Usefulness of pro forma accounting information mandated in IPO prospectuses : its association with IPO pricing and subsequent firm performance

Abstract

This study examines the characteristics and usefulness of pro forma accounting information disclosed in IPO prospectuses as required by Article 11 of Regulation S-X in the United States. Using hand-collected pro forma accounting data from IPO prospectuses during 1997-2008, I first collect descriptive evidence on the nature and characteristics of pro forma accounting data in my sample. I find that pro forma IPOs are more likely to occur in the service industry and increase significantly during the Internet bubble period (1999-2000). I also find that pro forma IPO firms are more mature than non-pro forma IPO firms. An examination of characteristics of pro forma transactions indicates that pro forma transactions are more likely to occur during the IPO year and related to mergers and acquisitions. I then concentrate my examination on a ''bottom line item" of pro forma accounting data - pro forma earnings adjustment. I find that pro forma earnings adjustment has, on average, an income-decreasing effect on historical GAAP earnings. A decomposition of pro forma earnings adjustment shows that positive pro forma earnings adjustment is more likely associated with gross profit and selling, general & administrative (SG&A) expenses, and negative pro forma earnings adjustment is more likely associated with depreciation and amortization (D&A) expenses. Next I investigate the usefulness of pro forma earnings adjustment for IPO investors by examining its association with future financial performance, IPO equity value and future stock returns. In general, my empirical findings suggest that the usefulness of pro forma earnings adjustment should be interpreted with caution. I find that positive pro forma earnings adjustment is positively and significantly associated with future financial performance as well as IPO equity value, indicating that this measure is reliable to gauge the continuing effect of a pro forma transaction on future firm performance and is priced by IPO investors as a component of IPO equity value. I also find an insignificant association between positive pro forma earnings adjustment and post-IPO stock returns, indicating that investors completely price this information initially. In comparison, I find that negative pro forma earnings adjustment is insignificantly associated with future financial performance but negatively and significantly associated with IPO equity value. The result indicates that negative pro forma earnings adjustment has poor quality to gauge the continuing effect of a pro forma transaction on future firm performance. The regression results also provide some evidence that investors' initial reaction to negative pro forma earnings adjustment is not complete. The conclusion, however, is not supported by portfolio analysis.