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MORE SUBSCRIBER QUESTIONS ANSWERED
by: Cary Christian


We always welcome and enjoy receiving questions from you guys. Here are a couple of good ones we received this week.

1. Should non-GAAP (proforma) financials be abolished?

Proforma financial statements present particular problems that are not applicable to historical financial statements. They can't be audited because they represent future events. There are provisions where proforma financial statements can be issued with a review report from a CPA firm, but the review is nothing more than a statement that the underlying assumptions have been reviewed and found to be "reasonable."

The assumptions are the crux of the problem. Projected results of operations are only as good as the assumptions underlying them. For example, if a company enjoys a 50% market share as a result of a market-leading product and projects it will increase market share by 10% in the coming quarter, the assumption might well be reasonable. However, if their largest competitor comes out with a better product 15 days into the quarter, the company may actually lose a huge chunk of its market share rather than increase it. There is normally no way to foresee these types of events.

Proforma statements are useful to an investor or other user of the statements if they are a realistic and HONEST reflection of management's belief as to where the company is going. If they are not, they are little more than sales hype.

If a user is to make use of proforma financial statements, he or she needs to know and understand the underlying assumptions in some detail. Only then can he or she form their own opinion of the reasonableness of the statements. Even then, this assumes the reader has the financial and business knowledge to understand and interpret these assumptions. Most do not.

I believe proforma statements are necessary. Investors and other users need to know where management thinks the company is going. They also need to hold management responsible for meeting these numbers. The new anti-fraud bill and any amendments to it in the future needs to address this as well. If management produces proforma numbers it knows it cannot meet, that should be considered just as fraudulent as issuing erroneous audited financial statements.

A literal reading of the bill would appear to impose this requirement on management. The CEO and CFO must sign off on financial statements, including the notes to the statements which is normally where proforma data is included. As long as management is accountable, we can have some comfort that proforma numbers will be reasonable.


2. Arthur Andersen seems to be closely aligned with all the major Chapter 11 filings in recent history, such as Global Crossings, Worldcom and Enron. Were they the only Big 5 firm doing such a poor job?

Andersen was the auditors for each of these firms, but don't think the problem is or was isolated to Andersen. The real problem is that auditing firms earn far more in consulting fees from their clients than they ever do from auditing. Auditing has become more of a "loss leader" product that allows an accounting firm to get in the door and sell other, more profitable services to a company. As a result, auditors have lost a lot of their independence. They'll do almost anything a large audit client asks of them out of fear of losing the work.

Andersen has been hit hard, destroyed actually, by these huge debacles, but I would look for others to come under fire as well. The new fraud bill will take care of a lot of these problems by forbidding audit firms to perform other work for the firms they audit. There are other provisions as well that will keep auditors and their clients from becoming too cozy.

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