Quality of Earnings (QoE) Report: What It Contains and How to Read One

What a Quality of Earnings Report Is For

A quality of earnings report exists because the price of a private company is usually a multiple of its earnings, and the earnings in its management accounts were not prepared for that job. They were prepared to run the business, to file tax returns or to satisfy a lender. The report takes those figures apart and rebuilds them into the earnings a buyer can price, a seller can defend and a lender can size debt against.

The ICAEW's best-practice guideline on financial due diligence, written by specialists at PwC, describes the work as supporting sellers, buyers and providers of finance by adding to what they know about a business's financial performance. The quality of earnings review sits at the center of that work, because the price, the debt and the purchase agreement all depend on what it confirms.

Quality has a working definition. In a survey of chief financial officers by Dichev, Graham, Harvey and Rajgopal, summarized on the Harvard Law School Forum on Corporate Governance, the CFOs said earnings are high quality when they are sustainable and backed by actual cash flows. A quality of earnings report tests both: whether each stream of profit will repeat, and whether the cash arrived.

It is not an audit. An audit tests whether the financial statements are fairly presented under an accounting framework, and it ends in an audit opinion. Baker Tilly's guidance on the work sets out the differences a buyer needs to know: a quality of earnings study is a consulting engagement rather than an attest service, so its approach and scope can be fitted to the deal, and it works to a much lower materiality than an audit. An audited company still benefits from one, because a clean audit opinion says the statements follow the rules, not that the earnings will last.

The work is done by accountants, usually a transaction advisory team at an accounting firm. What quality of earnings means as an idea, and who stands behind the work, is covered on the quality of earnings page. The wider workstream it sits in, from tax to forecasts, is financial due diligence.

What a Quality of Earnings Report Contains

Firms format the deliverable differently, and the scope agreed for each engagement decides what goes into it. The structure is still consistent enough to learn once. Most arrive in two parts: a narrative that explains the findings, and a databook of schedules that carries the workings, which careful readers spend more time in.

The outline below follows the usual order. For each section it names what the section rests on and the question to bring to it.

The Adjusted EBITDA Bridge, Line by Line

The bridge is the exhibit the price is built on. It starts at reported EBITDA, taken from the management accounts or the audited statements, and walks to adjusted EBITDA one line at a time. Each line is an adjustment with a label, an amount and a reason.

Most adjustments fall into a few families:

• Non-recurring items. Costs or income that will not happen again: a settled lawsuit, a one-off project, the sale of an asset.
• Owner and related-party effects. Pay above or below market, personal costs run through the company, rent paid to an owner at a price no landlord would set.
• Out-of-period items. Revenue or cost recorded in the wrong period, moved back to where it belongs.
• Pro forma and run-rate changes. The full-year effect of a change already made, such as a price rise, a closed site or a new senior hire.

Read the bridge in two layers. Many reports separate the adjustments management proposed from the ones the accountants added, and show which of management's they did not accept. That split is the most informative part of the document, because it shows where the seller's account and the evidence part company. Baker Tilly makes a related point about the adjustments the diligence team adds: their number tells a buyer something about the quality of the company's information and the strength of its finance team.

Then test each line as a claim. The SEC's staff, writing about adjusted measures in public filings, gives one example of a measure that could be misleading: one that excludes normal, recurring, cash operating expenses necessary to operate the business. The same test serves a private deal. A cost that appears every year is a cost of running the company, whatever the bridge calls it. Pro forma lines deserve the hardest look, because they are forecasts written in the past tense. Ask what action has already been taken, and which document shows it.

Working Capital, Debt-Like Items and the Price

Two other schedules move the price as surely as the bridge does, and they reach it by a different route.

The net working capital analysis sets out receivables, inventory, payables and accruals month by month, removes the items that do not belong in an operating balance, and shows the level the business normally runs at. That level is where the peg starts: the working capital the buyer expects at close. With completion accounts, the difference between the peg and the working capital at closing is settled after completion; with a locked box, there is no adjustment after completion, so the level shapes the agreed price instead. The monthly sequence matters more than any average drawn from it. Seasonality, growth and a seller managing the balance before a sale all show in the sequence, and none of them shows in a single figure.

The net debt schedule lists what comes off on the way from enterprise value to the equity the seller receives. Borrowings are the easy part. The arguments are about the items that behave like debt: deferred revenue, unpaid bonuses, taxes owed for periods before close, customer deposits, and earn-outs owed on the company's own acquisitions. Grant Thornton's practitioners call debt-like items a common area of debate and disagreement between buyers and sellers, because treating an item as debt takes its full amount off the equity value, while a seller would rather count it in working capital. Their research found deferred income to be the most debated item in price adjustments.

How these schedules reach the price depends on the mechanism in the purchase agreement. EY sets out the two common ones. With completion accounts, the parties pay a preliminary price at completion and settle the difference afterwards through a purchase price adjustment. With a locked box, they agree the final price from the company's most recent audited accounts, with no adjustment after completion, so the buyer needs protection against value leaking out of the business in the meantime. Either way, the definitions in the agreement decide what the analysis is worth, so the accountants who built it should read them before signing.

Proof of Cash and the Other Tie-Outs

Every number in the deliverable should trace to the company's own records, and the numbers the price rests on to a source the company did not write, such as its bank statements. The tie-outs are where that is tested.

The first reconciles the trial balance to the financial statements and to the tax returns, so every later schedule starts from one set of books. The second is the proof of cash. Forvis Mazars describes it, in its basic form, as a reconciliation of the cash flows the financial statements suggest to the company's bank statements: revenue is compared with deposits and expenses with payments, after allowing for movements in receivables, payables and inventory. It is typically completed for unaudited companies, and it can be for audited ones whose recent months are not yet audited. Its result is simple to read. Either cash-basis revenue and earnings reconcile to the bank, or there is a difference someone has to explain.

A proof of cash is not a substitute for the rest of the work, and the firm says so. It is the place to look first when the earnings look better than the business.

Sell-Side and Buy-Side Reports

The same document is commissioned from both sides of a deal, and the side that pays sets the scope.

A sell-side report is commissioned by the company or its owners before a sale. Its job is to find what a buyer would find, early enough to fix it or explain it, and to support the adjustments behind the asking price. Done well, it can shorten a buyer's work and narrow the room to reopen the price. A buy-side report is commissioned by the buyer, to test the seller's numbers for the buyer's own decisions: the price, the structure, the debt and what the purchase agreement has to protect.

The ICAEW guideline sets out best practice for financial due diligence on both sell-side and buy-side transactions. For a buyer handed the seller's version, three questions decide how far it can be used:

• Whose scope was it? The seller chose what was examined and what was not. Read the scope and limitations first.
• Who may rely on it? Sell-side work is written for the seller. Ask, in writing, whether the firm will extend reliance to you and your lenders, and on what terms.
• What does it leave to you? Commission your own work on the items that decide your price, and on anything the seller's scope left out.

Neither side's version is the whole truth. Each is the evidence its client paid for, and a careful reader treats it that way.

Commissioning One: Scope, Timetable and Fee

A deal lead's work on a quality of earnings report starts before the accountants open the data room, with the engagement letter. The scope written there decides what the report can tell you, because the firm stands behind what it agreed to examine and nothing more.

Settle these before the work starts:

• The periods. Enough monthly history to show the trend into close and any seasonality, with the current year to date.
• The entities. Every company in the group whose earnings are in the price, and anything being carved out of a larger group.
• The depth. Whether the scope includes a proof of cash, a full working capital analysis, payroll and headcount testing, tax, and the systems the numbers come from.
• The readers. Whether lenders or an insurer will rely on the findings, which changes what they will expect to see and the terms the firm offers.
• The timetable. When a draft bridge arrives, when the full draft lands, and how much time is left for the findings to reach the price and the purchase agreement.

The timetable and the fee depend mostly on the company. Clean monthly closes, a reconciled ledger and a finance team that answers quickly make the work shorter. Many entities, missing records, adjustments without support and late answers make it longer and more expensive. The number of adjustments a seller wants accepted is a cost in itself, because each one has to be supported line by line.

Choosing the firm is its own discipline. Due diligence services covers how engagements are scoped, priced and staffed, and the questions that separate one firm from another.

Red Flags a Careful Reader Looks For

The CFOs in the Dichev, Graham, Harvey and Rajgopal survey also named the red flags that point to earnings being misrepresented. The three most common were persistent gaps between earnings and the underlying cash flows, departures from industry and peer experience, and large and unexplained accruals or changes in accruals. All three can be read in a quality of earnings report, by a reader who goes looking.

In the deliverable itself, look for:

• Adjustments that recur. A restructuring charge in every year of the period is a cost of running the company.
• A bridge that only rises. When every line adds to earnings, ask what the accountants looked for and did not find.
• Accepted adjustments with thin support. Each accepted line should say what evidence it rests on, and whether that evidence came from management alone.
• Earnings the bank cannot find. A gap between the bridge and the proof of cash, or between EBITDA and the cash it converted into.
• Working capital that improved just before the sale. Collections pushed, payables stretched, inventory run down.
• Limitations written as caveats. Data the firm requested and never received is a finding, wherever in the document it is mentioned.

Any one of these can have an innocent explanation. Several pointing the same way, in the same period, are a finding about the deal.

What a Quality of Earnings Report Cannot Tell You

The deliverable is a study of the past, built from the company's books and management's explanations of them. That is its strength, and it sets its limits.

• It looks backward. It tests the earnings the business produced, not whether the plan the price assumes can be delivered.
• It stays inside its scope. What the firm was not asked to examine, it did not examine.
• It leans on management. Many adjustments rest on explanations and documents management supplies, and a good deliverable says so where it does.
• It reads the books, not the operation. It shows what the ledger recorded, not how the company runs: how work moves, who it depends on, how decisions get made, or whether the customers will stay.

The other workstreams cover what the books cannot. Commercial due diligence tests the market and the customers. Operational due diligence tests whether the company runs the way its numbers suggest, and human capital due diligence tests the people the plan depends on. The types of due diligence map shows how the workstreams fit together, and the due diligence checklist lists what each one confirms.