What Is a Quality of Earnings Report and Why Is It Important?

You’re ready to cash out of your company and move on to your next venture. But before the sale can go through, a potential buyer asks for a quality of earnings (QoE) report. 

At first, you might be worried. What is a quality of earnings report? Will it slow or potentially derail your acquisition? But a QoE report can help you identify any unknown issues before they become a problem, helping reassure the buyer your earnings are trusted and reliable.

In the world of mergers and acquisitions (M&A), quality of earnings reports assess the accuracy and sustainability of a company’s earnings, uncovering potential risks and issues that could affect the value of the business. 

In this article, we’ll examine what QoE reports are, why they’re important, and when you’ll encounter them during acquisitions. 

What Is Meant by Quality of Earnings? 

When we talk about the quality of a company’s earnings, we mean looking at how the business makes money, how reliable its financial projections are, and how well it has followed accounting practices. This information helps buyers, investors, lenders, and other stakeholders evaluate your company’s financial health and make informed decisions. 

Specifically, quality of earnings refers to the accuracy, sustainability, and transparency of your company’s earnings. It’s a measure of how well your company’s reported earnings reflect its true financial performance, and how likely those earnings will continue. 

• Accuracy refers to how closely your company’s reported earnings reflect its actual financial performance. Accounting practices, revenue recognition policies, and cost management strategies can affect accuracy. For example, sellers sometimes present their financials too aggressively, like a restated EBITA, to justify a higher valuation. Don’t do this unless you can justify it. Otherwise, you can’t substantiate your claims to potential buyers and might lose out on the sale.

• Sustainability refers to whether your company’s earnings will continue in the future. Watch out for factors like market trends, competitive pressures, regulatory changes, and customer preferences.

• Transparency refers to how well your company’s financial statements and reporting practices allow stakeholders to understand its true financial position. This can be affected by factors such as the clarity and completeness of financial disclosures, the effectiveness of internal controls, and the level of detail provided in financial statements.

According to Investopia, “A company’s quality of earnings is revealed by dismissing any anomalies, accounting tricks, or one-time events that may skew the real bottom-line numbers on performance. Once these are removed, the earnings that are derived from higher sales or lower costs can be seen clearly.”

Overall, you want to consider quality of earnings when evaluating your company’s financials. High-quality earnings boost confidence in stakeholders, investors, or buyers looking at your company’s financial performance and its ability to continue generating profits in the future. 

Why Might a Company Need a Quality of Earnings Report? 

A quality of earnings report (QoE) can provide valuable information for decision-making and risk management, helping you identify issues with your earnings so you can take appropriate action. 

Your company might need a QoE report in many situations, including:

1. Merger or Acquisition: If your company is planning to merge with or be acquired by another company, a QoE report can help the potential buyer evaluate the accuracy and sustainability of your company’s earnings. The report allows the buyer to make an informed decision about the acquisition.
2. Financing: A QoE report can help you obtain financing, such as a bank loan or private equity investment. The report can verify your company’s financial health and help you secure better financing terms.
3. Internal Management: Your company’s internal management team can also use a QoE report to identify any areas of financial weakness or inefficiencies and improve the company’s earnings.
4. Due Diligence: A QoE report is usually required as part of due diligence when investing in or partnering with another company, providing insights into the company’s financial performance, potential risks, and areas for improvement.

What Is the Purpose of a Quality of Earnings Report in an Acquisition? 

A quality of earnings report in acquisitions provides an independent and objective assessment of your company’s earnings. In other words, it helps the buyer decide if your company is a good investment, is within their risk appetite, and is likely to offer a return.

The quality of earnings report can also help determine whether your asking price is fair. If it reveals your company’s earnings are high-quality, sustainable, and transparent, the buyer may pay a higher price. Why? They’re more confident it will generate profits in the future.

On the other hand, if the QoE report identifies any issues, the buyer may be less willing to pay the asking price. For example, the report may reveal poor accounting practices, such as improper revenue recognition or inaccurate financial reporting. Or it might find problems with your revenue streams, such as declining sales, over-dependence on a single client, or a lack of diversity in your customer base. If so, the buyer might retreat from the sale or require additional protections, such as earnouts or holdbacks, to mitigate acquisition risks.

Does Every Buyer Request a QoE Report During Acquisition Due Diligence? 

No. The buyer’s decision to request a QoE report depends on many factors, including the size and complexity of the transaction, the level of due diligence required, and the buyer’s risk tolerance. While not always necessary, a QoE report can be valuable in many acquisition scenarios.

For example, if it’s a high purchase price or a company’s financial statements are complex, the buyer may want the additional peace of mind a quality of earnings report provides. The report also helps buyers seeking acquisition financing, as lenders may require the report as part of their due diligence process.

Who Prepares a Quality of Earnings Report?

Financial professionals, such as accountants, financial analysts, or due diligence experts, typically prepare quality of earnings reports. They have the expertise and knowledge to analyze your company’s financial statements and supporting documentation, and to identify any potential issues related to your company’s earnings.

Anyone can hire the team preparing your quality of earnings report, including you, a potential buyer, an investor, or a lender. During acquisition due diligence, the buyer usually arranges and pays for the quality of earnings report. 

What Should You Include in a Quality of Earnings Report?

To ensure a thorough assessment, a quality of earnings report includes several key components (listed below). Included items will vary depending on the company and the situation. But this checklist provides a good starting point for evaluating the quality of earnings for your company.

Quality of Earnings Report Checklist

1. Revenue recognition: A detailed analysis of your company’s revenue recognition policies and procedures to ensure they comply with Generally Accepted Accounting Principles (GAAP) and other relevant accounting standards. This also looks at any changes in accounting practices (such as switching from cash to accrual or changing inventory accounting rules), as these adjustments can impact revenue reporting.
2. Composition of revenue: A review of your company’s sources of income to assess the reliability and sustainability of earnings, including how much of your revenue is recurring versus one-time transactions.  
3. Cost of goods sold (COGS) and inventory management: An analysis of how you calculate COGS, the accuracy of inventory valuation, and any potential risks related to inventory management.
4. Expense analysis: A thorough examination of your company’s expenses, including whether expenses are properly classified and reported.
5. Quality of assets: An analysis of the quality of assets, such as accounts receivable aging, inventory, and fixed assets, to determine whether your company accurately valued and reported them. 
6. Accruals and reserves: An evaluation of your company’s accruals and reserves to ensure they are properly accounted for and reflect your company’s financial obligations.
7. Contingencies and liabilities: A review of your company’s contingent liabilities, such as pending lawsuits or regulatory fines, and their impact on your company’s financial performance.
8. Management and employee compensation: An analysis of the structure and terms of your compensation agreements and any potential compensation issues.
9. Tax and legal compliance: An analysis of your company’s compliance with federal, state, and local tax laws and regulations.

By including these key components, a QoE report provides stakeholders with a comprehensive understanding of your company’s earnings and helps them make informed decisions about investing, lending, or engaging in other financial activities with you.

Example of a Quality of Earnings Report 

We’ve organized the example quality of earnings report into categories based on the checklist above. Each section contains a description of the evaluated area and an assessment of whether your company’s practices in that area are acceptable or require improvement. This is a simplified example of a QoE report, providing an easy-to-read overview of your company’s quality of earnings. 

A Quality of Earnings Report Is a Win-Win for Buyers and Sellers

A quality of earnings report provides valuable insights into your company’s financial performance that help your acquisition close – so don’t get spooked when a potential buyer requests one. By working with experienced financial professionals to conduct a thorough quality of earnings analysis, your potential buyer can make informed decisions and achieve their acquisition goals with greater confidence. 

As a seller, a quality of earnings report can help you identify and address any potential issues or discrepancies in your financial statements before selling your business. You want to present your company in the best possible light, increasing the likelihood of a successful sale.

What’s more, a QoE report can help you negotiate a higher sale price. By providing a comprehensive assessment of your company’s financial health, you can demonstrate the true value of your business to potential buyers.

If a buyer asks for a QoE, embrace it – it’s a win-win for both parties!