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Pro-forma numbers attract the wrong crowd: study Print E-mail
Wednesday, 23 September 2009

By S.L. Mintz

There's a downside to putting a shine on financial performance by showing investors non-GAAP numbers, new research finds.

In conveying a selective picture of corporate performance, companies that use pro forma statements in addition to those prepared according to Generally Accepted Accounting Principles can lure an undesirable audience: short sellers. So shows a May 2009 study by Theodore Christensen at Brigham Young University Michael Drake at Ohio State and Jacob Thornock at the University of North Carolina.

The paper, entitled "Optimistic reporting and pessimistic investing: Do pro forma earnings disclosures attract short sellers?," finds that some types of non-GAAP measures draw more short attention than others. Generally speaking, however, the more optimistic the reporting, the bigger the risk.

The analysis centered on nearly 2,000 quarterly earnings announcements that contained pro forma disclosures for 2005 and 2006. To ensure the most relevant comparisons, it measured short activity at these companies in quarters when they issued pro formas versus quarters when they did not. It also adjusted for normal levels of short selling activity in a two-day window, prior quarter stock returns, market reaction to the earnings announcements and short seller sentiment prior to the earnings announcement and the firm's pro forma reporting history.

Quarters when these companies issued pro formas saw a net increase in short activity. On average, quarterly pro formas increased short sales by $1.3 million immediately after earnings announcements, or 1.1 percent of trading volume.

In mergers, restructurings and other exceptional or one-time scenarios, pro formas can add clarity. But quarterly pro formas send red flags. To rigorous short sellers, they imply doubt about valuation, enough reason to pounce. "It appears that the simple act of giving the market two different earnings numbers attracts short sellers," says co-author Michael Drake.

However objectively managers try to frame them, pro formas rest on favorable assumptions. By nature that warrants a skeptical eye. Warren Buffett, the dean of long-term investors, likens pro formas to a golf score he envisions. "In golf," he wrote in the 2001 Berkshire Hathaway annual report, "my score is frequently below par on a pro forma basis: I have firm plans to 'restructure' my putting stroke and therefore only count the swings before reaching the green."

To learn where short sellers look closest, the study divides pro formas into three principal categories: below-the-line items, infrequent items, and recurring items. Prudent managers can weigh resulting evidence that some exclusions get more short scrutiny.

pro formas that exclude below-the-line exceptional items and infrequent items get less attention. Those categories comprise, in part, discontinued operations, cumulative change in accounting principle, early debt retirement and preferred stock charges or IPO expenses. "If it's clear that you're adjusting unambiguously unusual items we find that short sellers don't increase their activity," Drake says.

Short sellers perk up when pro formas omit recurring items, such as research and development, tax-related items or stock-based compensation whose absence causes short interest to jump most, the study found.

Heightened short interest would make sense because expectations beyond the short term rest on recurring numbers in core earnings. When core line items are absent from pro formas, shorts may speculate that companies have exhausted less invasive means to meet financial targets.

If the authors have uncovered clues to short sellers' interest, at least one prominent short firm won't give anything away. Asked whether quarterly pro formas flag opportunity for prominent short seller James Chanos and his firm, Kynikos, a spokesman declined to comment.

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