Business mergers and acquisitions require a delicate balance. While sellers aim to achieve a maximum amount for their company, potential buyers want validation that the purchase price is in alignment with the current — and ongoing — financial performance.
A Quality of Earnings report can help both sides ensure the deal is fair, says Michael J. Kiene, CPA, director, Brady Ware & Company, and is more important than ever given the last 21 months of financial anomalies resulting from the pandemic.
“A Quality of Earnings (QOE) report is an analysis of a business’s historical information to determine what the operation will look like going forward,” says Kiene. “It eliminates anomalies that may have occurred, especially now as a result of COVID-related issues. Companies got PPP loans that were forgiven, and you need to eliminate that income from ongoing income. People weren’t travelling or entertaining, and you need to add those expenses back in to see what operations will look like in a normal year.”
Smart Business spoke with Kiene about why QOEs are critical in any transaction and how engaging a third-party CPA can increase confidence in the report.
What is a Quality of Earnings report?
A QOE report takes a detailed look at a target company’s financial performance to predict future earnings potential for a potential buyer. It can also be performed prior to a business being put up for sale to allow the owner to identify and remedy issues, accelerating the process once it begins.
The report is an objective analysis of a company’s records that identifies factors that aren’t reflected in the financial statement to determine the normalized financial performance and sustainability of the business. It differs from an audited financial statement in that audits look back and validate that activity is accounted for in accordance with GAAP, while a QOE report looks forward.
What are the benefits of a QOE report?
The report restates the company’s historical performance by identifying sustainable revenue. This very detailed look at the financial statements provides insight into how a potential buyer may look at the business. It also sends a message to potential buyers that the seller is serious about their intent to sell.
Finally, it identifies issues that may arise in due diligence. Identifying the anomalies and fixing them can increase the transaction price for an owner, so the earlier in the process you start, the better, to allow you to get ahead of any potential issues.
How does the process work, and how can an expert adviser assist?
A QOE report is a smart and necessary step in any transaction, and it should be done with a team of specialized advisers.
Business owners should engage a third-party CPA firm to conduct a QOE report early in the transaction process to take advantage of their financial acumen and objectivity. To do that, first decide who will assist in the process. This decision should be made among internal management, trusted external advisers and with key stakeholders.
When deciding to engage a CPA firm, ask about their experience with these types of reports, their familiarity with your industry, their timeline and the cost of the report. Reports generally take about 45 days to produce, and the cost can vary depending on the scope and unique qualities of the business and of the transaction. Make sure you are fully informed before making a decision.
Working with an expert third party allows you to produce a QOE report that gives you the information you need to understand your company’s earnings potential going forward and ultimately sell at a fair market price. ●
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