Before starting this assignment, make sure to read the article Pro Forma Financial Statements: An Illustrative Example (WHICH IS BELOW). Then, write a 1-page paper analyzing the relevance of a pro forma statement as a decision-making tool.
Pro forma financial statements i are a type of accounting engagement that gives the customer an idea of what his or her financial statements would look like if certain specific, prede- termined strategic decisions are made that will affect financial performance of the customer firm. For example, a cus- tomer may order pro forma financial statements for a scenario in which the customer will consolidate three offices into one centralized location and pur- chase a building. Alternatively, a cus- tomer may order pro forma financial statements to report what would have happened to the company if a certain decision had been made. Pro forma finan- cials are the standard financial statements – income statement, balance sheet, cash flow statement, etc. – except that they are based on hypothetical criteria or a “what if” scenario provided by the client.
To illustrate the use of pro forma finan- cial statements, I’m going to look at what the truck manufacturer Mack Trucks, Inc. would have looked like had it never been bought out by Renault, and was still an American company.
Timeline and historical point of reference
Mack Trucks had been fraught with finan- cial troubles almost since its inception in 1900, and even earlier under the own- ership of the Mack Brothers in the late 1800s. The bulldog emblem and the solid performance of the trucks through two world wars gave Mack an iconic flair, but the financial performance and posi- tion of the company teetered almost reg- ularly until 1967, when executives agreed to become an affiliate of Signal Oil and Gas Company while maintaining auton- omy and independent management.
Later, in 19 83, Mack Trucks, Inc. be- came an American public company but continued to fight a financial struggle that always seemed to be an uphill battle. Fi- nally, in 1990, when Mack was posting $900 million in losses, the company was rescued, so it would seem, when Renault (the French automaker that already owned 45 percent of Mack stock) bought the remaining shares of the company and took control.
At this point in 1990, Mack Trucks, Inc. was no longer an American com- pany, and an executive of Renault became the CEO of Mack Trucks, as Mack was brought into the Renault fold to try to remedy the financial difficulties that had beset the company for most of its life.
The turnaround was not accomplished without pain. About half the Mack work- ers ended up losing their jobs, the Cana- dian plant was closed, and the finance division was sold off, while productiv- ity and design were enhanced as the new CEO from Renault cracked the whip. But Mack didn’t show profits after the buyout until 1995, a full five years after the sale.
Mack, with its identity intact, soon expanded overseas and, through clever management, avoided a mid-1990s down- turn in demand by ending the millennium on a steep upturn in both financial per- formance and market share. Then, in 2000, Renault sold Mack Trucks, Inc. to Volvo, which, despite immediate prob- lems with a backslide in American de- mand, was able to continue to promote innovation, maintain popularity, and hit a financial peak. Just as many, many times before, the cyclical nature of Mack Trucks proved to be less than disastrous, and this heroic firm rode the tides back up to solid profitability.
The saga now continues, even though Mack is a wholly owned Volvo subsidiary. Mack continues to be an individuated brand in the United States, a strong presence in the premium high-end truck market.1
Pro forma financial statements
The first step in producing financial state- ments for a hypothetical situation is to look at five years of the company’s exist- ing financial statements up to the point of projection, which in this case is the year of Mack’s buyout, 1990. I looked up the financial statements for the years ending December 31, 1985 through December 31, 1989 (which are publicly available through Moody’s) and put them on a simplified worksheet as seen in Exhibit 1. I call this simplified because, if you notice, there are only two kinds of expenses: selling and general. This over- simplification is my effort to fit all oper- ating costs into two buckets: those that vary with sales and those that do not.
The bottom portion is simplified, too, because there are only three kinds of current assets and one kind of long-term asset. The liabilities are similarly “boiled down”; however, the totals of each dif- ferent type of account add up to the pub- lished figures. My effort to simplify, or distill, the financial statements into this format helps to move more readily to the next step in the development of the pro forma financial statements.
So then, through a complex set of cal- culations and financial estimations (that I charge top dollar to produce), I pro- ject the next five years of cash flows as if management did not change policies, and the company ran at status quo from the point of projection onward. For Mack, this was the last year before the buyout, which occurred in 1990. If you look at Exhibit 2, you will see I start with 1990 and go forward five years. But notice two things: These are not the published finan- cial numbers, and these are not financial statements.
To explain, first, these are my hypo- thetical projections as if I had access to only the financial data through 1989 and was creating projections based on a for- mulated approach. And, second, these are projected cash flows, not accrual- based income amounts and account bal- ances. Creating the cash flow forecast first is the best way I have come up with to create a set of quality pro forma finan- cial statements.
The things to note in Exhibit 2 are that sales, variable costs, and fixed costs up top are shown to be after tax because I am interested in the net cash that is generated, and tax is eventually a cash outflow. Notice also the list of assump- tions for Exhibit 2 (shown in Exhibit 3) and Exhibit 4. The assumptions bring forward some given information that helps me make the cash flow projections, while Exhibit 4 shows some of my major calculations in arriving at the forecast.
The important thing to notice in Exhibit 2, which is the precursor to the pro forma financial statements, is that bot- tom-line cash flows (labeled CATO) are all negative on the order of $120M to $130M a year if Mack’s management does nothing immediately to “fix” the company.
To get the company on the right track, and illustrate the development of pro forma financial statements, I put together the solution as a list of assumptions for Exhibit 5, which is printed as Exhibit 6. Exhibit 5 is a revised cash flow forecast showing positive cash flows and sus- tainability, based on implementing cer- tain key measures assumed to be taken by Mack’s management to save the company.
With the combination I created by reducing cost, increasing income, and giving Mack Trucks access to a large immediate infusion of cash by issuing stock, I can now present pro forma finan- cial statements of the new Mack Trucks, Inc., a going concern…an American con- cern…as shown in Exhibit 7.
You can see the income statement and balance sheet based on my projections going forward five years from 1989, the last year Mack was in actuality an Amer- ican company. In the pro formas, sales go up and net income becomes very pos- itive very quickly but, more importantly, the cash-flow problems that have both- ered Mack over its 89 years in business are eliminated because the balance sheet is in equilibrium.
For example, because of the large equity cash infusion, 1990 cash levels shoot to a record high. Then, as you can see, because of the lower costs and grow- ing sales, retained earnings is brought up from its near-zero value in late 1989 to a healthier level, while other rela- tionships amongbalance sheet accounts stabilize.
This kind of project for a client can be enlightening for both the accountant and the contractor. For instance, if the con- tractor wants to buy a multi-use facility, vacate multiple leases, and centralize its operations but doesn’t have the foresight necessary to pull it all together with con- fidence, pro forma financial statements can be created to show the executives financially what the company will look like for the next five years. This will be accomplished by accounting for the proper assumptions that represent financial deci- sions required to execute the land and build- ing purchase and the move.
Exhibit 7 includes Mack Trucks’ income statement on the top and the balance sheet down below. In a real client situa- tion I would not present rough numbers like this exhibit, but pretty them up and present them in a binder with proper for- matting, notes, and nomenclature.2 *
Moldof, A. (2013). PRO FORMA FINANCIAL STATEMENTS: AN ILLUSTRATIVE EXAMPLE. Construction Accounting & Taxation, 23(5), 41-47. Retrieved from http://ezproxy.snhu.edu/login?qurl=https%3A%2F%2Fsearch.proquest.com%2Fdocview%2F1468665555%3Faccountid%3D3783