GAAP is a common set of generally accepted accounting principles, standards, and procedures. U.S. public companies must follow GAAP for their financial statements. There are no universal rules that companies must follow when reporting pro forma earnings. This is why it is important for investors to distinguish between pro forma earnings and those reported using generally accepted accounting principles . GAAP enforces strict guidelines when companies report earnings, but pro forma figures are better thought of as “hypothetical” earnings, computed according to the relevance of certain events or conditions. For this reason, investors must examine not only the pro forma earnings, but also GAAP earnings, and never mistake one for the other. Calculate the estimated revenue projections for your business, a process called pro forma forecasting.

Some firms exclude unsold inventory from their statements, which, in a way, portrays inefficient management to produce inventory that cannot be sold. Set a production schedule that will let you reach your goal, and map it out over the time period you’re covering.

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Financial accounting creates pro forma statements for reporting a company’s earning while excluding any nonrecurring or unusual transactions. Some examples of these excluded transactions include restructuring costs, declining investment values or prior year’s accounting errors. Managerial accounting creates pro forma statements for future transaction planning, like mergers, acquisitions, new capital investments or changes in capital structure. The pro forma statement works as a forecast model to show potential net revenues, taxes or cash flow.

Types of Pro Forma Financial Statements

“Potential capital suppliers will carefully examine pro forma financial statements before committing capital to the firm,” Johnson said. Generally, pro forma financial statements tend to portray a business as being more successful than it really is, and having more financial resources available than may actually be the case. Consequently, investors should be extremely cautious when evaluating these types of financial statements, and spend time understanding how they differ from the issuing firm’s normal financial statements.

• The legal liability of the company may increase upon submitting forecasts instead of pro forma income statements, but the practice may be more relevant for certain businesses.
• Financing activities includes a mortgage on a building with the monthly payments categorized as an outlay; whereas borrowing money from a financial institution would bring cash into the organization as a cash inflow.
• The pro forma balance sheet includes projected changes in current assets and current liabilities, planned capital investments that would impact fixed assets, and changes in long-term financing.
• There are three main types of financial statements, the statement of financial position, also known as the balance sheet, the income statement, also known as the profit and loss statement, and the cash flow statement.
• Investors and creditors use it to analyze the financial position and health of a company.
• Intuit does not endorse or approve these products and services, or the opinions of these corporations or organizations or individuals.

Pro forma EPS are calculated in the pro forma income statement, but the figure is also used in the pro forma balance sheet and the pro forma cash flow statement, when necessary. According to the SEC, when the dividends from stock exceed or are planned to exceed the current earnings, the EPS must be calculated. The SEC assumes that that proceeds from any additional shares will be used to fund dividends. Statements of cash flow, or cash flow statements, measure the sources of a company’s cash and how it uses that cash over the stated period. Pro forma statements of cash flow estimate how much cash inflow and outflow is expected in one or more future periods. Often requested by banks, they may also be prepared as a part of the annual budgeting or forecast and estimate where cash shortages may occur in order to obtain additional funding. In the case of estimated cash overages, the company can produce a plan for investment.

How to Create a Pro Forma Income Statement

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• You have to assume that there is a real possibility that the projected figure may not be accurate.
• GAAP is an acronym for generally accepted accounting principles, which are common standards publicly traded companies must follow.
• Comparing pro forma figures across multiple companies is unlikely to create an accurate comparison unless you are acutely aware of how each company created their pro forma statements.
• As such, there’s always a possibility that the scenarios projected by your pro forma financial statements are going to be wildly inaccurate.
• The purpose of pro forma is to analytically predict how well a business will perform in the future to help business owners make the best decisions.

Sakshi Udavant covers small business finance, entrepreneurship, and startup topics for The Balance. For over a decade, she has been a freelance journalist and marketing writer specializing in covering business, finance, technology. Her work has also been featured in publications and media outlets including Business Insider, Chicago Tribune, The Independent, and Digital Privacy News.

What Are the Challenges & Responsibilities of Management Accounting?

Lenders and investors may be less concerned by a business owner’s conservative Pro Forma Financial Statements. Business owners should also use short-term pro forma statements to avoid creating specific long-term financial expectations. There are a variety of pro forma reports that can be used to help businesses make better financial decisions. The three most common types of pro forma reports are the income statement, the balance sheet, and the cash flow statement. The income statement shows a company’s revenues and expenses over a specific period of time, while the balance sheet shows a company’s assets, liabilities, and equity at a specific point in time. The cash flow statement shows how much cash a company has generated and used over a specific period of time.

• In this way, your management team (or C-suite) has all the information they need to make informed decisions.
• If a piece of new machinery is going to be purchased, there will be an increase in the Property, Plant and Equipment of the company.
• If you own a business or manage the finances of an organization, you would often think of different possible outcomes for revenue, capital costs, investments, or profits based on certain assumptions.
• However, to entice investors through optimistic projections, make sure not to stray away from standard accounting practices.
• Restructuring CostsRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations.
• For our widget vendor, let’s say the business owner would initially like to look backward at historical profit & loss.

Kiran Aditham has over 15 years of journalism experience and is an expert on small business and careers. As a senior editor he ensures editorial integrity through fact checking and sourcing and reinforces our mission to provide the most informative, accessible content to job seekers and small business owners. Below are the Pro Forma projections of the Income Statement of Alibaba. The projection of revenues https://www.bookstime.com/ is based on many assumptions, including growth rate, competition, market size, etc. On the other hand, if net cash flow is positive, you can plan on having enough extra cash on hand to pay off loans, or save for a big investment. Adjusted EBITDA is a measure computed for a company that takes its earnings and adds back interest expenses, taxes, and depreciation charges, plus other adjustments to the metric.

Intuit Inc. does not warrant that the material contained herein will continue to be accurate nor that it is completely free of errors when published. Sally learns from this statement that she projects $185,000 in current assets and $150,000 in liabilities, which gives her $35,000 in owner’s equity. An investment projection would showcase what an influx of cash could potentially do to your business. For example, if you were contemplating taking on an investor, it would give you a risk vs. reward scenario. David Kindness is a Certified Public Accountant and an expert in the fields of financial accounting, corporate and individual tax planning and preparation, and investing and retirement planning. David has helped thousands of clients improve their accounting and financial systems, create budgets, and minimize their taxes.

You can make pro forma adjustments based on new information and use these statements to find opportunities, reduce risk, and increase profits. A pro forma financial statement is supposed to include reasonably accurate information. However, companies that create these documents have some leeway in their assumptions. They might be overly optimistic or omit important information investors need to know about. When deciding whether or not to invest in a company or a project, it’s reasonable to wonder how the future will unfold. There’s no way to predict the future with certainty, but you can analyze multiple “what if” scenarios to understand the potential outcomes. Pro forma financial statements enable investors to do that with available information.

Limitations of Pro Forma Financial Statements

Pro forma balance sheets are difficult to compile, but banks generally ask for them and they are important for showing your potential financial picture. They can show the projection of what money will be tied up in receivables, equipment, and inventory.

As you track metrics along the way, you’ll be able to course correct and remodel what the future looks like. If a company purchases stock, they are paying money out and a cash outflow is recorded. If they sold the stock and made a profit, the cash is considered an inflow. Purchasing a building with cash is an example of an operating activity; the company has a cash outflow for the purchase.