If you are buying or investing in a business, you may feel a level of comfort knowing that the target company has audited financial statements. However, relying solely on those financial statements can be risky. What if the financial statements include significant nonrecurring revenues, lower-than-average expenses, or overly aggressive accounting policies that inflate the company’s financial results?
Although audits certainly have their place when buying, selling, or investing in a business, it helps to supplement the financial statement audit with a Quality of Earnings (QoE) report.
What Is an Audit?
In general, an audit provides financial statement users with a reasonable level of assurance that a company’s financial statements are not materially misstated. Audits are often required for financing or regulatory purposes. They can also give investors an increased comfort level in the reliability of the organization’s financial position and results.
What is a Quality of Earnings Report?
Buyers and investors typically want more information than can be gleaned from an audited financial statement. A QoE report supplements the audited financial statements by providing information about the company’s value now and in the future.
Either a buyer or a seller can engage a firm to complete a QoE report.
- A sell-side QoE report uncovers potential issues that could derail a sale or result in a lower selling price. This process allows the seller to take corrective action to fix potential problems and potentially increase the selling price or devise a game plan to address those issues when they inevitably arise during the buyer’s due diligence process.
- A buy-side QoE report provides buyers a more detailed picture of how well the business is really doing and whether it’s worth the sellers’ asking price. This information can help the buyer negotiate and structure the deal and lowers the risk of buyer’s remorse.
A QoE report can be modified or adapted to meet the buyer or seller’s needs or address specific concerns and key risks. It may include:
- Normalized and forecasted income and earnings before interest, taxes, depreciation, and amortization (EBITDA)
- Information on customer and vendor relationships, market drivers, and sales strategies
- Margin and trend analyses
- An analysis of account reconciliations and agings
- Unusual or nonrecurring revenues and expenses, as well as overstated or understated assets and liabilities, that help reveal the sustainability of the company’s earnings
- Information on working capital needs
- Qualitative information about ownership, management, internal controls, information systems, and the accounting team
- Transactions with related parties
- Whether the company consistently applies accounting policies
- Key assumptions used by the management team when assembling financial forecasts
- Proof of cash flow
- An analysis of key reserves and allowances
In essence, a QoE report provides a snapshot of the company’s value, either to identify risks for the buyer or help the seller discover opportunities to increase the business’s value.
Audit vs. QoE Report
A QoE report goes beyond the financials to provide insight into the factors that drive value within a company.
Here is an Audit vs. Quality of Earnings Report comparison chart with a brief snapshot of the differences between these two tools:
An audit can provide assurance that a company’s financial statements present a fair and accurate view of a company’s financial performance and position. But for merger and acquisition transactions, an audit is a complement to, rather than a replacement for, specifically tailored financial due diligence.
How Holtzman Can Help
In today’s competitive M&A environment, it’s crucial to identify and resolve deal-breakers at an early stage. With diverse experience across many industries, Holtzman has earned a sterling reputation for delivering both audits and QoEs to help our clients achieve their goals and strengthen business value. With clients ranging from startups and middle-market leaders to large multinational conglomerates, we dedicate ourselves to delivering stellar results for our clients. Learn more about our Advisory Services.