Pro forma accounting is a type of financial strategy that incorporates information that is projected as well as historical when preparing various types of accounting reports. The idea is to utilize this approach to provide a snapshot of what is expected to come to pass, using historical data as the basis for those projections. While speculative in nature, pro forma accounting is not about making unfounded guesses about the future, but creating financial forecasting that statistically has a strong potential for taking place.
One of the easiest ways to understand how pro forma accounting may be helpful is to consider a business that is considering an expansion project. As part of the process, there is a need to have some idea of what type of financial benefits will result from those activities in the future. In order to accomplish this, the business will rely on historical data to project how much of a return the expansion is likely to produce within one, two, or five years of completion. This calls for identifying as recurring costs or those expenses that will be absorbed on an ongoing basis and comparing those expenses to the projected revenue that will result from the expansion.
Using this application of pro forma accounting, business owners can have some idea of what to expect in the way of benefits from that expansion, and if the net returns are sufficient to justify the costs of the expansion and the ongoing operation of the new facilities in the future. If there are indications that those returns are minimal, the business may choose to delay the expansion or look at some other opportunity with a better chance of generating more desirable returns. From this perspective, using pro forma accounting to create projected income statements, balance sheets, and even profit and loss statements can help owners to avoid initiating a project that ultimately is not likely to increase the bottom line by an appreciable amount.
In order for pro forma accounting to be beneficial, the data collected for the projections must be as accurate as possible. This includes data that provides hints as to the movement of the economy and how those movements will impact the ability of the business to generate sales or to continue buying raw materials are reasonable prices. Unless the data is reliable, the projections that are reflecting the pro forma accounting statements will be worthless and leave owners and investors with a false impression of the viability of the expansion project.
