Why do I need a Quality of Earnings Report & What is it?

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Quality of Earnings is part of the due diligence process for privately owned companies. As privately owned companies are not under the jurisdiction of the SEC as public companies are, it is important to have a clear understanding of the financial position of a company before selling, buying, or investing in a business. Businesses will generally have financial statements prepared internally or by third-party audits or reviews. These reports focus on the history of business transactions, verifying the accuracy and compliance with GAAP but do not reflect the quality of the earnings of the company. Investors and buyers are more interested in the future of the companies rather than their past. Quality of Earnings evaluated how sustainable are revenues and earnings and how realistic are the seller’s projections. A quality of earnings report provides a detailed analysis of all the components of a company's revenue and expenses. 

So what exactly does Quality of Earnings mean? The purpose is to determine the quality of the companies’ profits, and whether are companies' earnings consistent and expected to continue. It is not a valuation but is a part of establishing a valuation of the business by reporting and analyzing to identify aspects that might not be as clear from financial statements.

A Quality of Earnings report is an evaluation of the company’s financials by diving into the company details to assure the accuracy of the information being presented. The process challenges the underlying data through transaction testing, statement verification, and management interviews to assess the accuracy, and risk of the business. For example, are there one-time or unusual transactions that are not expected to continue referred to as nonrecurring transactions? What are the sources of revenue, the make-up of the customers, consistency of accounting policy application, revenue & expense trends, and estimates used in accounting policies resulting in how these items impact future company earnings?

What is in a Quality of Earnings report? LeeAnne CFO will evaluate the breakdown of revenue and revenue trends, compare one-time and reoccurring transactions, compare fixed to variable expenses, changes in management impact on Revenue and Expenses, and Analysis of Assumptions Used. The resulting report includes 1) Executive Summary; 2) Quality of Earnings Analysis; 3) Income Statement Analysis; 4) Quality of Net Assets (Balance Sheet) Analysis; and 5) Working Capital Analysis. The report is customized to the business and may include additional sections as needed.

Sell-Side Quality of Earning Report 

At the beginning of the selling process, business owners can order a Quality of Earnings report to help uncover problems that might disturb or delay a potential sale. It helps the seller understand their business from a potential buyer's or investor's perspective allowing issues to be addressed early. This report focuses on portraying the company in the best possible light to investors and buyers. 

Buy-Side Quality of Earning Report 

Potential buyers and investors focus is on the future growth and profitability of the company in the future. The buy focus is to determine if the business is worth the investment. The Quality of Earnings report is often used by the buyer to increase confidence in their purchase and terms. 

1. The most recent federal tax returns for each business. 

2. Management Revenue and Growth projections

3. Bank and credit card statements for each month of the period under review. 

4. Loan statements for the period under review. 

5. Payroll records for the period under review via excel format or PDF including payroll journal, liability report and check register from the payroll processing company or access to the payroll processing company system to download reports.

6. Production, deposit, and collection reports from production software for the period under review if applicable. 

7. List of any special requirements or forms needed to be considered for the project. 

8. Organizational chart of practices, management company and/or organizations.

9. Access to, accountant copy or back of accounting system as of the closing date of the review period. This would eliminate the need for the below item: 

          a. Financial Statements for the period under review (Balance Sheet and P&L Statements) via excel format, financials should be sent via month over month view 

          b. Detailed report of any owner withdrawals or investments into the company for the period under review 

         c. Detailed General Ledger report for the period under review. 

         d. Bank & credit card reconciliation reports for each of the statements provided above.