A Quality of Earnings Report (QoE) is part of the due diligence in an acquisition or a merger.
When you acquire a company, you want confidence in their financial figures. Their financials affect the amount you’re willing to pay, and whether you want to go through with the deal.
Thus, the buyer (and in some cases the seller) can hire a third party to inspect the financial statements of the company selling its business.
The goal is to understand:
• The extent to which earnings are cash or noncash
• The extent to which earnings are recurring or nonrecurring
• The extent to which earnings are the result of aggressive accounting
The buyer wants to know the seller’s adjusted EBITDA, because valuation is often expressed as a multiple of EBITDA.
To determine the adjusted EBITDA, a QoE analysis would look for:
• Improper revenue recognition
• Improper capitalization of expenses
• Unsupported changes to allowance accounts
• Non-GAAP accounting
• Changes in accounting methods, principles, policies, or procedures
• Overstated inventory
• The loss of key customers
• Contingent liabilities that have not been reported
• Related-party transactions
The QoE report makes adjustments to the seller’s EBITDA based on these factors.
If the QoE report finds a significant discrepancy between the EBITDA reported by the seller and the actual EBITDA, this could result in (1) a renegotiation of the purchase price or (2) the buyer walking away from the deal.
While a QoE analysis usually focuses on earnings, it can also analyze topics such a free cash flow, customer retention, and working capital.
Remember, the management team of the seller has an incentive to make the company look as good as possible, because they’re trying to sell the business.
A QoE report tells you whether the financial situation is as good as the seller says it is.
Thus, getting a QoE report is like having a mechanic inspect a used car before you buy it.
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