Quality of Earnings reports are generally associated with the sale of a business and are typically prepared by an independent professional as part of the due diligence phase in an acquisition. The main objective of a Quality of Earnings review is to determine the accuracy of historical earnings, quality of earnings and assets, and the sustainability of earnings into the future.
Quality of Earnings reports may include, but are not limited to:
- Breakdown of revenue by categories and customers
- Historical revenue and operating expense analysis and trends
- Balance sheet and working capital analysis
- Identification of one-time or non-recurring expenses
- Due diligence adjustments by the due diligence team
- Identification of debt and debt-like items
- Summary of seller changes and their impact to revenues and expenses
- Summary of EBITDA before adjustments, with management and due diligence adjustments, and adjusted for capital expenditures
- Review of revenue recognition policies and procedures
- Review of Federal, state and local tax filings (i.e. proper S Corporation elections)
While the buyer generally completes Quality of Earnings reports during a transaction, a strong case can be made to have a Quality of Earnings review (reverse due diligence) completed in advance of a transaction when a company’s stakeholders anticipate a future sale. This strategy has several advantages:
- It can allow the seller to objectively assess and evaluate the condition of the business.
- It allows the seller to understand issues that may come up during the buyer’s due diligence and be in a better position to discuss these issues.
- It identifies non-recurring items and other issues that could impact the sale price of the business.
- It 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.
There is very little upside to the seller when a buyer has a Quality of Earnings review completed, but there can be some significant downsides. Discovering surprises once the due diligence phase begins can put the seller at a significant disadvantage in the negotiation process and can often lead to adjustments to the sale price, the inclusion of an earn-out to protect the buyer, or may lead to the transaction being terminated. Additionally, the process often consumes a significant amount of time, can distract from day-to-day operations, and can be very stressful on owners and senior management.
By understanding what is involved in a Quality of Earnings review and being prepared for the questions that may come from the buyer, the seller can gain some advantages. The seller puts themselves in a much better position to manage the due diligence phase of the transaction and limit or anticipate the number of changes the buyer may propose.
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