Estimates of which of the following are needed to prepare pro forma income statements?

What is the Pro Forma Income Statement?

Pro Forma Income Statement (also known as pro forma profit and loss) means how the adjusted income statement will look when certain assumptions like non-recurring items, restructuring costs, etc., are excluded or if a loss-making unit is discontinued. When used in a business plan, it represents financial forecasts based on managers’ or analysts’ assumptions about the company.

Inhaltsverzeichnis Show

• What is the Pro Forma Income Statement?
• Two Types of Pro Forma Income Statement
• Uses of Pro Forma Income Statement
• Recommended Articles
• Which of the following are considered pro forma financial statements?
• When estimating expenses for the pro forma income statement it is best to be conservative?
• Which items from the sales budget are reported on the pro forma financial statements?
• Which one of the following is the equation for estimating operating cash flows using the tax shield approach?

Two Types of Pro Forma Income Statement

A Pro forma income statement is the statement prepared by the business entity to prepare the projections of income and expenses, which they expect to have in the future by following certain assumptions such as competition level in the market, size of the market, and growth rate, etc.

#1 – Pro Forma of Historical Profit and Loss Statement

Below is an example of Amazon. As noted below, Amazon removed its non-recurring charges, including restructuring costsRestructuring Cost is the one-time expense incurred by the company in the process of reorganizing its business operations. It is done to improve the long term profitability and working efficiency. This expenditure is treated as the non-operating expenses in the financial statements.read more and stock-based compensation, to correctly represent its Net Income.

source: Amazon SEC Filings

#2 – Pro Forma Projections of Income

Below are the Pro Forma projections of the Income Statement of Alibaba. The projection of revenues is based on many assumptions, including growth rate, competition, market size, etc.

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For eg:
Source: Pro Forma Income Statement (wallstreetmojo.com)

Uses of Pro Forma Income Statement

• Forecasting revenues are the most difficult part of any business plan. The assumptions have to be realistic and should be able to support the forecast. It is used to produce the Cash Flow Statements and Balance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, all of which are important business plan components.
• It may be prepared in advance of a transaction to project the company’s future status. For example, if a company is planning to acquire another company, it may prepare a pro forma financial statement to estimate what effect the acquisition would have on its finances.
• Pro forma profit and loss statements can also be used to calculate the financial ratios.
• If a company has a one-time expense, it may drastically reduce its net income in that particular year. This cost is irrelevant in subsequent years. Hence companies exclude such costs while making the pro forma profit and loss to give investors and analysts a better picture of the company’s financial position.
• For some companies, the pro forma profit and loss statements provide a clear and accurate view of their performance, given the nature of their business. Example: telephone and cable companies.

Drawbacks

• One of the major drawbacks is that it is just a mere projection, the future of which is uncertain. The basis of any pro forma is the assumptions made. If the assumptions are inaccurate, it may lead to inaccurate planning and execution. Past data may not always help to paint the correct picture in a dynamic and ever-changing business environment.
• Since there are no set rules while making such a pro forma, companies tend to manipulate their financial earnings. Companies can exclude anything it believes that conceals their true financial performance.
• Some firms exclude unsold inventory from their statements, which, in a way, portrays inefficient management to produce inventory that cannot be sold.
• It does not mean that every firm manipulates its earnings. Hence while evaluating, investors and analysts should pay attention to what is and is not included while preparing the pro forma income statements.

Conclusion

Although the pro forma profit and loss statements provide a better picture, it is prudent for the investor to dip deep and analyze what is included/excluded and why so? It also advised comparing the pro forma and actual statements to understand them better.

Recommended Articles

This article has been a guide to what is a Pro forma income statement. Here we discuss the two types of pro forma income statements along with their uses and drawbacks. You may learn more about Accounting from the following articles –

• Pro Forma Financial Statement
• Pro Forma Cash Flow Statement
• Comparative Income Statement Meaning
• Partial Income Statement
• Gross Sales vs. Net Sales