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Tuesday, March 19, 2019

Why Order a Quality of Earnings Report?


Audited financial statements, while valuable, are not the only reports that buyers will request when considering a merger or acquisition. Audited financial statements focus on whether the company’s financial statements comply with GAAP. The quality of earnings report, or QOE report, is focused on helping a potential buyer understand the key operating metrics of the company. These are primarily revenue, gross margin, EBITDA, adjusted EBITDA and working capital. Buyers therefore seek a QOE report to help them make well-informed investment decisions.

What the Buyer Wants to Know

When an investor—be it an individual, venture capital fund, private equity group, or strategic investor— is considering acquiring, or making a substantial investment in, a target company, the buyers will want to dig into the financials for more details, such as:

  • Trends in revenue, including seasonality, customer concentration, geographic concentration and product concentration
  • Cost of revenue and gross margin
  • Consistency of operating expenses
  • Working capital requirements
  • Accuracy of timing and cutoff at the end of each reporting period

The buyer will also want to identify one-time or unusual revenue and expenses. These may be properly recorded per GAAP, but the buyer will still want to adjust the income statement for these items.

In addition, the buyer may also want to adjust the income statement for “missing” expenses, like additional marketing or sales expense, the buyer thinks need to be added to the company after the transaction. Similarly, the buyer may want to remove expenses the buyer feels will not be needed after the transaction, like a duplicate warehouse if operations are being consolidated.

The goal is to determine an adjusted EBITDA or proforma income statement to show the buyer what their profits and losses would look like if they acquired the company.

Quality of Earnings Report vs. Audit

The QOE report differs from an audit in a few key ways.

First, the QOE report is less regimented than an audit. The individuals or firm assessing the target and preparing the QOE report is not independent, as defined by audit standards, of their client. Instead, they are working on behalf of their client. Thus, the scope of the QOE report can be tailored to focus on those items the client is most concerned about. This flexibility can make the process quicker, simpler and cheaper.

Second, audits generally evaluate the financial statements taken as a whole. As noted earlier, the QOE report focuses primarily on the income statement, working capital and key business metrics. While other parts of the financial statements are considered, unless specifically requested by the client, they are not the focus of the report.

Determining Quality of Earnings

Not all target companies prepare their financial statements in accordance with GAAP. If requested by the client, the first step in preparing the QOE report is to adjust the financial statements to conform to GAAP. The next step is what differentiates a QOE report from an audit: the assessors will record “normalizing adjustments.” These are typically shown as adjustments to EBITDA to arrive at the target company’s adjusted EBITDA.

Expenses or revenues that are not expected to persist in future years, or not expected to continue in the new entity, are corrected. Are there employees that the buyers will not need going forward? Those expenses should be removed. Are the founders of the business taking above-market salaries? Correct for those. Will the buyers need the entire marketing department, or will they want to pare it down? If a revenue or expense is an anomaly or will change under new management, the QOE report will remove it and recalibrate.

The assessors will also consider working capital (current assets less current liabilities). Because working capital directly affects cash flow, they will ask questions about receivables, inventory and short-term liabilities. They may ask: what does the accounts receivable aging schedule look like? How closely do actual collections match up with formal terms? What are the reserves? Or they may want to know if liabilities are being properly recognized. The QOE assessment will consider working capital as an input to the final values.

Why a Seller Might Order a Quality of Earnings Report

Sellers often commission a QOE report on themselves to prepare for an expected transaction. This often gives the buyer more confidence in the target organization. A QOE report prepared before a transaction will also position the seller for the fast turnaround necessary in a merger or acquisition. These deals can happen quickly—sometimes in just a month—so having the key information the buyer will want readily available can make the process go more smoothly.

An audit is extremely valuable in an M&A scenario, but it does not provide all the details buyers often require. A QOE report can fill that gap and can make both buyers and sellers feel comfortable to complete the transaction.

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