Sometimes, before your bank will finance an acquisition, they require a quality of earnings (“QoE”) report. You might be saying, what is a QoE report? A QoE report analyzes the earnings power of a business to determine how sustainable and accurate the business’ earnings are. Specifically, a QoE report digs into the seller’s financial information and reports how well the underlying data relates to the financial statements. Another way to think about a QoE report is that it has the same purpose as a home inspection report does in a real estate transaction, to find hidden risks before the transaction is completed.
This makes a QoE report different from an ‘audit report’, which is only designed to test management’s ability to accurately prepare financial statements. For example, audited financial statements may record personal use travel expenses in the income statement and the audit report is considered accurate under generally accepted accounting principles because the expense has been recorded properly. A QoE report, on the other hand, will identify and quantify the amount of personal use travel expenses and present an adjustment in the QoE report.
A typical QoE report analyzes the following items:
- Cost of revenue
- Selling and marketing expense
- General and administrative expense
- Other (income) expenses
- Cash Requirements
- Working Capital accounts
- Fixed assets
- State and local tax issues
- IT environment
- HR environment
- Management prepared forecasts or budgets
Remember, a QoE report takes time, up to 60 days in some cases, and the availability of data is the number one limiting factor in completing the report. And as more and more M&A transactions are occurring, the buy-side QoE is becoming a necessity to accomplishing a successful M&A transaction.
Mike Metzler, CPA, ABV, CMA, CGMA, ASA
Director, Litigation+Valuation Services