Quality of Earnings Report: Essential Due Diligence
By Christopher Hatten, CPA, CVA, CM&AA, Managing Director
A pickup in middle-market mergers and acquisitions (M&A) work is anticipated once parties become more comfortable with doing more transactions, or with larger parts of them done remotely. Having a detailed quality of earnings report as part of the due diligence process will be key in getting any deal across the finish line.
Although a quality of earnings report is not an audit, it can help provide additional support of a target company’s revenue and expenses, including sustainability and accuracy of past operations. In this article we will advise our readers of five fundamental goals of a quality of earnings engagement.
Complete Interim Financial Statements
It is beneficial to note that often times middle-market companies being sold have not had their financial statements audited or reviewed. Some also may not be generating monthly internal financial statements or waiting until year-end to book certain closing entries that should be made monthly or quarterly. In turn, any interim financial statements may be starkly different than what would be included in audited annual financial statements.
Risk Areas and Assessment Periods
Identification and due diligence of risk areas is key. In particular, it is essential to assess those areas subject to management estimations, such as the accounts receivable allowance, inventory reserves and accruals. Evaluate whether accruals, such as warranties and bonuses, and allowance accounts are only being made at year-end for financial reporting obligations or as part of a monthly close. Often times, these risk areas are not made on a recurring basis which results in misstated assets and liabilities.
Specifically, the assessment period should cover at least the last two fiscal years and the latest interim period. This will assist in identifying trends in the business, and potentially improper adjustments to these accounts.
Identification and Assessment of Metrics
Although it is commonly recognized as a preferred metric, earnings before interest, taxes, depreciation and amortization (EBITDA) – there are limitations in how it fails to address the need for growth reinvestment as a capital-intensive business doesn’t cash-flow as well as others. It is necessary to revisit the EBITDA calculations after the due diligence procedures are finished to further assess management representations and where the figures ultimately settle. However, the quality of earnings procedures could help identify other metrics to take into account as part of the purchase negotiations.
Flow-Through of Owner’s Personal Expenses
For closely-held businesses, there will always be adjustments regarding the seller’s activity. Sellers and other key members of management may be taking excess compensation out of the business, which requires certain adjustments or replacements after the transaction closes. There could also be other discretionary bonuses and “unrelated expenses” the owner may be flowing through the business. With that knowledge to consider, it is important for the buyer to thoroughly examine and substantiate these amounts.
Consistent Revenue Recognition
Revenue will always be a risk to address and could support an article by itself. Does the seller have good controls around revenue recognition and is it being recognized in accordance with US Generally Accepted Accounting Principles (GAAP)? Understanding the seller’s methodology, even if not in accordance with the accounting rules, will be key in determining whether the policy has been applied on a consistent and rational basis.
Concentrations of customers and seasonality of sales is also important to take into account. With the presence of customer concentrations, the loss of even one customer could significantly disrupt business. You would also want some comfort that sales aren’t being supported by one-off transactions that aren’t indicative of sales on a recurring basis.
Finally, a buyer could be coming in at the slow point of the seller’s business cycle, which in turn, would require assurance that enough cash is left in the business to support operations for an extended period of time, or a cash infusion by the buyer at the time of purchase.
When the above matters aren’t given the proper assessment, and a deal is being structured as simply a multiple of revenue or EBITDA, the increase or reduction in the deal size can differ significantly.
Christopher Hatten, CPA, CVA, CM&AA, is a Managing Director at PKF Advisory. He can be reached at (713) 860-5446 or via email at CHatten@PKFAdvisory.com.