By Mark G. Metzler, Director, Audit & Accounting and Center for Private Company Excellence Specialist, Kreischer Miller

Companies considering buying, selling, or investing in a business are often advised to obtain a quality of earnings report. Doing so has become commonplace as part of due diligence procedures in private company merger and acquisition (M&A) transactions. 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. 

Here are a few of the questions that are typically asked regarding quality of earnings engagements:

1. What is meant by quality of earnings? Quality of earnings (QOE) is a subjective term that refers to an evaluation of a company’s financial performance to identify nonrecurring transactions, revenue sources, customer concentrations, unusual or cyclical trends, significant estimates, consistency in application of accounting policies, etc., to arrive at an adjusted earnings before interest, taxes, depreciation and amortization (EBITDA). It involves delving into the details to ensure that what is being presented represents an accurate picture.

 

2. How does a QOE report differ from an audit or a review? Although many consider accounting to be a science, it is actually closer to an art, where significant estimates are made by management and reflected in the company’s financial statements.
   
   There are a number of differences between a quality of earnings report and audited or reviewed financial statements. 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.
   
   The quality of earnings report is often done at an interim period and reflects the trailing twelve months (TTM) of financial performance compared to year-end and the comparable prior TTM periods. Additionally, it may provide a forward-looking analysis of the business.

 

3. Is a QOE report only prepared for the buyer? There are both buy-side and sell-side reports that may be prepared. As one would expect, 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.  

 

4. What is the format/presentation of a QOE report? The typical quality of earnings report comprises five sections as well as some exhibits. The five sections are: 1) Executive Summary; 2) Quality of Earnings Analysis; 3) Income Statement Analysis; 4) Quality of Net Assets (Balance Sheet) Analysis; and 5) Working Capital Analysis.
   
   Included in the exhibits are assumptions and limiting conditions and the scope of services. The procedures are tailored to the user of the report and may be enhanced or limited depending upon the results/needs of the engagement. Each of the sections provides the user with an assessment of the business based upon inquiries with management, review of supporting documentation, and analyses of the information provided.

 

5. How long does a QOE report take? Depending upon the size of the proposed transaction and requested procedures, a typical QOE report can be completed in 45-60 days.

It’s rare that M&A transactions are conducted without the preparation of a QOE report. Whether you are a buyer, seller, or investor, the QOE report provides the information necessary.