BUS202: Principles of Finance

A pro forma income statement is planned and prepared in advance to of a transaction to project the future status of the company.

TERMS

• depreciation

  The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

• pro forma

  For the sake of form only.

• write-off

  The term written-off describes a reduction in recognized value. In accounting terminology, it refers to recognition of the reduced or zero value of an asset.

Pro forma

The term pro forma, Latin for "as a matter of form" or "for the sake of form", is a term applied to practices or documents that are done as a pure formality, perfunctorily, or seek to satisfy the minimum requirements or to conform to a convention or doctrine. It has different meanings in different fields.

Pro forma financial statements are prepared in advance of a planned transaction, such as a merger, an acquisition, a new capital investment, or a change in capital structure like an incurrence of new debt or issuance of equity.

The pro forma models the anticipated results of the transaction, with particular emphasis on the projected cash flows, net revenues and (for taxable entities) taxes. Consequently, pro forma statements summarize the projected future status of a company, based on the current financial statements. For example, when a transaction with a material effect on a company's financial condition is contemplated, the Finance Department will prepare, for management and Board review, a business plan containing pro forma financial statements demonstrating the expected effect of the proposed transaction on the company's financial viability. Lenders and investors will require such statements to structure or confirm compliance with debt covenants, such as debt service reserve coverage and debt to equity ratios. Similarly, when a new corporation is envisioned, its founders will prepare pro forma financial statements for the information of prospective investors.

Pro forma accounting is a statement of the company's financial activities while excluding "unusual and nonrecurring transactions" when stating how much money the company actually made. Expenses often excluded from pro forma results include company restructuring costs, a decline in the value of the company's investments, or other accounting charges, such as adjusting the current balance sheet to fix faulty accounting practices in previous years.

Income Statement

The income statement is a company's financial statement that indicates how the revenue is transformed into the net income (the result after all revenues and expenses have been accounted for, also known as Net Profit or the "bottom line"). It displays the revenues recognized for a specific period, and the cost and expenses charged against these revenues, including write-offs (e.g., depreciation and amortization of various assets) and taxes.

Pro Forma Income Statement

Pro forma figures should be clearly labeled as such and the reason for any deviation from reported past figures clearly explained. A pro forma Income statement could be planned and prepared in advance, which includes the items below:

Operating Section:

• Revenue - Cash inflows or other enhancements of assets of an entity during a period from delivering or producing goods, rendering services, or other activities that constitute the entity's ongoing major operations. It is usually presented as sales minus sales discounts, returns, and allowances.
• Expenses - Cash outflows or other using-up of assets or incurrence of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity's ongoing major operations.
• Cost of Goods Sold (COGS) / Cost of Sales - represents the direct costs attributable to goods produced and sold by a business (manufacturing or merchandising). It includes material costs, direct labor, and overhead costs (as in absorption costing).
• Selling, General and Administrative expenses (SG&A or SGA) - consist of the combined payroll costs. SGA is usually understood as a major portion of non-production related costs, in contrast to production costs such as direct labor.
• Depreciation / Amortization - the charge with respect to fixed assets / intangible assets that have been capitalized on the balance sheet for a specific (accounting) period. It is a systematic and rational allocation of cost rather than the recognition of market value decrement.
• Research & Development (R&D) expenses - expenses included in research and development.

Non-Operating Section:

• Other revenues or gains - income from other than primary business activities (e.g. rent, income from patents). It also includes gains that are either unusual or infrequent, but not both (e.g. gain from sale of securities or gain from disposal of fixed assets)
• Other expenses or losses - not related to primary business operations, (e.g. foreign exchange loss).
• Finance costs - costs of borrowing from various creditors (e.g. interest expenses, bank charges).
• Income tax expense - sum of the amount of tax payable to tax authorities in the current reporting period (current tax liabilities / tax payable) and the amount of deferred tax liabilities (or assets).
• Irregular items - these are reported separately because this way users can better predict future cash flows - irregular items most likely will not recur. These are reported net of taxes.
• Discontinued operations is the most common type of irregular items. Shifting business location(s), stopping production temporarily, or changes due to technological improvement do not qualify as discontinued operations. Discontinued operations must be shown separately.