Going Beyond the Numbers with Quality of Earnings Reports

A Quality of Earnings (QOE) report allows potential buyers in mergers and acquisitions to evaluate seller’s reported earnings, ensuring their accuracy and sustainability. Sellers can also obtain their own QOE reports to spot potential problems that might derail a transaction, and identify methods for preserving or increasing the company’s value.

What’s the different between QOE reports and audits?

In accordance with generally accepted accounting principles (GAAP), an audit yields an opinion on whether a company’s financial statements present its financial position fairly. This opinion is based on historical results at the company’s fiscal year end.

In contrast, a QOE report determines whether a company’s earnings are accurate and sustainable, and whether its future performance forecasts are achievable. It also typically evaluates performance over the most recent interim 12-month period.

How is quality of earnings affected?

A company’s earnings before interest, taxes, depreciation and amortization (EBITDA) are generally QOE report starting points. Many buyers and sellers believe this metric provides a better indicator than net income of a company’s ability to generate cash flow. In addition, EBITDA helps filter out the effects of capital structure, tax status, accounting policies and other strategic decisions that may vary depending on company management.

To “normalize” EBITDA, a company must:

• Eliminate certain nonrecurring revenues and expenses
• Adjust owners’ compensation to market rates
• Add back other discretionary expenses

To reflect industry accounting conventions, additional adjustments may be needed. Examples include valuing a manufacturer’s inventory using the first-in, first-out (FIFO) method, rather than the last-in, first-out (LIFO), or recognizing revenue based on the percentage-of-completion method, rather than the completed-contract method.

Factors that affect a company’s continued viability are identified on a QOE report, including operating cash flow, working capital adequacy, related-party transactions, customer concentrations, management quality and supply chain stability. It’s also critical to scrutinize trends, and determine whether they reflect improvements in earnings quality or potential red flags.

An upward trend in a manufacturer’s EBITDA, for example, could be caused by increasing sales (a positive indicator of future growth) or decreasing costs (a sign that management is being more fiscally responsible). Alternatively, higher earnings may result from deferred spending equipment and important items (a sign that the company isn’t reinvesting in its future capacity), or from changes in accounting methods (which is unrelated to genuine economic improvements).

A Powerful Tool

A QOE is a valuable tool, whether you’re buying or selling a business, or simply looking for ways to improve performance. It goes beyond standard financials and provides insight into factors that drive value.

To learn more about how QOE reports differ from audits, what affects earnings’ quality and why the QOE report is a valuable tool for evaluating reported earnings’ accuracy and sustainability, contact a Weaver professional today. 

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