Quality of Earnings Reports

What Is a Quality of Earnings Report?

A Quality of Earnings (QofE) report is a financial due diligence document, prepared independently in connection with an anticipated merger, acquisition, or divestiture. Among other things, a QofE highlights (i) the acquisition target’s historical financial performance, (ii) potential transaction risks and opportunities, and (iii) the sustainability of earnings. QofE reports are intended to cut through bias and are generally performed by an independent, third-party accounting firm with a team that specializes in Quality of Earnings analyses. A QofE report is often required by lenders or other stakeholders involved in the M&A transaction. Additionally, most financial due diligence engagements will assist the buyer or seller with other complex deal issues, such as estimating the normalized level of working capital needed to operate the business, net debt considerations, go-forward considerations, and other financial matters relating to the transaction.

Why Obtain a QofE?

A carefully thought out diligence plan is critical to executing a successful M&A transaction. Successful M&A transactions are notoriously hard to execute, many acquisitions fail due to buyer bias, incomplete or erroneous information, or a poorly executed diligence plan. Buyers and sellers generally do not come to the table with equal information. A buy-side QofE helps minimize the seller’s informational advantage over the buyer in regards to financial performance, accounting policy, and operations. Even strong financials that are compliant with GAAP can be manipulated and hide material inaccuracies or inconsistencies. A well-executed QofE helps level any financial information differences between the buyer and seller. Similarly, a sell-side QofE provides transparency and allows a seller more time and information to understand complex deal structures and identifying the best successor or go-forward partner.

Obtaining a Quality of Earnings analysis is comparable to obtaining a home inspection prior to closing on a house. After submitting an offer and going under contract, most buyers will seek a home inspection to ensure there are no water leaks, roof damage, foundational issues, electric system problems, etc. Similarly, buyers of a business will want to gain confidence in the financial information, understand key reporting metrics, and recognize any risks associated with the change of control prior to closing.

How Is It Different From an Audit?

An audit primarily focuses on evaluating a company’s financial reporting and compliance with accounting principles, using the balance sheet as the main source of the point-in-time review. An audit is not designed to assess the sustainability of earnings or the reliability of earnings on a go-forward basis. A QofE gives a broader financial and operational view of the business, typically focusing on EBITDA and highlighting key financial metrics and trends in the business. A quality of earnings will delve into gross margin and performance metrics, sales and customer analyses, and other relevant data to provide insights into the underlying economic performance of the business and net working capital trends. While audits are focused on annual results, a QofE will emphasize monthly performance as buyers (and lenders) are particularly interested in the trailing twelve month results. Further, a QofE is often used as the foundation to illustrate and project go-forward earnings post-transaction. A QofE may also contain pro-forma considerations of interest to a buyer.

Why Perform Buy-Side Due Diligence?

• To identify potential opportunities, such as eliminating excess costs, identifying unprofitable customers and business segments. Additionally, buy-side due diligence can help identify risks in a transaction such as a change in accounting policy distorting financial results, customer concentrations, one-time revenues, inventory valuation methods, reversal of accruals resulting in income, customer collectability issues, and inappropriate capitalization on balance sheet, among other issues.
• To assess validity of seller adjustments to EBITDA.
• Certain findings, including adjustments that reduce EBITDA may reveal trends that do not warrant the current multiple or valuation applied to the business. Ultimately, allowing the buyer to ensure purchase price is in line with expectations and, if not, provide the opportunity to renegotiate the deal on better terms.
• It allows the buyer to better understand complex accounting assumptions, policies, and issues related to the business.
• Banks generally will require a QofE to secure financing.
• It provides context for the buyer to better project forward-looking performance models and forecasts.
• Summarizes voluminous sets of complex data into a concise and digestible format.
• To provide confidence and clarity in the transaction.

Why Perform Sell-Side Due Diligence?

• To identify any potential issues a buyer (and the buy-side QofE team) may uncover and proactively address them, eliminating any surprises that could disrupt a sale process.
• To better understand value drivers and help maximize transaction value. A buyer typically will not share adjustments that are favorable to the seller.
• To help reduce the number of buyer assumptions during the bid process, and allow for more precise and informed offers.
• Transactions are taxing on the seller and accounting personnel. A sell-side QofE reduces deal fatigue and grants the seller more control over the transaction process.
• It provides sellers the ability to answer complex financial questions in advance and obtain support for the QofE. 
• It allows a seller to organize relevant financial information to readily share with prospective buyers.
• Overall, a sell-side QofE prepares and gives the seller more control over a quicker and more efficient transaction process.