Importance of a Quality of Earnings (QOE) assessment in an acquisition

A QOE (quality of earnings) analysis is a very important part of the due diligence process when an acquirer is considering the purchase of a target company.

Though we (Athena Consulting Partners) don't actually conduct QoEs, we often work closely with:

• Acquirers that are reviewing the results of a QoE
• Targets that are going through a QOE on their business or
• Accounting firms that are actually performing the QOE and often have M&A advisors as a stakeholder

Here's a quick primer based on my experiences.

First, a definition: A QOE analysis is designed to evaluate the quality, sustainability, and accuracy of the target company's earnings.

When is it important?

Here are some situations in which an acquirer should consider conducting a QOE analysis:

1. Large or Complex Transactions: In large or complex transactions, the risk of missing or misunderstanding the target's business can cause a serious loss of value for the acquirer. The analysis can identify potential risks and opportunities, and help the acquirer make a more informed investment decision.
2. High-Growth Companies: High-growth companies often have especially complex financial statements. A QOE analysis can help identify any issues typical with these businesses (revenue recognition, expenses management, inventory management) that could impact the target company's earnings.
3. Companies with Accounting Issues: If an acquirer is buying a company that has a history of accounting issues or financial restatements, a QOE becomes a must-do.
4. Private Companies: Private companies, especially those with no audited financials, have less transparency in their financial reporting. A QOE analysis can help the acquirer identify any potential issues or risks associated with the target company's financial statements.
5. Companies in Highly Regulated Industries: Companies in highly regulated industries, such as healthcare or financial services, may have unique accounting challenges that require a QOE analysis to untangle.

What are some of the issues that may surface through a QOE analysis?

1. Revenue Recognition: One of the most common issues in a QOE analysis is related to revenue recognition. A QOE analysis will evaluate whether revenue has been recognized correctly and whether there are any discrepancies between the company's reported revenue and its actual revenue.
2. Expense Misclassification: Another common issue is expense misclassification. This occurs when expenses are incorrectly classified or recorded in the wrong period, which can lead to an inaccurate picture of the company's financial health.
3. Inventory and Working Capital Management: Inventory management is especially relevant for asset-heavy businesses. Working capital is relevant for most businesses, but especially those in retail, manufacturing, or services.
4. Off-Balance Sheet Liabilities: Off-balance sheet liabilities are not recorded on the company's balance sheet. A QOE analysis will evaluate whether the company has properly disclosed its off-balance sheet liabilities.
5. Acquisition-Related Accounting: Accounting for acquisitions can be complex. A QOE analysis will evaluate whether the company has properly accounted for any acquisitions it has made, including the treatment of goodwill and intangible assets.
6. Related Party Transactions: Related party transactions are transactions between the company and its affiliates or insiders, which can create conflicts of interest. A QOE analysis will evaluate whether these transactions have been properly disclosed and whether they are at arm's length.
7. Non-Recurring Items: Non-recurring items, such as one-time expenses or gains, are often added back to earnings to provide a normalized EBITDA. A QOE analysis will evaluate whether these items have been properly identified and whether they are truly non-recurring or if they should be included in the company's ongoing earnings.

How are the results of a QOE used?

1. Valuation: The QOE report can provide insight into a company's historical and projected earnings, which can be used to estimate its value. As mentioned above, the report can be used to adjust earnings for one-time events or non-recurring items and to identify trends in revenue, margins, and expenses.
2. Due Diligence: The QOE report can help acquirers and investors identify potential issues that could impact the company's future earnings. The report can highlight accounting irregularities, non-recurring items, or other issues that may require further investigation.
3. Risk Management: The QOE report can provide insight into the sustainability of a company's earnings and the level of risk associated with its financial performance. The report can be used to identify potential areas of risk, such as customer concentration, accounts receivable aging, or inventory levels.
4. Financing: Lenders often use the QOE report to assess a company's ability to generate sufficient cash flow to repay debt.

Running a QOE on the business does take management's focus - and requires heavy inputs from both the finance teams (to provide the data and color on the accounting policies) and the commercial teams (to explain the business trends).

... but is often homework that needs to be done by the seller anyway, for a buyer to get comfortable with the business.

Of the many expenses related to an M&A transaction, and especially when considering a private company without independently audited financials, I'd handily list a QOE in the top three spend categories that'll pay off during the process.

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