Quality of earnings report vs. an audit report

Demystifying Valuation, Economic Damages + Forensic Accounting

FASB, accounting, audit, definition of a businessWhat is the difference between a financial statement audit and a financial due diligence (aka quality of earnings report)?  In general terms, an audit report provides assurance to the public that a company’s financial statements are not materially misstated while a financial due diligence performs analytical procedures to gain a deeper understanding of the economic risks of a company in the context of an eminent M&A transaction.

Don’t miss: Your banker says you need a QoE. Now what?

What are the differences between a financial audit and a financial due diligence?

An Audit Report

  • Is focused on the balance sheet
  • Coincides with the company’s fiscal year end
  • Is focused on net income
  • Is concerned if revenue and expenses are recorded in the correct fiscal period
  • Verifies the ending balances of accounts on the balance sheet as of fiscal year end
  • Verifies that revenue is earned in the correct fiscal year

A Due Diligence Report

  • Is focused on the earnings power of the company
  • Analyzes the trailing twelve-month period
  • Is focused on EBITDA and free-cash flow
  • Is concerned if revenue and expenses are recorded in the correct fiscal period and if all expenses are necessary to operate the business
  • Analyzes the working capital accounts over a period (quality of working capital)
  • Analyzes the recorded fixed assets over a period (quality of fixed assets)
  • Analyzes historical capital expenditures and categorizes purchases into replacement vs. growth purchases
  • Analyzes the company’s revenue and pricing strategy (quality of revenue or pricing)
  • Analyzes the company’s customers
  • Performs a proof of cash analysis
  • Analyzes the company’s contribution margin
  • Performs a revenue bridge analysis to understand the seller’s projections

The procedures above are an overview of possible areas to focus on and it is up to the buyer to identify areas of concern to validate their investment assumptions and to make sure the financial due diligence report provides useful information.

Fore more information on financial reports, check out this article on when you should get a financial statement audit.

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Mike Metzler, CPA, ABV, CMA, CGMA, ASA, Director, Litigation + Valuation Services