If you're considering merging with or acquiring another business, CPA-prepared financial statements may offer useful insight into historical financial results. However, you may also want to think about using an independent quality of earnings (QOE) report. QOE reports look beyond the quantitative information included in the seller’s financial statements and can serve as another valuable tool in the due diligence process.
These reports can give you more detailed information on potential acquisition targets—and help you justify a discounted offer price if your target faces significant threats or risks. The results of a QOE report can also add credibility to the seller’s historical and prospective financial statements when included in an offer package, or help to justify a premium asking price for a business by highlighting its ability to leverage key strengths and emerging opportunities.
In-depth analysis with QOE reports
A QOE analysis can be performed on in-house financial statements as well as on statements compiled, reviewed, or audited by a CPA firm. QOE reports focus on how much cash flow companies are likely to generate for investors in the future, rather than compliance with U.S. Generally Accepted Accounting Principles (GAAP) and the companies’ historical results.
A QOE report may uncover any of the following issues:
- Excessive concentration of revenue with one customer
- Unusual revenue or expense items
- Insufficient loss reserves
- Deficient accounting policies and procedures
- Overly optimistic prospective financial statements
- Inaccurate period-end adjustments
- Transactions with undisclosed related parties
QOE reports usually analyze the revenue and expenses on a monthly basis in order to determine whether earnings are sustainable. A QOE report can also help to spot issues that might affect the company’s ability to operate as a going concern by identifying both internal and external risks and opportunities.
QOE vs. EBITDA
When pursuing M&A due diligence, many buyers focus on earnings before interest, taxes, depreciation and amortization (EBITDA) over the previous twelve months. Although it’s not a bad idea to use EBITDA as a starting point for assessing earnings quality, you may need to adjust for several items, including:
- Above- or below-market owners’ compensation
- Nonrecurring items
- Discretionary expenses
- Differences between accounting methods used by the company and industry peers
QOE reports also typically include detailed ratio and trend analysis, which may allow you to identify unusual activity. You can then use additional procedures to determine whether these changes are positive or negative.
For instance, an increase in accounts receivable could result from a buildup of uncollectible accounts (a negative indicator) but may also be a result of revenue growth (a positive indicator). If it’s the latter, further analysis should be conducted on the gross margin on incremental revenue to establish that the new business is profitable—and that the revenue growth doesn’t result from a temporary change in market conditions or aggressive price cuts.
Customizing QOE reports
Since QOE reports aren’t bound by prescriptive guidance from the American Institute of Certified Public Accountants, their scope and format can be easily customized. If you have questions about how you can use an independent QOE report in mergers and acquisitions, contact us.