They say the devil is in the details.
There are times when the same might be said of a financial statement.
For the most part, we’re not talking fraud here. Instead, the devil might be something as simple as a one-time revenue source, a smaller-than-usual expenditure, a change in production or an overly aggressive accounting policy that acts to inflate or deflate a business’ reported performance and perceived value.
The reason? It could be anything, from accurately reporting a current-but-unsustainable activity to reducing income taxes or even maximizing executive compensation that is tied to the company’s performance. Or the motive may simply be to make the business look its best in advance of a possible sale.
So, if you’re a seller, buyer or investor, how do you sort this all out? Enter the quality of earnings report.
What is a Quality of Earnings Report?
A quality of earnings report is a vital part of due diligence when selling, buying or investing in a business. If you’re selling the business, it is referred to as a sell-side quality of earnings report. If you’re buying or investing, it’s a buy-side quality of earnings report. The difference has more to do with who’s requesting the report and why than it does with the report’s analysis and contents.
Regardless, the quality of earnings report identifies the impact of things that don’t reflect a business’ actual or normalized performance and cash flow, or are not repeatable or sustainable over time. Some of these might result from accounting choices, others from the business climate or management decisions made regarding operations, to name a few.
While the income statement is a major focus, the report also typically drills down into the other financial statements — for example, examining the condition and worth of various assets on the balance sheet.
Finally, it considers the company’s systems of control and important elements of its business operations including by client, industry, product line or other relevant metric.
All of this means that the analysis in a quality of earnings report is fundamentally different from the work performed during an audit or review.
How is the Quality of Earnings Report Different from a Financial Statement?
The goal of an audit or review is to provide a level of assurance that the business’ financial statements conform to generally accepted accounting principles, or GAAP. These statements are also inherently backward-looking.
A quality of earnings report helps to understand the sustainable and forward-looking performance of the business at a very detailed level.
Why a Quality of Earnings Report?
A quality of earnings report helps to establish the value of a business by analyzing and reporting on detailed aspects that may not be readily identifiable to a seller, buyer or investor in reviewing the financial statements.
The report is not a valuation, but it does play an important role in negotiating and structuring the deal. And hopefully in reducing risk and the possibility of buyer’s or seller’s remorse.
Sell-Side Quality of Earnings Report
For a seller, a sell-side quality of earnings report uncovers potential problems that might derail a future sale — or at least extend the process or reduce the selling price.
Let’s say you’re the CEO or CFO of the business. There’s probably nothing surprising or misleading to you in its financial statements. You know its cash flow inside and out, the impact various accounting choices make on its reported profitability, the quality of its assets.
But a sell-side report can help you understand the business from the perspective of a potential buyer or investor. It can also enable you to take any remedial actions that may be necessary in advance of a sale — accelerating the due diligence process and potentially increasing the selling price.
Buy-Side Quality of Earnings Report
Now assume you’re the potential buyer of the business or a potential investor or lender/financial institution. Relying on the financial statements without a thorough understanding of what went into them and why could be disastrous.
As part of your due diligence process, it’s invaluable to have an independent buy-side report that drills down into the account balances, cash flows, and operations of the business.
For a buyer or investor, a buy-side quality of earnings report provides a more detailed and representative picture of just how well the business is really doing and whether it is worth the price under consideration. For example, it evaluates such things as the recurring nature and quality of its operations and cash flows, as well as the underlying assets and liabilities of the business.
Examples of Analyses and Findings in a Quality of Earnings Report
The types of detailed analyses in a quality of earnings report vary depending on the business and industry, as do the report’s findings.
Examples include the following:
unusual trends and variances in internally prepared balance sheets and income statements
significant and/or unusual accounting policies
changes in accounting methods, principles, policies, procedures or practices
nature and extent of period-end closing adjustments and reconciling items between general ledger balances and internally prepared financial statements
unusual or nonrecurring items of income or expense
transactions with related parties
proof of cash: analysis of cash receipts and expenditures compared to reported EBITDA (earnings before interest, tax, depreciation, amortization)
customer sales, concentrations and backlog analysis
analysis of key reserves and allowances
reviews of account reconciliations, agings, composition