Ten considerations in a quality of earnings study

Clients frequently ask why there is a need to perform a quality of earnings study when the subject company is already audited. There are several differences between an audit and a quality of earnings study. Such differences include the following: In a quality of earnings, the focus is on the economic earnings vs. the balance sheet serving as the focus in an audit; a quality of earnings is a consulting engagement, not an attest service, providing flexibility in the approach and scope; and the materiality is much lower in a quality of earnings study than an audit.

While a due diligence study should never be confused with an audit, due diligence does have the following procedures in common with an audit that help to isolate earnings. When attempting to isolate the earnings of the trailing 12 months, the due diligence professional should be performing a proof of cash. (If the cash cannot be proved, then the buyer cannot be sure of anything.) Next, revenue recognition should be tested to ensure it is in compliance with the company’s policy, as well as with general accepted accounting principles. Any variations from either could have a material effect on earnings calculations. Finally, the beginning and ending balance sheets of the trailing 12 months should be scrutinized to determine if revenues and expenses are in the proper periods, liabilities and reserves are appropriately recorded, etc.

These adjustments are those identified by the due diligence team and might include overlooked onetime expenses, accounting errors, effects of unrecorded or under recorded liabilities or even a reversal of the seller’s adjustments that fail to hold up to scrutiny. The number of these adjustments should give the buyer not only a better understanding of the economic earnings, but provide some insights into the quality of the company’s information and the strength of the finance team.

Other diligence procedures that might provide insight on the quality of earnings that you should discuss with your due diligence advisor include the following: 

• Run rate study – if the company is in a high growth mode or in sharp decline, the run rate may be more relevant than the most recent trailing 12 months. This is also true with assessing the net working capital to be delivered at closing (the “PEG”). 
• Related party analysis – if the company has numerous related party transactions, the buyer may want to be satisfied that the transactions are at arm’s length or that any change in control will not affect critical relationships with customers or suppliers. 
• Debt and debt-like items – liabilities that do not provide any value to the company, but may have an effect on future cash flows, may need to be dealt with in negotiations. Such liabilities might include pending regulatory or legal disputes, underfunded pension plans and deferred compensation plans. 
• Commercial analysis – if the investment thesis is highly dependent upon management’s projections, it may be necessary to analyze the competitive environment, the go-to-market strategy and the existing customers’ perception of the company and its products.