Before a potential buyer merges with or acquires a new entity, they should perform adequate financial due diligence. Looking at the seller’s audited financial statements is a great place to start, but it shouldn’t end there. Buyers may also want to gather information about the target entity’s historic and projected earnings, income and expense trends, and forecasting assumptions. A quality of earnings report can provide much of this information. A quality of earnings report is typically performed alongside or subsequent to an annual audit but focuses on the income statement. It breaks down how a company accumulates its income, from both cash and non-cash sources and from both recurring and nonrecurring revenue streams.
How Does A Quality of Earnings Report Differ From an Audit?
One of the key differences between an audit and a quality of earnings report is the commissioning party. Typically, selling entities order audits of their own financial statements. Even though these reports will benefit buyers, they can also give sellers confidence that they have tied up all loose ends and will help them defend their asking price. Quality of earnings reports, on the other hand, are typically ordered by the purchasing party. Quality of earnings reports do not require independence from the assessors, specific statements or conclusions, or even a particular scope. The purchasing party can focus on any part of the target’s revenue stream that they think needs a closer look. Even though quality of earnings reports are not required, they are becoming an industry best practice before transacting a merger or acquisition.
What Does a Quality of Earnings Report Look Like?
A quality of earnings report begins with the seller’s reported net income. From there, assessors will make certain corrections.
- Corrections for EBITDA
Interest, taxes, depreciation, and amortization can distort profits. Reporting earnings before interest, taxes, depreciation, and amortization (EBITDA) helps measure the organization’s underlying profitability.
- Corrections for GAAP
Non-listed entities may utilize a different method of accounting that, even though it is sound and reasonable, does not follow generally accepted accounting principles. Some quality of earnings reports will convert those audited financials into GAAP-compliant financials.
- Corrections for extraordinary values
Extremely large expenses, income, gains, and losses may need to be removed from the calculation. Excessive compensation is a common value that target entities will want to correct for, as are large gain or losses from the sales of property and equipment.
- Corrections for nonrecurring values
One-time expenses, like fees incurred during a rare lawsuit, should be removed to report more normalized annual activities.
- Corrections for due diligence discoveries
During other due diligence procedures, the buyer may uncover issues that would need to be corrected during a quality of earnings assessment. Incorrect timing of revenue recognition, for example, can distort an entity’s annual earnings; a recurring accounting error can skew profits; and underreported liabilities can obscure true earnings.
Depending on the report, these end values are then interpreted alongside the assessing entity’s summary of key issues and list of recommendations. Because this is not a full audit, the assessor will not list an opinion, but they can provide much-needed context to the quality of earnings adjustments.
Although it is less common, some sellers choose to order a quality of earnings report themselves. Before searching for a purchaser, they may want an outsider to confirm they are reporting themselves in the best light. These reports can uncover weaknesses, which potential sellers can address before they seek a buyer. Because these reports do not require assessor independence, buyers will want to be skeptical of those reports. But if done correctly, they can pacify sellers enough to move forward with the purchase to meet the quick deadlines often required of mergers and acquisitions.
Quality of earnings reports are just one step in the due diligence process that buyers and sellers alike will want to be prepared to discuss with their financial advisors. Mergers and acquisitions will go much more smoothly with improved transparency, and both parties will be able to agree to a price that is mutually beneficial. If you have any questions about mergers or acquisitions, business valuations, or any assurance service that you have been considering, get in contact with us. We want you to have complete confidence in the quality of your financials, and our experts are here to help make that happen. We look forward to speaking with you soon.