What is Quality of Earnings?

Thinking of buying or selling a business? A Quality of Earnings report drills into the details of the business’ financial statements and cash flows. A Quality of Earnings report is essential in a due diligence process.

What is a Quality of Earnings report?

A Quality of Earning report, also called a QOE or QofE report, helps investors understand the historic earnings and forward-looking performance of the business through rigorous financial analysis. QOE reports are one of the two most important components of due diligence when buying a company (the other being legal diligence.)

QOE reports go beyond the balance sheet and profit and loss statement – they challenge the underlying data through rigorous testing and management interviews to assess accuracy, and risk.

Think of a QOE report like taking a used car to the mechanic before buying it. Even if the “check engine” light is not on, that does not mean you can assume the car is in good working order. Businesses are no different – strong financial statements can often mask risks or material inaccuracies under the surface. A QOE report is designed to detect those risks and inaccuracies.

The use of a QofE report will differ by who is requesting the information: the buyer or the seller.

Sell-Side Quality of Earning Report

Sellers order a Quality of Earnings report before soliciting buyers to uncover any problems that might disrupt the sale. In addition to uncovering potential problems, a sell-side report will help you understand the business from the perspective of a potential buyer/investor. In either case, the additional perspective enables you to remedy any pitfalls ahead of the sale.

Buy-Side Quality of Earning Report

A buy-side quality of earnings report provides more details around the business’s net income and EBITDA to help buyers determine whether the business is worth the price. For example, the report evaluates the recurring nature of its operations and cash flows, potential over-statements of inventory, and the quality of the assets and liabilities of the business.

Buyers use the results of a QOE report to feel confident in their acquisition, negotiate better terms, or walk away from a deal with too many problems under the hood.

What is the difference between a quality of earnings report and an audit?

Audited financial statements focus on compliance with GAAP accounting standards, whereas Quality of Earnings reports focus on the company’s earnings history and potential. Financial audits do not weigh in on the outlook of the company—a Quality of Earnings Report does.

Examples of Analyses and Findings in a Quality of Earnings Report

The type of analysis performed should be relevant to the industry and business model. Examples of findings include:

  • Unusual financial trends and variances
  • Significant and/or unusual accounting policies such as:
    • Changes in accounting methods
    • Changes in accounting principles
    • Changes in accounting policies
    • Changes in accounting practices or procedures
  • Unusual or nonrecurring items of income or expense
  • Transactions with related parties
  • Inability to prove cash impact from accrued items
  • Sales concentrations and/or backlog risk
  • Analysis of inventory reserves and allowances
  • Reviews of account reconciliations, account aging, and composition

In need of a Quality of Earning report or due diligence services? Book an appointment with a CFO today.

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