When buying a company, some investors hire a third party to create a quality of earnings report (QoE). It’s part of the financial due diligence, and helps the buyer better understand the seller’s financial performance.
But you might be wondering: why would someone commission a QoE analysis if the seller’s financial statements have already been audited?
The reason is that a QoE analysis and an audit are not the same thing. They differ in terms of their purpose, scope, and procedures
Purpose
The purpose of an audit is to provide reasonable assurance that the financial statements are free from material misstatement. The auditor is trying to determine whether the financial statements conform with the relevant accounting standards, such as IFRS or U.S. GAAP.
The purpose of a QoE analysis is to make adjustments to the seller’s EBITDA so it accurately reflects the seller’s financial performance.
For example, it’s possible that 90% of the seller’s EBITDA was due to a one-time gain that isn’t going to recur. If you’re the buyer you’d want to know this, as it affects the amount you’d be willing to pay for the company. But an audit isn’t going to raise issues about this provided the accounting confirms to the appropriate accounting rules.
Thus, an audit is about making sure the financials conform to accounting principles, while a QoE analysis is about making sure the buyer doesn’t overpay for the company and end up with buyer’s remorse.
Scope
In terms of scope, an audit usually covers the most recent two fiscal years. A QoE analysis might cover the past fiscal year or two, but it will also cover anything that happened in the interm period after the last fiscal year end.
Thus, if you commission a QoE report on July 1, 2021 for a company that operates on a calendar year basis, its most recent audit will cover the year ended December 31, 2020. But a QoE report will cover not just 2020, but everything that happened during the first six months of 2021.
Procedures
In terms of procedures, the auditors are going to test the company’s internal controls, confirm account balances with third parties, and perform analytical procedures to identify irregularities. They’ll do things like physically count inventory and mail confirmations to customers. This is a very involved process, and for some firms it can take months.
A QoE analysis, on the other hand, can be performed in just a few weeks. There won’t be any counting of inventory; instead, you’ll have an in-depth analysis of the selling company’s financials to determine:
• Has the company been too aggressive in its accounting
• Has the company lost any key customers
• To what extent is profit driven by one-time, nonrecurring transactions
• To what extent is profit driven by noncash sales
• What is the adjusted EBITDA, and how does this differ from the EBITDA reported by the seller
Thus, you should view a QoE analysis as a complement to an audit.
They both have value, but they’re conducted for different reasons and yield different results.
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