Before describing what took place, I first should explain that there are two different varieties of pro forma earnings. Let's call them GAAP pro forma earnings and non-GAAP pro forma earnings. Both types of pro forma earnings are "as if" earnings; in other words, pro forma earnings equal the corporate earnings if the company measured income in this or that manner. The difference between the two categories is whether they are based on some formal accounting promulgation or are the product of some "creative" entrepreneur or investment banker or Andersen auditor.
GAAP pro forma earnings are the earnings of the company when the earnings are measured according to some method that an accounting standards-setting body designed. For example, APB Statement No. 3 issued in 1969 did not require but allowed firms to restate financial statements for general price-level changes. If an entity did prepare such statements, it would refer to them as pro forma earnings. In 1971 the APB in Opinion No. 20 required firms that changed accounting methods to report previous numbers as if the business enterprise had been applying the new method all along. The idea was to assist the readers in understanding what this change in accounting principle means. These new figures are also referred to as pro forma earnings.
Non-GAAP pro forma earnings, however, are not tied to any accounting pronouncement; rather managers and their advisors fabricate these compositions out of their own desires. Frequently, these constructions equal earnings minus anything that will makes the company look bad. The key feature is that nobody governs how these non-GAAP pro forma earnings are measured, so managers have a license to do anything they want in these so-called disclosures. Understandably managers have tweaked these things to a fine art by squeezing out anything that makes them look bad. In the process, however, astute readers have learned that these non-GAAP pro forma earnings are little white lies -- or worse.
Most companies in the U.S. implement FASB's Statement No. 123 by disclosing pro forma earnings and earnings per share -- that is, earnings as if they deducted stock-based compensation as an expense. The important item to keep in mind is that this disclosure is a GAAP pro forma earnings. The FASB dictates how this number should be measured and how it should be reported.
What eBay did, very simply, is report a certain set of pro forma earnings prior to 2002. In its 2002 annual report, eBay changed these disclosures and did not call attention to its accounting restatement. The numbers are (in thousands):
We may infer that during its 2002 review eBay or its auditor found an error to the tune of $127 million. It appears to be an error instead of a change in estimate because eBay claims, "The 2000 and 2001 pro forma amounts have been adjusted to reflect the correction of previously calculated pro forma option pricing and amortization amounts." The question then becomes what if anything should the managers have done about this error. Clearly, the amount is material with respect to the other income numbers.
Since the matter is an error, APB Opinion No. 20 says that the corporation should handle it as a prior period adjustment and restate the past years if the numbers are given. The prior period adjustment does not fit this case since we are talking about pro forma earnings rather than what goes on the income statement, and eBay did recast its former pro forma numbers. APB Opinion 20 also calls for a disclosure of the nature of the error and I would like to hear more about the error: for example, was it due to incorrect data, human error, or a model error.
More importantly, in this era in which we hope that accounting scandals are getting removed from the scene, I would prefer that managers take the initiative to point out such huge errors. And the place to confess such a discretion to the investment community is via an 8-K.
Managers at eBay might prefer that I ignore the Statement 123 pro forma earnings, but in fact I and many others think they are far more relevant that the reported numbers. The SEC currently might not require such errors to trigger an 8-K, but I think eBay's managers would have been better served if they had pointed out the problem clearly and directly by proclaiming the accounting restatement in a Form 8-K.
Transparency is very important today. When somebody doesn't reveal something, I assume the worst. When somebody reveals a problem but does it in a subtle way that can be easily missed, then I assume that managers wanted me to overlook the disclosures. In those cases, I become skeptical of management's intentions.
The good news is that eBay corrected the errors. The bad news is they weren't transparent enough in making these corrections.
J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of the forthcoming Hidden Financial Risk, which explores the causes of recent accounting scandals.
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