Do I Need a Quality of Earnings Report?

By Tiffany Boozer
Audit Associate
Bauknight Pietras & Stormer, P.A.

 

What IS a Quality of Earnings?

A quality of earnings (QoE) is an analysis of the accounting policies and procedures used to prepare financial statements.  It dives deep into certain components of an organization’s revenue and expenses to deliver a buyer, seller, or investor an estimate of a business’s sustainable, quality earnings through:

• Estimation of normalized operations presented on an accrual basis.
• Identification of potential deviations from Generally Accepted Accounting Procedures (GAAP).
• Identification of any one-time or extraordinary operations items.
• Identification of significant changes in accounting policies.
• Identification of management bias in preparing financial statements.
• Presentation of normalized historical earnings.

A quality of earnings report generally translates the Company’s historical earnings into a measure of normalized EBITDA — earnings before interest, tax, depreciation, and amortization — which is a commonly used measure of the amount of cash a business generates.

What a QoE is NOT?

A QoE is not a financial statement audit, review, or compilation.  It is not an assessment of internal controls.  A QoE analysis provides NO opinion on the accuracy of the reported financials.  Assurance services inherently focus on past transactions, while a QoE gives insight into the profitability and potential future performance of a business on a more comprehensive level.

A QoE has a narrow focus on the finances of a business.  While other matters may come to light during a QoE engagement, the matters listed below are not primary objectives of a QoE. A CPA, attorney, or other consultant may be engaged to perform these other important due diligence procedures:

• Operational Assessments
• Revenue Cycle Optimization
• Staffing Optimization
• Quality Product or Service Analysis
• Fraud assessment
• Compliance with laws and regulations
• Valuation of Interest Held in the Entity
• Assessment of Management Capabilities
• Key Contract Assignment Terms

Why is a QoE important?

A QoE report provides sellers, buyers, or investors with a unique view of the value of a business that can’t be gleaned from a set of historical financial statements or future projections alone.  A QoE can be a valuable tool to help improve the chances of a successful transaction, by estimating a fair transaction price for both parties.  Of course, such a price is typically only a starting point for negotiations.

Sell-Side Quality of Earnings Report

The sell-side QoE report helps the seller understand the type of adjustments a buyer might identify when performing their due diligence.  For the same reason a homeowner may have an inspection done prior to listing their house, a sell-side QoE gives a seller time to fix any issues or prepare to explain or defend why things are the way they are.  A good sell-side QoE team should work with two goals in mind: (1) uncover any issues that a buyer might use to deflate the sales price and (2) identify issues that help the seller support a higher sales price.

Buy-Side Quality of Earnings Report

The buy-side QoE report, on the other hand, provides an independent analysis to help the buyer/investor understand the overall operations and earnings potential of a business.  The buy-side QoE team is incentivized to deflate EBITDA, which gives the buyer leverage to negotiate a lower sales price.  The buy-side QoE practitioner should also be looking for any “red flags” that might indicate their client is buying a lemon.

What is the cost of NOT having a QoE?

Not engaging a QoE during the due diligence process is a big risk for any seller, buyer, or investor and can translate to big losses of time and resources.  Diversity of revenue sources, non-recurring and over/under-market expenses, customer churn, and overly aggressive accounting policies are just a sample of characteristics that are not generally apparent in a company’s historical financial statements alone.  Without a good QoE, a business may be severely overvalued or undervalued.  A QoE analysis is invaluable in the evaluation of the overall financial performance and fair pricing of a business.

 

About Bauknight Pietras & Stormer, P.A. (BPS)

Established in 1991, BPS is among the Southeast’s premier accounting and consulting firms and among the largest locally owned public accounting firms in South Carolina with 50 Certified Public Accountants and 30+ professional staff. BPS is a strategic partner to clients in the insurance, construction and real estate, employee benefits, hospitality, manufacturing and distribution, professional services, telecommunications, and technology industries. BPS is a member of Prime Global, an association of private accounting firms, and was recognized as one of America’s 50 Best of the Best Firms in 2020 by INSIDE Public Accounting, the top tax advisory firm in the U.S. by Captive Review, and in 2020 and 2021 was recognized by Forbes Magazine as among the top recommended tax and accounting firms in America. BPS has been recognized as one of the top places to work in South Carolina 6 of the past 7 years. Learn more at www.bps.cpa