Companies considering buying, selling, or investing in a business are often advised to obtain a quality of earnings (QOE) report. Doing so has become commonplace as part of due diligence procedures in private company merger and acquisition (M&A) transactions to ensure investors are not misled by inaccurate earnings.
But what’s meant by quality of earnings? While most companies have externally prepared financial statements (e.g., audit or review), such statements assess the company’s compliance with generally accepted accounting principles (GAAP) rather than the perceived quality of its earnings.
In this article, we’re here to discuss what quality of earnings means and what a standard earnings report or analysis looks like. Ultimately, we’ll help you determine if you need one when merging or acquiring a business.
What Does Quality of Earnings Mean & Why is It Needed?
Quality of earnings is an assessment of a company’s earnings that accurately removes distortions or anomalies such as one-time events that may skew the true bottom line of a business’s financial performance.
Quality of earnings refers to an evaluation of a company’s financial performance to identify items such as:
- Nonrecurring transactions
- Revenue sources
- Customer concentrations
- Unusual or cyclical trends
- Significant estimates
- Consistency in the application of accounting policies
Evaluating all of these factors and more helps a financial professional calculate a business’s adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA).
A QOE assessment involves delving into the above details to ensure that what is presented represents an accurate financial picture of a business’s earnings.
What is Shown in a Quality of Earnings Report/Analysis?
When determining your quality of earnings, an accountant or valuation specialist will typically organize their findings in a concise quality of earnings report after conducting a thorough analysis.
The typical QOE report is comprised of five sections, as well as some exhibits. The five-section checklist includes:
- Executive Summary
- Quality of Earnings Analysis
- Income Statement Analysis
- Quality of Net Assets (Balance Sheet) Analysis
- Working Capital Analysis
The procedures are tailored to the user of the report and may be enhanced or limited depending on the results/needs of the engagement.
Each provides the user with an assessment of the business based upon inquiries with management, review of supporting documentation, and analyses of the information provided.
How Long Does a Quality of Earnings Report Take?
Depending on the size of the transaction and requested procedures, a typical QOE report can be completed in 45-60 days.
How Does a Quality of Earnings Report Differ From an Audit or a Review?
Although many consider accounting to be a science, it is closer to an art, where significant estimates are made by management and reflected in the company’s financial statements.
There are several differences between a QOE report vs. audited or reviewed financial statements:
1. Reviewed or audited financial statements are often the beginning of a quality of earnings report.
Since the financial statements reflect past performance, they provide a historical perspective for the company and the accountant’s assessment of their compliance with GAAP.
A potential buyer is interested in the future performance of the company and, therefore, is concerned about the length/term of customer contracts, unusual or nonrecurring income or expense items, trends, backlog/pipeline analyses, etc.
2. Quality of earnings reports are often done during an interim period.
These analyses reflect the trailing twelve months (TTM) of financial performance compared to year-end and the comparable prior TTM periods. Additionally, they may provide a forward-looking analysis of the business.
Are Quality of Earnings Reports Only Prepared for a Buyer of a Business?
There are both buy-side and sell-side reports that may be prepared.
The buy-side report focuses on providing the buyer or investor with a thorough understanding of the operations, assets, and cash flows of the target.
In a sell-side QOE engagement, the focus is to identify issues that could hinder a transaction and/or result in a reduction in the sales price. It provides the potential seller with the opportunity to identify the company’s warts, address any concerns, and potentially accelerate the due diligence process. Explore more benefits of a sell-side QOE report here.
When Would You Need a QOE Report?
M&A transactions are rarely conducted without the preparation of a QOE report.
However, while the buyer generally completes quality of earnings reports during a transaction, a strong case can be made to have a QOE review (reverse due diligence) completed in advance of a transaction when a company’s stakeholders anticipate a future sale. This strategy has several advantages that we explore in our Why Wait For a Sale? article.
Get a Thorough Quality of Earnings Report from Kreischer Miller
Whether you are a buyer, seller, or investor, a quality of earnings analysis and the resulting report provide the information necessary to make an informed decision.
Obtaining a quality of earnings report is a crucial step in buying and selling a business, as well as mergers — helping all parties obtain peace of mind in the true accuracy of the business’s earrings.
Creating a QOE report is just one of the many examples of services we offer in our M&A/ Transaction Advisory department to help with business transitions. Contact us today to learn more.