"Pro forma," originates as a Latin phrase which, literally translated, means something like "for the sake of form." It is often used for specific purposes in economics and finance.
Our Ambivalence About the Phrase in Finance
The briefest perusal of some dictionary definitions begins to express our ambivalence about the use of the term in economics and especially in finance.
Some online dictionaries give relatively neutral definitions that adhere closely to the phrase's Latin origins, such as "according to form," "as a matter of form," and "for the sake of form."
Other dictionary definitions begin to express more complex assessments of the meaning of the phrase, Merriam-Webster's, for example: "done or existing as something that is usual or required but that has little true meaning or importance" (emphasis added). It's not a far reach from "little true meaning" to "not meaningful at all and potentially deceptive."
Legitimate Instances of "Pro Forma"
In reality, the greater number of uses of pro forma documents in finance are not deceptive at all; they serve a valuable purpose. One such use, one that occurs frequently, has to do with financial statements.
In most circumstances, a financial statement reflects reality. In some circumstances, a financial statement that does not do so could be considered (in ascending order of "wrongness"): valueless, misleading or evidence of criminal misrepresentation.
But a pro forma financial statement is (usually) a legitimate exception to that rule. Instead of answering the question "What is the state of the balance sheet?" or "how much money did the enterprise earn in a given time period," a question answered by the income statement, a pro forma balance sheet and income statement answers the question "What would happen if… ?"
Here's a good example: The corporation has earnings for the past year of $10M, with expenses of $7.5M. These are figures you might find in the income statement. But, executives wonder, what would be the effect of introducing a new product line (which would sharply ramp up expenses)? You would expect that in the shortest term, before the revenues from the new product line were realized, that profits would diminish considerably and that revenues would go up very little. You'd also expect that over time the additional revenue from the new product line would more than pay for the increased expenses, and that the business would be more profitable.
But, is that really true? At the point of "you'd expect… " this is just a guess. How can you know, if not for sure, but at least with some increased confidence that increased profitability will result? That's where pro forma financial documents come into play. A pro forma set of financial documents will refer to past performance as a guide to project would would likely happen in the future if we make a similar introduction. It answers the question "What if… " When the company introduced a past product, the MicroWidget, operating costs rose X percent in the following three quarters, but in the fourth quarter increased revenue from the MicroWidget more than made up for the increased operating cost expense and net profit actually rose 14 percent year over year. The pro forma balance sheets, income statements and statements of cash flows show what might happen if a new MacroWidget product is introduced, based on the data available.
Pro Forma Statements vs. Certainty
Note that a pro forma financial statement does not express certainty. It expresses what, with the data available, business leadership and accountancy professionals believe is likely to happen. Often it does, and sometimes it does not. Nevertheless, pro forma statements serve a valuable purpose by introducing data that supports (or does not support) the original intuition that, for example, adding a MacroWidget to the product line is a good idea. It does so by quantifying the probable results based on past performance. The pro forma balance sheets, income statements and, importantly, statements of cash flows give business executives a better idea of "what will happen if… ".
The Downside of Pro Forma Statements
The general intent of pro forma financial statements, to answer the question "what will happen if… " can be abused. In the notorious Enron collapse, pro forma statements played an important part. Arthur Andersen Enron's auditors, it became clear in retrospect, were too close to the company to deliver reliable financial statements to financial markets. This was particularly true of the pro forma statements that projected a rosy future for Enron and purportedly were based on reasonable assumptions. They utterly failed to predict what became instead a total collapse that sent Enron executives to jail, ended the Arthur Andersen company and culminated in a prolonged and messy Enron bankruptcy in which stockholders and others lost hundreds of millions of dollars.
Absent criminal intent, data that already exist are reliably what they propose. Data that are projections based on assumptions -- which is the essence of a pro forma statement -- are inevitably and categorically more subjective. In short, they are useful financial tools that are particularly easy to abuse. You shouldn't avoid using them, but you need to exercise caution.
Books on Pro Forma
- Profits You Can Trust: Spotting and Surviving Accounting Landmines
- How Companies Lie: Why Enron Is Just the Tip of the Iceberg
- The Valuation of Technology: Business and Financial Issues in R&D