Why You Should Supplement a Financial Statement Audit With a Quality of Earnings Report When Buying a Business

A common misconception when purchasing a business is that a financial statement audit is sufficient to support a purchaser’s investment decision. However, an audit alone may not reveal some surprising information hiding just under the surface of the financial statements. A Quality of Earnings report (“QofE report”) and a financial statement audit both use the entity’s underlying financial records, but they have different purposes. An audit gives confidence that the financial statements are not materially misstated. A QofE report, on the other hand, helps potential investors understand the financial statements and the intricacies that are not always apparent when taking the financials at face value. Audited financial statements go hand in hand with a QofE report as essential elements of any business transaction.

What Exactly Does a QofE Report Provide That an Audit Does Not?

Buyers and sellers often base the purchase price for a transaction on a multiple of adjusted EBITDA (earnings before interest, taxes, depreciation and amortization), which an audit report does not typically provide. The goal of financial due diligence that results from a QofE report is a normalized and representative adjusted EBITDA. The transaction may also include stipulations related to net working capital, the net of current assets and current liabilities, as defined in the transaction. Both buyers and sellers of a business can hire a firm to perform financial due diligence on the company and obtain a QofE report. During a QofE engagement, each side has opportunities to present their version of adjusted EBITDA. The seller might propose removing personal expenses from the business’s financials to increase EBITDA. In contrast, the buyer might suggest removing specific non-recurring income items such as income from PPP loan forgiveness or income from an insurance payout. The adjustments aim to present a normalized and consistent view of the earnings across multiple periods, a perspective not provided by a financial statement audit. Other common items identified and potentially adjusted for through this analysis are notable trends and variances, transactions with related parties, customer concentrations, discounts on certain goods that will not persist after the sale, and significantly aged accounts and their risk of uncollectibility.

To Purchase or Not to Purchase: What Does the QofE Report Say?

While an audit will confirm that a business has not materially misstated its numbers, a QofE report will show you a normalized financial picture of the company. This vital component will influence your decision to purchase the business and the price you may pay. The QofE report helps support the value of the business by delving into and presenting aspects of the company that may not have been readily apparent to the buyer or seller when they analyzed the audited financial statements, allowing the investor to make an educated investment decision. If you need assistance evaluating a potential transaction, the Moore Colson Consulting team can help. Our Transaction Services professionals can provide expert financial due diligence, including a Quality of Earnings report, to identify opportunities and issues within the proposed acquisition. Don’t hesitate to contact us for more information. Contact an Expert

Abigail Quigley, CPA, is a Senior Associate in Moore Colson’s Transaction Services Practice Area. She provides clients with strategic consulting on buy-side and sell-side transactions. Abigail has a Master of Accountancy degree with a focus on Auditing and a Bachelor of Business Administration degree with a focus on Accounting from the University of Georgia.