Quality of earnings: a unique perspective on a business

In a market in which deal valuations have reached a high-water mark, many owners are exploring a possible sale of their business. Those who are ready to take the next step should first think about how their business will look to potential buyers through the lens of a quality of earnings report.

“A quality of earnings report is typically ordered after a letter of intent as part of the financial due diligence,” says Thomas G. Wolf, CPA, a senior manager at Brady Ware & Company. “It’s important in negotiating and structuring a deal as it determines what may or may not be sustainable in terms of revenue and profits.”

Smart Business spoke with Wolf about quality of earnings reports, how they differ from audited financial statements and how they can be used outside of deal negotiations.

What is a quality of earnings report, and how does it differ from audited financial statements?

A quality of earnings report typically comes about as part of a transaction that’s being negotiated and is ordered by the buyer, seller or someone interested in investing in the business. The report aims to identify financial performance factors that aren’t reflected in the business’s financial statements, whether those are internal statements or audited financial statements, to determine the company’s normalized performance and sustainability.

Audited financial statements look to determine if transactions happened in accordance with GAAP. In performing an audit, CPAs look backward at what has happened and how it was reported.

A quality of earnings report looks forward. It seeks to identify sustainable revenues — those that are repeatable — and eliminate anomalies — anything outside the control of the company, such as broad economic factors, that won’t have an ongoing impact on the company’s financial performance. These reports can assess whether revenues are part of a smart management decision, or the lucky swing of a market force.

How long might this report take to produce, and what information is needed to create it?

It takes 30 to 45 days to produce a quality of earnings report, and it’s based on any and all financial information that would typically be part of an audit, such as transaction history, financial statements, customer and vendor contracts, employment agreements, a market analysis and any other information that may be relevant to the business. But the assembly of a quality of earnings report is more fluid than an audit. To understand how a revenue stream works, the report’s creator will follow any important information to its source — if a business says it’s got great vendor contracts, then evidence of that should be provided.

Owners will want to purify their financial statements ahead of a quality of earnings report. That means getting rid of any personal assets or expenditures that are on the company’s books. That will give the parties an accurate snapshot of the business and its performance at the due diligence stage.

Who should companies work with to get a quality of earnings report?

Typically, CPA firms are used because quality of earnings reports have financial information as the starting point, then dive deeper. There are specialized firms that will put together these reports. Private equity firms might have internal experts who can produce these reports, but sometimes that can present a conflict of interest. CPA firms, on the other hand, are necessarily independent of a transaction, and that objectivity lends more weight to the report for both sides.

How can a quality of earnings report be used to improve a company and its internal processes?

Not every deal goes through. Things can fall apart for any number of reasons. If that happens, the owner has a window to use the report to find aspects of the business that could be tightened up. This could include market risks that could be mitigated, vendor contracts that could be improved, etc. Just as a buyer could take the report and find potential pitfalls, the seller can do the same, using the report to make the company better and more attractive to buyers.

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