A quality of earnings (“QoE”) report and an audit are both essential tools in the business world, but they serve distinct purposes and offer varying insights. Audits are broader and regulatory in nature, whereas QoE analyses are more focused and strategic, catering to the needs of investors and decision-makers who require a deeper understanding of a company’s true financial health and future potential.
The purpose of an audit is to form an opinion as to whether the financial statements are fairly presented in conformity with appropriate accounting principles. An audit is not intended to look at business trends and the future outlook of the company. These engagements provide assurance that financial records are free from material misstatements.
While an audit provides general assurance of financial statement accuracy and compliance, a QoE analysis offers a nuanced evaluation of the earnings’ quality and sustainability.
“Quality of earnings” is a term that refers to the overall health and sustainability of a company’s earnings, typically evaluated as part of the due diligence process in a merger or acquisition transaction. The objective of a quality of earnings report is to “translate” historical financial information into a relevant picture of earnings and cash flow that is useful in developing a credible view through the windshield.
For sellers, an independent QoE report is vital to advancing and defending their asset’s value in the marketplace. For buyers, a QoE analysis is a cornerstone of their broader diligence efforts to avoid overpaying for earnings that are not sustainable.
The scope for a quality of earnings analysis will typically take the form of “Agreed Upon Procedures” that includes financial review of company performance, and analyses that focus on earnings, cash flow, non-recurring revenue and expense, working capital, net fixed assets, and other relevant attributes.
A quality of earnings report diverges from the sole financial scope of an audit and considers key operating metrics, sustainability of the business, potential uncovered risks, as well as the impact non-financial aspects may have on earning power, to create a more accurate picture of a company’s financial health.
QoE reports analyze the underlying factors driving earnings, identifying different adjustments that might need to be made to the historical earnings to identify a measure of pro forma run rate earnings that is relevant to buyers and sellers. These adjustments can be classified into discretionary expenses, nonrecurring items, timing / accounting policy adjustments, major customer adjustments, and M&A run rate adjustments.
In contrast, audits assess the reliability of a company’s historical financial records. The process involves testing transactions, verifying account balances, and assessing internal controls. The scope of each individual audit, as well as items like overall materiality and tolerable misstatement, is determined during the planning stage.
The scope of an audit will differ for a financial audit and an integrated audit. An integrated audit includes a financial audit (audit of the financial statements) as well as an audit of internal control over financial reporting. For an integrated audit, the auditor will design tests of controls to obtain sufficient evidence to support the opinion on internal control over financial reporting and support the auditor’s control risk assessments for the audit of financial statements.
An audit focuses on reported earnings in accordance with generally accepted accounting principles (“GAAP”). GAAP earnings are backward looking: they report how a business has performed in the past under specific rules.
Although quality of earnings analyses are developed based on historical financial statements, the main focus is on the economic earnings of the business on a normalized going-forward basis. Credible perspectives on the future must be grounded in a reliable base of historical information. However, not every dollar of GAAP earnings is equally relevant to establishing that base. Buyers and sellers care about the view through the windshield, not the rearview mirror.
The outcome of an audit is an audit report, which expresses an opinion on whether the financial statements are free from material misstatement. Audit engagements are typically conducted annually and are often required by law or regulation, especially for publicly traded companies.
Depending upon the size of the proposed transaction and requested procedures, the timing of a QoE report can range around 45-60 days. The report itself will contain sections including Executive Summary, Quality of Earnings Analysis, Income Statement Analysis, Working Capital Analysis, as well as accompanying Excel exhibits. Included are assumptions, limiting conditions, and the scope of services provided. The report and procedures performed are tailored to the user of the report and the needs of the engagement.
A QoE report analyzes the company to assess sustainable earnings on a going-forward basis, while an audit forms an opinion as to whether the historical financial statements are fairly presented in conformity with appropriate accounting principles.
A comprehensive QoE analysis helps investors and shareholders understand the true economic performance and future earning potential of a business, offering a more nuanced view that extends beyond the scope of a traditional audit.
