Beyond the Financials: What’s a Quality of Earnings Report?

Financial statements provide insights into a company’s historical performance. But the parties to a merger or acquisition are also interested in assessing the acquisition target’s potential to generate cash flow in the future. That’s where an independent quality of earnings (QOE) report comes into play.

QOE reports look beyond the quantitative information provided in the financial statements. While these reports may be customized to meet the needs of the party requesting them, they typically analyze the individual components of earnings (that is, revenue and expenses) on a monthly basis.

The goals are twofold. First, QOE reports help buyers and sellers assess whether earnings are sustainable. Second, they may identify potential risks and opportunities, both internal and external, that could affect the ability of the company to operate as a going concern. Examples of issues that a QOE report might uncover include:

• Inadequate accounting policies and procedures
• Customer and supplier concentration risks
• Transactions with undisclosed related parties
• Inaccurate period-end adjustments
• Unusual revenue or expense items
• Insufficient loss reserves
• Overly optimistic prospective financial statements

QOE analyses can be performed on financial statements that have been prepared in-house, as well as those that have been compiled, reviewed or audited by a CPA firm. The starting point for assessing earnings quality is usually earnings before interest, taxes, depreciation and amortization (EBITDA) for the trailing 12 months. However, EBITDA may need to be adjusted for elements such as:

• Nonrecurring items, including a loss from a natural disaster or a gain from an asset sale
• Above- or below-market owners’ compensation
• Discretionary expenses
• Differences in accounting methods used by the company compared to industry peers

QOE reports typically include detailed ratio and trend analysis to identify unusual activity. Additional procedures can help determine whether changes are positive or negative.

For example, an increase in accounts receivable could result from revenue growth (a positive indicator) or a buildup of uncollectible accounts (a negative indicator). If it’s the former, the gross margin on incremental revenue may be analyzed to determine whether the new business is profitable or whether the revenue growth results from aggressive price cuts.

Consider obtaining a QOE report from an objective financial professional. It can help the parties focus on financial matters during M&A discussions and add credibility to management’s historical and prospective financial statements.

Contact Scott Levy, CPA for more information.