The volatility our markets suffered at the onset of the coronavirus pandemic has altered how businesses, private investors, venture capitalists, and private equity groups manage acquisitions. Mergers, acquisitions, and other transfers of company ownership are alive and well, but investors are performing more robust procedures before finalizing a transaction to accommodate these new uncertainties. As part of this additional due diligence, purchasers are seeking more in-depth quality of earnings reports.
What is a Quality of Earnings Report?
Quality of earnings (QOE) reports are documents prepared by third-party professionals – typically CPA firms – that provide detail about a company’s revenue and expenses. Net income is a helpful metric, but it is often distorted by financial reporting rules regarding items such as depreciation and amortization, accounting accruals and non-cash transactions. Additionally, non-recurring items can impact net income making it look stronger or weaker than it is on an on-going basis. Because of these issues, purchasers seek an analysis that peels back the onion on net income to provide a true picture of the quality of a company’s earnings.
QOE reports are like audits in that the reports help the user assess the financial viability of a company. But QOE reports differ from audits in a few major ways.
- While audits review the financial statements as a whole, QOE reports dig deeper into some of the financial statement’s key components. Instead of reporting revenues, for instance, QOE reports may assess how a company accumulates its revenues and when throughout the year they make those sales.
- QOE reports are less regimented than audits. There is not one set objective or scope; the report can be customized to meet the needs of one or both parties.
- Audits require the CPA firm be independent from the company while QOE reports do not.
- Audits are almost always commissioned by the company itself, whereas QOE reports are typically commissioned by the acquiring entity preceding a transaction. This allows the buyer to direct what aspects of the financials get scrutinized and how the information gets presented.
In conjunction with an audit report, QOE reports can give purchasers unique insight into a company that would be difficult to ascertain from financial statement values alone.
What Does a Quality of Earnings Report Look Like?
Because the report’s goal is to assess the quality of the company’s earnings, many QOE reports begin by removing items from the balance sheet or income statement that distort earnings. Interest, taxes, depreciation, and amortization provide little information about a company’s profitability, so these values are often removed first. From there, analysts correct earnings for some of the following:
The purchasing entity will likely want to see the target’s financials presented using their preferred method of accounting.
Abnormal items of income or expense – like an insurance payout after a natural disaster – are not relevant to the purchaser and are often removed from earnings.
Extraordinary gains or losses need to be reversed to get a better understanding of an entity’s predictable annual earnings.
Transactions with Related Parties
Unless the buyer plans to uphold existing business relationships, these amounts are often disregarded.
Assessors often discover that target entities are reporting unreasonably high compensation for executives or other members of leadership. These amounts are corrected to be more in line with what the target would pay going forward.
The buyer will sometimes want to see earnings reported absent of expenses that would be redundant after the merger. For example, the target’s marketing team’s salaries may not be relevant if the buyer has its own marketing department.
Recurring accounting errors, incorrect application of accounting principles, or overvalued assets are often discovered in other areas of the due diligence proceedings, and these are corrected for the QOE report.
How is a Quality of Earnings Report Useful?
The buyer will use an earnings report to estimate how the company is expected to perform in the future. If the report is a good representation of the company’s earnings, the purchasing entity can project that information years into the future and better estimate the potential merger’s success. These reports can also help them better understand how both businesses would synergize under the same management.
Although most QOE reports are commissioned by buyers, sellers can benefit from requesting a report on themselves. By addressing problems before they even go to market, future due diligence proceedings will go more smoothly, and they can seek an even higher business valuation.
If you are considering a business transaction from either the buyer’s or seller’s perspective, our LaPorte advisors can help. Our CPAs are experienced in business transactions and QOE engagements and would welcome the chance to help you through this process. Contact Transaction Advisory Services co-leaders Michele Avery, CPA, ABV, CVA, MAFF, or Micah Stewart, JD, LL.M., for more information.