Question

Why a firm would want to create pro-forma statements. Explain why creating pro-formas is beneficial to your firm and a healthy practice for a business.     

Additionally, discuss two challenges or shortcomings of using the percentage of sales approach.

Answer 1

Need of Creating Pro-forma Statements:

Pro forma financial statements are financial reports issued by an entity, using assumptions or hypothetical conditions about events that may have occurred in the past or which may occur in the future. These statements are used to present a view of corporate results to outsiders, perhaps as part of an investment or lending proposal. A budget may also be considered a variation on pro forma financial statements, since it presents the projected results of an organization during a future period, based on certain assumptions.

Benefit of creating pro-formas for firm and a healthy practice for a business :

• Projection of Year to Date Result.
• A company may be seeking funding, and wants to show investors how the company's results will change if they invest a certain amount of money in the business. That can be estimated using Pro-forma statement.

Shortcoming of using Percentage of Sales Approach:

• Many expenses are fixed or have a fixed component, and so do not correlate with sales. For example, rent expense does not vary with sales. Many balance sheet items also do not correlate with sales, such as fixed assets and debt.

• Step costing may apply, where a cost is variable but will change to a different percentage of sales when the sales level changes to a different volume level.