In mergers and acquisitions, potential buyers may obtain a quality of earnings (QOE) report to evaluate the accuracy and sustainability of the seller’s reported earnings. It’s also common for sellers to obtain their own QOE reports to spot potential problems that might derail a transaction and identify ways to preserve or even increase the company’s value.
How do QOE reports differ from audits?
An audit yields an opinion on whether a company’s financial statements fairly present its financial position in accordance with Generally Accepted Accounting Principles (GAAP). It’s based on historical results as of the company’s fiscal year end.
In contrast, a QOE report determines whether a company’s earnings are accurate and sustainable and whether its forecasts of future performance are achievable. It typically evaluates performance over the most recent interim 12-month period.
What affects earnings’ quality?
Generally, the starting point for a QOE report is the company’s earnings before interest, taxes, depreciation and amortization (EBITDA). Many buyers and sellers believe this metric provides a better indicator of a company’s ability to generate cash flow than net income does. In addition, EBITDA helps filter out the effects of capital structure, tax status, accounting policies and other strategic decisions that may vary depending on who’s managing the company.
The next step is to “normalize” EBITDA by:
• Eliminating certain nonrecurring revenues and expenses,
• Adjusting owners’ compensation to market rates, and
• Adding back other discretionary expenses.
Additional adjustments may be needed to reflect industry accounting conventions. 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.
A QOE report identifies factors that bear on the company’s continued viability as a going concern, such as operating cash flow, working capital adequacy, related-party transactions, customer concentrations, management quality and supply chain stability. It’s also critical to scrutinize trends to determine whether they reflect improvements in earnings quality or potential red flags.
For example, an upward trend in a manufacturer’s EBITDA 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 on plant and equipment (a sign that the company isn’t reinvesting in its future capacity) — or from changes in accounting methods (which is unrelated to real economic improvements).
A valuable tool
Whether you’re buying or selling a business, or simply looking for ways to improve performance, a QOE report is a powerful tool. It goes beyond the financials to provide insight into the factors that drive value.
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