their forecasts, the participants were asked to

comment on the study material. Of those who received the GAAP report, one par-

ticipant considered the material to be unrealistic, while the equivalent figure for

the pro forma group was five. Eight in the former group and 11 in the latter con-

sidered the material to be realistic. The rest of the participants said they were

doubtful about the realism of the study material. At the same time, many partici-

pants (50 and 65%, respectively) wanted additional information and found the

material as it stood to be insufficient for economic forecasting. Overall, the per-

ceived lack of unrealism and the demand for additional information seem reason-

able, given the need for simplification in experimental settings. Nevertheless, the

response to the debriefing questions did not suggest that the study material was

perceived as incorrect or misleading. Moreover, statistical tests (i.e. t-tests,

Mann–Whitney U) showed that the responses to the debriefing questions were

unrelated to the EPS forecasts.

6. Discussion and Conclusions

The purpose of this study was to investigate the impact of pro forma reporting on

the judgment of financial analysts, and particularly on their earnings forecasts. In

line with our hypothesis, the participants who examined the pro forma earnings

release predicted EPS (according to GAAP) to be significantly higher than those

who received the report based on GAAP information only. This result has been

interpreted here as a consequence of the more positive framing and the higher

anchor level generated by the pro forma report compared to that generated by

the GAAP report. This result differs from the findings in Frederickson and

Miller (2004) and Elliott (2006), where financial analysts reached similar judg-

ments regardless of the type of earnings release. We believe that this difference


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in results can be explained primarily by the effects of framing and anchoring,

which have been emphasized in the present study. In our experiment, there

was a significant profit in the pro forma statement (10.47 SEK or $1.37 per

share) and a significant loss in the GAAP statement (222.46 SEK or $ 2 2.94

per share). In Frederickson and Miller (2004), the comparable figures were

$1.68 (pro forma profit) as against $1.24 (GAAP profit) and in Elliott (2006)

the comparable figures were $0.01 (pro forma profit) as against $ 2 1.02

(GAAP loss). Further, the difference in results may be due to the use of a

more valid dependent variable (earnings forecasts) and greater reliability (mon-

itored experiment).

Regarding the question of possible effects on analysts’ confidence in their fore-

casts, we found that when comparing with the perceived confidence in the GAAP

report, the pro forma report did not diminish or increase the participants’ confi-

dence in their own forecasts, even though it contained more – albeit contradic-

tory – information. This observation is consistent with the findings of earlier

research (cf. Maines, 1995). One might speculate that the greater volume of infor-

mation in the pro forma report raised the level of confidence, but that this effect

was cancelled out by the contradictory details in the report concerned. Another

interpretation could be that both participant groups were uncertain about their

forecasts, because of the lack of additional information.

As in all research, the present study has its limitations. Admittedly, the number

of participants could have been greater, but it is in fact much the same as in

Frederickson and Miller (2004). It should also be emphasized that recruiting pro-

fessionals to take part in scientific studies is generally difficult (cf. Libby et al.,

2002). Attempts were in fact made to re-run the present experiment with another

group of financial analysts, but it was unfortunately impossible to get access to

more subjects. Another potential limitation concerns the study material. First,

the material could have been more detailed and/or more extensive, and thus

also more authentic. Secondly, the participants could have assessed more than

just one company thus enabling stronger results. On the other hand, such an

approach would have needed more time and might have interfered with the finan-

cial analysts’ normal work. Finally, a within-subject research design might have

been more powerful than the employed between-subjects setting. With such a

design, participants would evaluate a single company, making forecasts over

several periods with or without pro forma earnings reporting.12 It must be

stressed, however, that the setting adopted here is in line with the procedures

common in behavioural accounting studies (e.g. Libby et al., 2002), and

resembles that adopted in prior studies on pro forma reporting (Frederickson

and Miller, 2004; Elliott, 2006).

Standard setters put considerable effort into developing ‘better’ financial

reporting standards, assuming that capital market participants will benefit.13

Over time, this effort has made accounting standards increasingly complex.

Pro forma reporting, which excludes some of the complex GAAP-required

items, offers a simplified way of communicating the company’s ‘core earnings’.


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Earlier research on analysts’ forecast revisions indicates that analysts find pro

forma earnings to be significantly more informative, providing a more stable

measure of future profitability than GAAP earnings (Bhattacharya et al., 2003,

p. 310). However, if pro forma numbers draw attention away from GAAP in a

way that affects users’ judgments, this may have adverse effects for some user

groups. Earlier studies have reported that the judgments of non-sophisticated

users tend to be affected by pro forma reporting, whereas sophisticated users’

judgments remain unaffected (Frederickson and Miller, 2004; Elliott, 2006;

Allee et al., 2007). In contrast, our results show that sophisticated users will

also be affected when there is a substantial difference between GAAP earnings

and pro forma earnings. This should make standard setters concerned. Analysts

have a legitimate demand for financial statements that constitute a good basis

for forecasting. However, the increasingly complex financial statements pro-

duced under IFRS and US GAAP have been unable to satisfy this demand and

therefore analysts seek more forecasting-relevant, pro forma accounting infor-

mation. This observation implies a questioning of the standards as such.

Further, our study shows that such alternative (non-GAAP) measures may bias

analysts’ judgment. If pro forma accounting becomes the dominant source of

information for analysts, they may gradually lose their trust in accounting,

since earlier research indicates that pro forma accounting numbers are not com-

parable across companies and not consistently reported over time (Doyle et al.,

2003; Bhattacharya et al., 2004).

We believe that there is room for more experimental research on pro forma

reporting. The results reported in Elliott (2006) regarding the role of quantitative

reconciliation between pro forma and GAAP needs to be examined further.

In view of the results of the present paper, it would be interesting to include

reconciliation in a setting where the discrepancy between pro forma and

GAAP earnings is substantial, involving a pro forma profit and a GAAP loss.

In addition, the results reported in Bhattacharya et al. (2004), namely, that pro

forma reporting appears to be manipulated by companies to meet analysts’ expec-

tations, hold interesting possibilities for future experimental research.

Acknowledgements

Both authors contributed equally to this work, the order of authorship is arbitrary.

Helpful and valuable comments from Salvador Carmona and two anonymous

reviewers are gratefully acknowledged. The first author wishes to thank the

research foundation of Jan Wallander and Tom Hedelius for financial support.

Notes

1Ordinary net profit, calculated according to Generally Accepted Accounting Principles

(GAAP), is adjusted for items that are in some sense ‘unusual’. This could include restructuring

charges, write-downs and impairments, research and development expenses, merger and


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acquisition costs, stock compensation expense, goodwill amortization, etc. (Bradshaw and

Sloan, 2002).2Bradshaw and Sloan (2002) reported this empirical result on the basis of a comparison between

GAAP earnings and pro forma earnings as registered by analyst tracking services. Thus, they do

not use the companies’ pro forma earnings measures. However, the analyst tracking services

base their pro forma measures on companies’ specifications of what is referred to as non-

recurring or non-cash expenses.3Quotations from the speech are included in Bhattacharya et al. (2003, pp. 286–288).4These results reported in Frederickson and Miller (2004) and Elliott (2006) also agree with

those of a recent study based on archival data by Allee et al. (2007).5According to the descriptive statistics in Elliott (2006), analysts who received the press release

emphasizing pro forma earnings gave slightly higher earnings performance ratings than ana-

lysts who received GAAP information only (31.94 compared to 28.82 on the 100-point

scale). The pro forma earnings press release with reconciliation caused analysts to give signifi-

cantly higher earnings performance rankings compared to the press release including GAAP

information only.6Elliott (2006) reports a case in which the GAAP loss of $1.02 is transformed into a pro forma

profit close to zero ($0.01).7Analysts’ stock price appraisals could be expected to be preceded by analyst forecasts of a par-

ticular valuation attribute, such as earnings. Furthermore, the appraisal will involve subjective

risk considerations. In the case of investment decisions, analysts do not typically make such

decisions. The analysts’ earnings performance ranking (Elliott, 2006) is likely to be the depen-

dent variable that comes closest to the analyst’s primary real-world task of making earnings

forecasts.8In a study based on archival data, Doyle et al. (2003, p. 159) reported that some of the items

excluded from pro forma reports (denoted ‘special items’) are unrelated to future cash flows

from operations, whereas other excluded items (denoted ‘other exclusions’) have a pronounced

negative relation with future cash flows from operations. It is possible that analysts use the

reconciliation to learn more about the type of items affecting the pro forma reporting. If

there are a lot of ‘special items’, this might be a reason for viewing the company more posi-

tively than if the items were part of the group of ‘other exclusions’.9The complete research instrument can be obtained from the corresponding author.

10There were also additional questions prompting the participants to make subjective probability

forecasts with respect to the likelihood of higher sales, lower costs, improved income or a stron-

ger financial position, as well as indicating their confidence in the forecasts concerned.11As suggested by one of our reviewers, an alternative procedure would involve splitting the

sample into three subgroups so that the participating analysts were categorized as limited, mod-

erately or highly experienced (n ¼ 19, 13, 16). Such a procedure was also adopted. A Kruskal–

Wallis test showed that the subgroups did not show significantly different reactions to the types

of financial report. Nor were the differences between the limited and highly experienced ana-

lysts significant.12We thank an anonymous referee for suggesting this design.13We thank an anonymous reviewer for helpful comments on the implications of our results for

standard setters.

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Does Pro Forma Reporting Bias Analyst Forecasts?

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