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Understanding the Need for a Quality of Earnings Report in a Transaction

By: Damien Strohmier, Senior Manager, CPA, CCIFP

Dealing in the transaction market space requires a deep understanding of various terms and acronyms that are commonplace when discussing a potential sale, merger, or acquisition of a business. An example of this is Quality of Earnings (QoE).

Below is an explanation of what a QoE Report is and why it is requested as part of a transaction.

What is a Quality of Earnings (QoE) Report?

QoE Reports are one piece of the transaction process requested by a buyer and seller to validate both internal analysis and normalization adjustments to Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) that are included in pitchbooks and other transaction materials. QoE Reports provide understanding and help validate normalization adjustments to EBITDA. EBITDA is used in the income approach to valuing a business.  Specifically, weighted average adjusted EBITDA based on historical or forecasted results, is the starting point that is then multiplied by a transaction multiple. The transaction multiple is based on recent transactions for similar businesses to arrive at an expectation of value under the income approach.

This means any normalization adjustment is going to be multiplied under the income approach, which increases the importance of understanding all adjustments to EBITDA. Transaction multiples will vary by the specific nature of the business’s industry, market appetite, competition, geographic location, and the quality of management.

Normalization Adjustments

Normalization is the process of bringing or returning something to a normal condition or state. This definition provides great insight to the purpose of this part of the transaction process. A seller wants to present their business’s true profitability and a buyer wants to exclude one-time increases to the operational results that will not be repeated in the future.

Types of Normalization Adjustments

There are two categories of normalization adjustments that may be referred to in a QoE Report.

The first category is simply a general normalization, which is the removal of those one-time impacts that will not be recurring in the future.  This more accurately presents the income recognized and expenses incurred by the business during the year.

The second category represents due diligence adjustments. Due diligence adjustments are those adjustments necessary to reflect a company’s financial statements in accordance with generally accepted accounting principles (GAAP).

Examples of General Normalization Adjustments:

  • Ownership’s salaries and benefits could be too high, too low, or simply not expected to be needed in the post-transaction corporate structure.
  • Related party transactions could be consummated at a value that cannot be found in an arm’s length transaction. Items such as rent, or other services provided by related parties that again may be too high, low, or not expected to be incurred moving forward.
  • Discretionary expenses, such as charitable contributions or other items that aren’t required for the company to operate.
  • Other non-recurring or extraordinary income or expenses can cover a variety of situations. The key is to understand and challenge the nature of these adjustments that are present, but also investigate and analyze the records to find those adjustments that are missing.

Examples of Due Diligence Adjustments:

  • GAAP provides guidance on the treatment of certain activities in a business’s operation and how to account for them. Common adjustments related to due diligence include:
    • Application of the revenue recognition standard may require adjustment to the timing or amount at which a transaction can be recorded.
    • Accruals for expenses that haven’t been reflected in the financials shown. These could be simple timing items in closing books, but larger adjustments may relate to recognizing a warranty accrual or payroll accrual.
    • Other cash to accrual adjustments that may be required.

This short list of examples has likely sparked questions about the different types of transactions that may fit in these categories. A seasoned professional providing QoE services facilitates the evaluation of whether these adjustments are properly included and at what amounts. Even more importantly, a QoE professional analyzes a wealth of corporate data in drafting the QoE report and identifies what may be missing from the normalization adjustment list.

The EBITDA normalization table is by far the most stressed item included in a QoE report, but the remainder of the report is equally useful to understanding other elements of the business being sold, including special payment terms from customers or to vendors, aging of balances in both accounts receivable and accounts payable, components of significant balances or transactions, and analytical analysis of the income statement, from concentrations to margin or variance analysis.

A QoE Report provides confidence and understanding of the business and the numbers the transaction value is based on. Confidence and understanding provide a route to a successful transaction, and realistic expectations of the transaction, and also help to prevent a bad transaction from occurring.

Learn more about QoE:

Case Study: Normalization Adjustments and the COVID-19 Pandemic

Case Study: Construction Acquisitions Gone Awry – a Quality of Earnings Story

If you have any additional questions on QoE Reports, please reach out to your local Blue & Co. advisor and we can facilitate your understanding of properly planning for a future sale and facilitate the execution of a QoE engagement to assist in your business transition.

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