QUALITY OF EARNINGS (QOE): A Key Foundation for Financial Due Diligence

Financial due diligence, the process of ensuring that the value of an asset is in line with its operating performance “under the hood”, uses the quality of earnings as one of its key tests. It answers the question “How sustainable is the business’ reported financial performance?”

We all have to agree that net income is not a definite indicator of a business’ financial performance. A company’s large net income figure does not equate to being financially sound if its operating cash flow is negative. If you are an investor or a buyer, or even if you’re selling your company, it is very important to identify the many key details that are not included in the financial statement of a company.

WHAT IS A QUALITY OF EARNINGS (QOE) REPORT?

A quality of earnings report is an essential part of due diligence in the process of selling, buying, or investing in any company. It is a routine step for private acquisitions as a due diligence process. This report evaluates how a company accrues revenues (both cash and non-cash, recurring or non-recurring).

QOE determines the impact of things that are not reflected on a business’ real or stabilized cash flow and performance (neither those that are not observable or viable over time), which can be rooted from accounting preferences, business climate, or management choices.

Aside from the income statement which is a focal point in QOE, the report should also capture the information in other financial statements such as the state and value of different assets on the balance sheet.

QOE also takes into consideration the systems of control of a company and the crucial elements of its operations (i.e. client, industry type, product line, and other pertinent metric).

Essentially, QOE is different from doing an audit or review.

The objective of an audit is to provide a level of assurance that the financial statements of a business match up to the generally accepted accounting principles (GAAP). These statements are inherently retrogressive.

Clients commonly question the need to perform QOE despite being audited. There are a number of differences between an audit and a quality of earnings study. A QOE report gives us a better understanding of how a business performs and how sustainable it is at a very detailed level. A QOE report focuses on the economic earnings while an audit focuses on the balance sheet. A QOE, being not at attest service, provides a consulting engagement approach wherein the methods and scope are flexible. The applicability of a QOE report is much lower as compared to an audit.

A QOE report institutes a business’ value by conducting a deep dive analysis on detailed aspects that cannot be easily identified by a buyer or investor and a seller whenever they conduct a review of financial statements.

Not a valuation report though, but a QOE report has a crucial role in the process of structuring and negotiating a business deal, with the hopes of trimming down the risks and from preventing a seller or buyer regret the deal afterwards.

The sell-side QOE exposes the possible problems that might disrupt any future sale (or anything that might prolong the process or minimize the selling price). For a CEO or a CFO who might know their business’ cash flow inside and out, their assets’ quality, and how the different accounting choices impact the reported profitability of their company, a QOE provides an in depth analysis of the business from a potential buyer’s perspective. Thus, this gives them an opportunity to take on any corrective action that may be essential prior to a sale which speeds up the sale process and possibly increasing the selling price.

Any potential investor / buyer or lender usually relies on the financial statements of a company without a comprehensive understanding of all the details. A buy-side QOE report provides an independent analysis of what went into the account balances, cash flows, and the business’ operations. Simply put, this type of report provides a thorough and representative picture of how the business fares and if the price it is sold for would be worth it. It assesses a business’ inveterate nature and the quality of its cash flows and operations, moreover, its core assets and liabilities.

What Analyses and Findings Does a QOE Provide?

Depending on the type of business and industry, a quality of earnings report provides the following analyses and findings:

  • Atypical trends and variances in balance sheets and income statements that are prepared internally
  • Major and / or odd accounting policies
  • Variations in accounting methodologies, principles, guidelines, processes, or practices
  • Nature and degree of period-closing amendments and reconciling items between internally prepared financial statements and general ledger balances
  • Remarkable or non-recurring items of expense or income
  • Related parties transactions
  • Evaluation of expenditures and cash receipts and compare it to earnings before interest, tax, depreciation, amortization (EBITDA)
  • Customer sales, backlog analysis and concentrations
  • Breakdown of allowances and key reserves
  • Analysis of account reconciliation, composition, and agings

 

OTHER DUE DILIGENCE PROCEDURES THAT IMPROVE

QOE REPORT

Run Rate Study

The run rate is more important to assess than the past 12 months figure if the company is in an abrupt decline or in its peak growth mode. This is also accurate when evaluating the net working capital to be delivered at closing (known as the “PEG”).

Commercial Analysis

The cutthroat environment, the go-to market approach, and the current customer insights of the company and its products must also be evaluated if the company merely replies on its management projections.

Related Party Analysis

When the company has several related party transactions, the buyer should be assured that any change in power will not affect vital dealings with suppliers or customers.

Debt and Debt-Like Items

Liabilities that do not give value to the company but might possibly affect future cash flows should also be discussed during negotiations. These are legal disputes, imminent regulatory discourse, underfinanced pension plans and on hold compensation plans.

What Is the Responsibility of the Management and the Audit Committee Corresponding to the Quality of Earnings?

While the company’s management is responsible for choosing and applying the accounting principles (as well as the causal estimates and judgments employed in applying those principles), the best practice is to have everyone involved in discussing the quality and acceptability of the body’s accounting principles pertaining to the financial statements. However, it must be noted that the quality of earnings differs from the quality of accounting principles (though they are intrinsically related in the sense that the judgments applied in choosing and employing such principles precisely impact the quality of earnings.

Why Is Disclosure Important?

The main vehicle that informs investors about the quality of the earnings of a company is the Management’s Discussion and Analysis (MD&A). Since the estimates and rulings are intrinsic in the application of accounting principles, a number of factors affecting earnings may be unclear and anyone who interprets the financial statements should b vigilant via full and transparent disclosures in the financial statements, MD&A, and footnotes. The disclosures should well communicate that it is the object being quantified to the so-called “fuzziness” and not the “camera” (in this case the accounting in the financial statements) or the photographer (the management). The reader must be provided with sufficient information that would help in making the different components and earnings, risks and vagueness that shape the future results of the company.

ATTRIBUTES INFLUENCING THE PERCEPTIONS OF QOE

It is a generalization to regard quality of earnings as “good” versus “bad,” or even “high” versus “low” as QOE is relative and covers a specific range. There are specific attributes that influence the quality of earnings that can be used by users of financial statements in evaluating a particular earnings component. Here are some attributes and examples of both income and expense earnings components.

Attributes Influencing the Perceptions of QOE
ATTRIBUTES EXAMPLES
Cash earnings Recurring sales for which cash has been received
Based on fixed and certain amounts from completed transactions Recurring sales of tangible delivered products
Result from consistent application of accounting principles Consistent application of LIFO method of inventory valuation
Result from consistent application of estimation principles and methods Consistent application of pension expense calculation
assumptions
Result from estimates for which the range of possible balances is relatively small Changes in the accounts receivable reserve that has a Rs. 10 lacs
range for the possible balance
Based on transactions that are recurring Rental income
Result from arm’s-length, commonly executed transactions with independent parties Sales to an independent customer
Result from assets or liabilities recorded at cost Interest on investments
Reflect proposed external/internal audit adjustments as presented in the financial statements Repairs and maintenance expense that reflects the recording of
external auditor adjustments for expenses that were originally capitalized
Noncash earnings Goods sold in exchange for stock of another company
Based on amounts subject to change due to changes in estimates and future market conditions Mark-to-market derivative contracts
Result from discretionary changes to existing accounting principles that result in earnings but no cash increase Switch to the FIFO method of inventory valuation
Result from changes in application of estimation principles and methods that increase earnings but not the reliability of the estimate Change in the assumed rate of return on pension assets
Results from estimates for which the range of possible balances is relatively large Changes in the environmental contingencies reserve that has a
Rs. 1 crore range for the possible balance
Based on assets with uncertainty of recovery or liabilities subject to change Expenses associated with warranty reserves
Result from sales to related parties or uniquely structured transactions Sales to an off-balance sheet, special purpose entity
Result from assets or liabilities recorded at fair value Mark-to-market, held for sale investments
Do not reflect proposed external/internal audit adjustments as presented in the financial statements Repairs and maintenance expense that does not reflect the
recording of external auditor adjustments for expenses that were erroneously capitalized

This graph shows that the quality of earnings is directly proportional to the portion of the earnings that is representative of the present or near-term cash flow. Additionally, the QOE is also directly proportional to the certainty and possibility or regularity of the earnings. It is important to remember that position is a skewed process and depends deeply on the perceptive of the nature of the transactions and accounting principles augmenting a particular income or expense item.

INDICATORS OF OVERALL EARNINGS QUALITY

 

Depending on the scenario distinct to an industry or company, other indicators are possible aside from the list above. A number of industries use common measures that are generally used and followed. Thus, it is not recommended to merely rely on a sole indicator to review the overall earnings quality. All factors should be considered cumulatively as part of the process.

The attributes that affect the quality of earnings offer a basis for allowing the individual income and expense items that consist of earnings. There are several indicators in the financial statements that can be used to evaluate earnings on a high level.

  • Overall stability of accounting policies from year to year or quarter to quarter

  • Overall level of estimation or prejudice in identifying earnings

  • Trend in reserve balances

  • Transparency of footnote disclosures

  • Intricacy of MD&A and debate on nonrecurring, unusual transactions

  • Existence of pro forma measures of earnings

  • Disclosure of related-party transactions

  • Ratio of net income to cash from operations

  • Uncertainties and contingencies disclosed in the footnotes and MD&A

QUESTIONS TO ASK IN ASSESSING QOE

General Questions

Are there changes in the accounting principles since the last reporting period? If so, what are they?

What was the earnings impact of any changes in accounting principles?

What prompted changes in accounting principles?

Are the accounting principles selected by management in line with those of peers in your industry?

What are the most significant estimates made by management in the current financial report?

What was the range of possible balances for such estimates?

What changes in accounting estimates were made during the period and which were disclosed in the earnings release? If they were not disclosed, why not?

How close to analysts’ expectations were earnings? Over time, has there been a recognizable trend in the difference between actual earnings and analysts’ expectations?

How close to management’s plan were earnings?

Over time, has there been a recognizable trend in the difference between actual earnings and management’s plan?

Financial Statement Presentation and Disclosure

Are all gains and losses properly classified as operating or non-operating?

Do the MD&A and footnote disclosures clearly and adequately explain significant accounting policies
and estimates?

Are nonrecurring and/or complex transactions adequately disclosed?

Were pro forma presentations of earnings used? If so, why? Were they reconciled back to GAAP earnings?

Are there any significant assets and liabilities that are recorded at fair value? If so, which ones? What was the method for determining the fair value? What impact did the recording of fair value have on earnings?

Unrecorded External/Internal Auditors’ Proposed Adjustments

Was materiality used as the reason for not recording any or all the proposed external/internal audit adjustments?

If the proposed external/internal audit adjustments had been recorded, collectively or individually, what would have been the impact on earnings?

How would the recording of proposed external/ internal audit adjustments have altered the company’s earnings situation in relation to meeting analysts’ expectations, management’s plan, debt covenants, or compensation plans tied to earnings performance?

Is there a guidance in assessing the quality of earnings: – Are there any intentional misstatements? – Did any of the misstatements arise from segments of the business that have been identified as playing a significant role in the company’s operations or profitability? – Do any of the misstatements affect the company’s compliance with regulatory requirements? – Do the misstatements, collectively or individually, change income to a loss, or vice versa? – Do any of the misstatements arise from an item capable of precise measurement?

Revenue Recognition

Were there any unusually large sales recorded immediately prior to period end? What was the nature of the transaction?

Are there significant installment sales?

Are there significant sales in exchange for a note receivable or other noncash consideration? If so, have adequate reserves been placed against such receivable?

Are gross margins rising while sales are stagnating or declining?

Are there any contingencies related to any sales transactions such as the right of return, right of refund, or ability for the customer to resell? If so, what is the nature of such contingencies?

Are there any side agreements associated with sales transactions? If so, what is the nature of such agreements?

Are there any sales transactions for which revenue was recorded, but the goods remained in the possession of the company? If so, why?

Does the company have any post-sale obligations? Have these been considered in accounting for the sale?

Are large, nonrecurring revenue sources disclosed?

Are there unusual trends in the allowance for doubtful accounts receivable?

Are there uncertainties about collections?

Have payment terms or other forms of financing been extended to any customer? If so, why and how much?

Expenses

Were there any unusually large expenses recorded immediately subsequent to period end? What was the nature of the expense?

Have any costs been deferred or not accrued?

Are recurring expense amounts improperly characterized as nonrecurring?

Inventory

Over the long term, is there an unusual relationship between inventory and sales (e.g., sales levels are decreasing but inventory levels are increasing)?

Are books adjusted or are differences dismissed in taking the physical inventory?

Are inventory obsolescence, returns, and warranty reserves adequate?

Fixed Assets and Intangibles

Were tests performed to detect impairment of longlived assets? Were there any indications of impairment based on the tests? If so, were appropriate writedowns taken?

Was there a change in the depreciable or amortizable life of fixed assets or intangibles? If so, what gave rise to that change?

Was there a change in the method of capitalization or depreciation? If so, why?

Are capitalization and depreciation policies consistent with those of competitors?

Is goodwill tested for impairment annually and on an interim basis when conditions require?

Reserves and Liabilities

Are there any unusual trends in total reserves?

What changes were made to existing reserves?

What reserves were added in the current period?

Did estimates related to the calculation of reserves (e.g., warranty, environment, etc.) change in the current period? If so, why, and what was the impact on earnings?

What reversals or additions were made to merger or restructuring reserves? Were such reversals or additions adequately classified and disclosed?

Do factors such as falling securities market values, drop in interest rates, and projected increases in health care costs require revision in accounting estimates related to benefit plans?

Have all probable and estimable contingent liabilities been recorded?

What gave rise to changes in contingent liabilities from the prior year?

What off-balance-sheet debt exists? What is the operating reason for having off-balance-sheet debt?

CONSULT WITH CREDO

Credo provides expert advice when it comes to financial due diligence and how it works in practice. When assessing the quality of earnings, there are specific attributes, indicators, and questions that should always be considered. We, at Credo, make sure that you’ll be on the leading edge of quality financial reporting and that through our evaluation and sound advice, you’ll be able to create lasting value most especially with your investors.

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