What is a Quality of Earnings Report?
A Quality of Earnings Report (“QOE”) provides a buyer of a business with a base level of expectation related to earnings potential of a target business. Buyers of businesses work with their trusted financial advisors to develop the expectations of the earnings potential of the business being acquired. The buyer and the financial advisor need to work together to tailor the financial analysis for the unique circumstances of the potential transaction – while at the same time, applying tried and true approaches to assessing the ability of the target to generate earnings once acquired.
Both buyers and lenders rely on QOE reports to support the decision to acquire and finance a business acquisition. A QOE supports the purchase price decision and provides insight for performance risk and integration risk.
Many buyers turn to their accounting firm when considering who to hire to prepare the QOE. A crisis management firm, like Focus Management Group, in uniquely qualified to prepare a QOE. Not only do our consultants have accounting experience, but they have all analyzed multiple businesses to identify performance weaknesses and accounting issues. It is that experience which provides the opportunity to prepare of QOE that goes further into performance risk analysis.
What Does a Quality of Earnings Report Deliver to the Reader?
The quality of earnings refers to the extent to which reported earnings accurately reflect the underlying economic performance of a company. High-quality earnings are reliable, transparent, and sustainable, providing stakeholders with a clear understanding of the company's financial health. A QOE report begins with reported earnings and then impacts the reported earnings for a variety of positive and negative adjustments which will be discussed in this article.
A broad range of areas must be considered when developing a QOE report that will provide accurate detailed guidance on the ability of an acquired business to generate earnings post acquisition.
Factors Affecting the Quality of Earnings
Revenue Recognition Policies:
Companies utilize various revenue recognition approaches and a thorough understanding of the method used and testing of transactions will be key to a QOE. When revenue is recognized – at shipment, at delivery, etc. impacts the quality of the top line revenue. Aggressive revenue recognition practices, such as prematurely recognizing revenue at order date, could inflate earnings which would lead to poor quality of earnings.
Diligent expense management is crucial for maintaining the quality of earnings. Companies that consistently incur excessive expenses may be understating their potential performance. Companies that remove expenses from the income statement to capitalize the expense may be overstating their earnings. Considering standard cost methods of inventory valuation and evaluating the frequency of updating the bill of materials can provide insight for the QOE. One-time expenses that are truly one-time expenses need to be identified. Any expenses that are unique to the current ownership structure would also need to be verified.
Accounting Methods and Estimates
The choice of accounting methods and estimates can significantly impact earnings quality. Companies with accounting practices tied to a conservative implementation of generally accepted accounting principles (“GAAP”) tend to provide more reliable and transparent financial statements. Companies that use a non-GAAP accounting approach, such as tax basis accounting, need to be further analyzed for quality of earnings. A company that pushes GAAP to the limits may be using aggressive methods to manipulate earnings to meet desired targets.
Non-recurring items, such as gains or losses from asset sales, restructuring costs, or litigation settlements, distort earnings. These items should be clearly disclosed to enable stakeholders to differentiate between core operating earnings and one-time events.
Earnings management involves intentional actions taken by management to manipulate financial results at a period end. Techniques such as income smoothing or cookie jar reserves can be used to either artificially inflate or deflate earnings, compromising their quality. Attention to accruals – both positive and negative from a financial performance perspective – needs to be part of a QOE. Roll forwards of working capital accounts, such as accounts receivable, allow the QOE to address dilution, restatements and other post month end or post year-end adjustments.
Key Metrics for Assessing Earnings Quality
Time Periods for Assessment
A QOE should include evaluation of the trailing twelve month period (“TTM”) as well as at least two year ends. When a business is being considered for sale, evaluating earnings over year ends could identify accounting practices intended to improve the reporting earnings. Looking at the TTM helps identify recent adjustments or changes to performance. When available, comparing the TTM to the same period twelve months previously also identifies recent changes in performance without the analysis compromises that occur when comparing year to date periods to historic annual results.
Earnings persistence measures the extent to which earnings are likely to continue into the future. In this category, the preparer of the QOE looks for consistent performance over annual or seasonal periods. Customer concentration will need to be evaluated for each time period. One-time events could also change the expectations for quality of earnings. When preparing a QOE in 2023, the impact of the Covid shutdowns, then the supply chain issues, and now inflation, must all be considered for their impact on earnings. Changing consumer demands are also an important consideration in QOE reports today. A higher degree of persistence suggests better quality of earnings.
Cash Flow Analysis
Analyzing the relationship between reported earnings and cash flows can provide insights into the quality of earnings. A significant divergence between the two may indicate aggressive revenue recognition or expense manipulation. The cash flow analysis would consider the changes in working capital accounts and long-term assets and liability accounts. This portion of the QOE analysis helps to evaluate the cash that a business is able to consistently generate based on its sales and expense levels. Without a review of balance sheet accounts a QOE could miss key accounting practices that impact earnings.
Quality of Balance Sheet
Examining the quality of a company's balance sheet, including the reliance on debt versus equity, working capital management, and asset quality, can impact the quality of earnings. For example, a target may have a lower investment in automation but a higher payroll expense, or a target may have a high level of accounts receivable because it provides extended terms to customers to keep customers happy.
Importance of High-Quality Earnings:
Investor or Owner Confidence
High-quality earnings instill confidence in investors or owners. Knowing that there is a transparent and accurate representation of a company's financial performance leads to a higher value for the targeted business. The method of preparation of the QOE can improve the stakeholder’s confidence in the ability of the target to continue to produce earnings.
Credibility with Stakeholders
Companies with high-quality earnings enjoy greater credibility among stakeholders. This credibility enhances relationships and facilitates access to capital and business opportunities. Many buyers and lenders require a QOE when merger and acquisition activity is undertaken to support the decision to acquire a target without negatively impacting the existing business.
Accurate and reliable earnings information helps stakeholders assess the financial risks associated with a company. It enables stakeholders to make informed decisions regarding investment, lending, or strategic partnerships. A QOE can improve analysis of performance risk and integration risk when determining the strategy to incorporate a target into the existing business.
The quality of a Quality of Earnings Report depends on the discipline employed by the preparer of the report. Working with a trusted financial advisor who understands the buyer’s appetite for performance and integration risk will improve the ability to rely on the QOE. Leaning on a financial advisor who has crisis management and performance risk experience helps identify risks to the quality of a target’s earnings.
A financial advisor that clearly understands the different accounting approaches used for everything from revenue recognition to inventory valuation to fixed asset depreciation methods will produce a higher quality QOE.
A financial advisor that understands the intricacies of cash flow versus accrual accounting will produce a higher quality QOE.
The better the underlying QOE analysis is, the more reliance a buyer or other stakeholders can place on the ability of the target company to produce the earnings level identified in the QOE.
FMG is uniquely qualified to produce the highest quality QOE reports. Please contact us to discuss your QOE needs.