Introduction
Financial statements offer companies the necessary information regarding the financial health and stability of their investments. Also, it provides them with crucial information that shows their ability to manage operations cost-effectively. Generally Accepted Accounting Principles (GAAP) utilisation provides a platform that ensures constant treatment of unique constituents on financial statements.
Generally Accepted Accounting Principles earnings offer an accurate, historical image of incomes. On the other hand, pro-forma earnings offer a prediction of future earnings or Generally Accepted Accounting Principles earnings omitting nonrecurring items.
Before setting up a limited company, you need to understand how GAAP and pro-forma earnings differ, understanding their pros and cons and their implications for investors. Whether you have set up a limited company or not, let’s dig deep into the world of pro-forma and GAAP earnings to discover more.
What’re Pro-Forma Earnings?
In most cases, pro-forma earnings refer to earnings that eliminate certain expenses a business believes lead to a distorted image of its real profitability. These earnings aren’t in compliance with standard Generally Accepted Accounting Principles techniques.
They’re usually higher compared to those compliance with Generally Accepted Accounting Principles. Also, pro-forma earnings may refer to estimated earnings included as a section of an initial public offering or a business plan.
Pro-Forma Earnings: The Benefits
Pro-forma earnings have vital benefits for both external and internal use. Here are some reasons why pro-forma earnings are important.
- Listing pro-forma earnings provides a more realistic presentation of a business’s earnings.
- Including pro-forma earnings on a company’s financial statement may help attract and retain stakeholders or investors.
- Pro-forma earnings calculations can benefit companies by enabling them to anticipate how huge changes may affect their net profits.
- Aside from helping companies calculate estimated earnings from the latest business alterations, pro-forma earnings may enable financial managers to plan for future investments.
Pro-Forma Earnings: The Cons
Companies often release positive earnings statements that exclude things such as acquisition-related expenses and stock-based compensation. Such businesses, however, are expecting investors to forget that these costs are actual and need to be included. From time to time, businesses take unsold inventories off their balance sheets when reporting their pro-forma earnings.
Try to ask yourself this question; does preparing and producing those inventories cost money? If yes, why should the business simply write them off? It’s bad management to produce items that cannot be sold, and a business’s poor decisions should not be erased from its financial statements.
Generally Accepted Accounting Principles (GAAP)
Shortened as GAAP, Generally Accepted Accounting Principles are a standard set of accounting rules provided by the financial authorities. Businesses need to follow GAAP requirements when their accountants compile financial statements to their authorities.
GAAP: The Benefits
- GAAP helps companies maintain consistency in their presentations of financial information, reducing the risk of misrepresentation while avoiding fraud.
- Adhering to GAAP rules can help your business implement proper safeguards and controls.
- Presenting company information using GAAP helps to instill trust in investors who’ve got an interest in the business.
- Investors and other interested individuals and parties can compare the financial information of different businesses since GAAP offers standardised guidelines that financial, accounting and auditing experts follow.
Limitations of Using GAAP
GAAP strives to minimise inaccurate financial reporting and guide businesses in preparing clear and accurate financial data. However, there are some limitations you need to keep in mind when using GAAP. They include:
- Generally Accepted Accounting Principles (GAAP) aren’t globally recognised as the standard for creating financial reports.
- Generally Accepted Accounting Principles (GAAP) tend to utilise the ‘one-size-fits-all” technique instead of accounting for the vast diversity that is, in most cases, seen between businesses.
By understanding these types of statements, you now have a grasp of when and why businesses use pro-forma earnings and their implications for investors.
