This article originally appeared in the August 2016 issue of Smart Business Philadelphia magazine.
Quality of earnings reports are independent reports that are generally associated with the sale or acquisition of a business. While quality of earnings due diligence occurs more frequently on the buy side of transactions, they can be very effective for owners looking to sell their business.
Business owners may be taking a big risk by not completing a quality of earnings report in advance of any effort to sell their company, says Richard Snyder, CPA, Director of Audit & Accounting at Kreischer Miller.
“Discovering surprises once the due diligence phase begins can put the seller at a significant disadvantage in the negotiation process and can often result in adjustments to the sale price, the inclusion of an earn-out to protect the buyer or may lead to the transaction being terminated altogether,” Snyder says. “Moreover, the process of selling a business is very time consuming, can be a distraction from day-to-day operations and can be very stressful on owners and senior management.”
The intent behind a quality of earnings review is to create an objective document that determines the accuracy and quality of historical earnings and assets, as well as the sustainability of earnings in the future.
Smart Business spoke with Snyder about the value of this report when considering the sale of your company.
What does a quality of earnings report include?
A quality of earnings report is usually prepared by an independent professional as part of the due diligence phase in an acquisition. It typically includes a summary of EBITDA before adjustments, with management and due diligence adjustments, and adjusted for capital expenditures; identification of debt and debt-like items; and a summary of seller changes and their impact to revenue and expenses. In addition, reports include a breakdown of revenue by categories and customers; historical revenue and operating expense analysis and trends; balance sheet and working capital analysis; and identification of one-time or nonrecurring expenses. Reports also include key observations noted during the due diligence assignment, a review of revenue recognition policies, and a review of federal, state and local tax filings.
What are the advantages to completing a quality of earnings report in advance of a transaction?
There are several reasons why completing this report is beneficial to a potential seller. It can allow the seller to objectively assess and evaluate the condition of the business, as well as understand issues that may come up during a buyer’s due diligence process. This allows the seller to be in a better position to discuss potential issues with a prospective acquirer if they arise. Completing the report also identifies non-recurring items and other issues that could impact the sale price of the business and minimizes potential surprises when the buyer completes its due diligence review. When performed well in advance of an anticipated exit, owners will have time to correct or change identified issues and concerns.
When you understand the components of a quality of earnings review and are equipped to answer the majority of the questions that may come from a potential buyer, you put yourself as the seller in a stronger position to manage the due diligence phase of the transaction. You are also better able to limit or anticipate the number of changes the buyer may propose.
How do you know when it’s the right time to request a quality of earnings report?
Determining when is the right time to have a quality of earnings report completed is a matter of judgement. Owners and management need to consider the need for the report and the potential timeframe for the sale of the business. Owners and management should consult with their professional advisors (i.e. accountant, attorney or consultant) to discuss the advantages and benefits to performing a quality of earnings report prior to the sale of a business. In most instances, an owner should consider this type of due diligence about a year to two years from the time the business is anticipated to be available for sale. This will give the owner and management the necessary time to make any recommended changes or adjustments as a result of the due diligence. ●
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