Quality of Earnings Report

When a company is considering an acquisition, a certain level of due diligence must be done. A critical step in due diligence is the quality of the earnings report. The quality of earnings report breaks down the financials of a target firm and rates its earnings as "high" or "low" quality.

As you may or may not know, net income is not always the best metric and certainly not the only metric by which a company can be valued. Net income can be manipulated through various means, it may be skewed, and frankly, it does not show the whole picture.

The quality of earnings report analyzes the financials of the company, including how revenue and net income are earned. 

The quality of the earnings report looks to break down the sources of cash, which is a crucial aspect to consider. Not all line items on the income statement directly affect how much money is taken in by the business at the end of the fiscal year.

Earnings may also be subject to various factors of risk, including:

• How frequently are transactions made with the business
• How likely are the transactions to continue
• Are records kept accurately/consistently
• Under what circumstances were earnings made

These are some of the questions regarding risk, which quality of earnings reports answers.

A quality of earnings report seeks to:

• Dismiss anomalous earnings
• Account for accounting tricks
• Make considerations for one-time events

Any above can skew or manipulate what is recorded on the bottom line. The quality of earnings report is concerned with finding the natural bottom line of a business. When a quality of earnings report (or QOE report) is made, it seeks to remove confusion and to see the actual numbers.

For example, external market factors can influence revenue and earnings. However, markets change, and certain events cannot be counted on to continue indefinitely or have the same effect on the business over time. 

Factors that might be considered could be:

• Inflation
• Rapid expansion or contraction of a nation
• Sudden, one-time changes in consumer behavior
• Trends that are not likely to continue, or which the effects of change over time

Examples

• During high inflation, companies might charge more this year than the last for its product or service. This price increase will earn more revenue and potentially more earnings. But costs cannot be increased at this rate indefinitely, and COGs may catch up.

Many people have recently switched to online video chat platforms for work, school, etc. But this growth, or even the new customers attained during this time, might not be considered reliable long-term sources of revenue.

The QOE report may also consider specifics of the operation, including:

• Specific clients and their level of risk
• Industry trends and risks
• Product lines or services' economics and trends
• Other specific yet relevant metrics

Specific clients may be analyzed due to the company's reliance on particular business(es). REITs, for example, may have one or few clients that rent many units. SRU.UN, for example, relies heavily on Wal-Mart and other superstores, which rent many large units from them.

Accounting practices can also affect business risk. For example, your country may use GAAP (generally accepted accounting principles) or IFRS (international financial reporting standards), depending on where you are. 

The more closely these standards and principles are followed, the less risky the earnings may be. However, due to historical events, we know that poor accounting practices can lead to significant issues with company financials down the road, thus increasing the risk of earnings.

​However, the quality of earnings reports can go beyond just the income statement and earnings and analyze the actual value of items on the balance sheet, for example. But, again, this falls back on ensuring accounting practices are being followed correctly. 

Management also affects the Q.O.E. report since it can influence company policy and keeping accounting records. This is a further reason to go beyond just the income statement and analyze the balance sheet.

It is also of concern if the business has very high net earnings but very little operating cash flow. This could increase the risk of payments for the company in the long term.

The riskiness of the cash flows is not simply subject to the accounting records, though. As we discussed, what is recorded and how it is recorded play a significant role in the riskiness of earnings, but sometimes payments can be risky for reasons outside the business itself.

Quality of Earnings Report Explained

Despite net earnings not being the only metric used in analyzing a company, this does not take away the importance of its accuracy. Many investors use metrics that rely on net earnings in one manner or another; hence, its quality must still be considered.

In accounting, there are many considerations they can and must make when recording the company's financials. This means, as we mentioned, a potential investor or acquirer should look at a deeper analysis of earnings to gain a better understanding of them.

Why would an accountant be interested in adopting a higher or lower income policy?

On one end, a company may try to reduce its net income to pay fewer taxes. For example, P.P.E. might be depreciated more aggressively to reduce EBIT and therefore reduce the taxes paid by the business. Yet this would not materially affect its cash position.

More applicable to companies considering an acquisition, net earnings may appear higher when adopting specific accounting policies. As a result, a corporation may seem more attractive to a potential acquirer once they see significant increases in net income.

If a firm is caught adopting unusual policies to change its appearance to investors, this can cause the quality of earnings to be deemed poor or of low quality. This is why it is essential for businesses, even private ones, to follow either GAAP or IFRS closely and with integrity.

One of the most common reasons specific policies are adopted is to reduce a business's tax burden. However, we mentioned that the third-party examiner conducting the Q.O.E. report might look at the balance sheet. Here is an example of why:

Suppose something is not appropriately depreciated (for example, property, plant, and equipment is being depreciated over a timeline more significant than its useful life). In that case, the quality of the earnings report will see this and deem the earnings riskier due to this practice.

While IFRS fundamentals are worth following, IFRS is still just principle-based and therefore open to some interpretation. It is recommended for more rigidity that GAAP is followed. GAAP relies on the following principles:

1. Principle of utmost good faith
2. Principle of consistency
3. Principle of sincerity
4. Principle of permanence of methods
5. Principle of non-compensation
6. Principle of materiality
7. Principle of continuity
8. Principle of prudence
9. Principle of periodicity
10. Principle of regularity

As GAAP is rules-based accounting and was made to create continuity and standardization in how financials are recorded, it can lead to more reliable and higher quality earnings.

These are the key takeaways for understanding Q.O.E. reports:

1. These reports analyze and make it easier to understand the prospects of business performance by dissecting muddled financial statements.
2. The third-party acts as a second set of eyes for the buyer and seller to catch information that might be missed or misinterpreted.
3. The report helps investors understand if earnings are internally developed and sustainable or if they result from external and abnormal events.

How the quality of earnings report works

The quality of the earnings report works to solidify business valuations. Of course, the word itself does not provide valuation estimates for the business, but it can help remove any confusion or ambiguity in the financial statements.

The report includes, in great detail, aspects of the business's finances that the acquirer might not have considered an issue or information that the acquirer overlooked.

If used properly, the quality of the earnings report will improve the acquirer's understanding of the acquirer. With a better experience, negotiations run smoother as the buyers and sellers better understand risk. But buy-side and sell-side both have unique benefits to the Q.O.E. report.

Sell-side benefits

• Areas of concern can be identified before seeking acquisition, and remedies for these concerns can be implemented before purchase.
• A third-party perspective can identify organizational norms that might cause concern to investors and catch issues management might not be aware of
• If issues can be identified and remedied, this may lead to higher quality earnings. This can improve the speed of due diligence during acquisition, and with higher quality earnings, the business might receive a higher valuation.

Buy-side benefits

• The acquirer has more certainty regarding understanding the target firm's financials.
• The acquirer's risk of losing capital unnecessarily is reduced by understanding the quality of earnings of the acquiree.
• With a better understanding of risk, the future performance of the acquiree can be projected with more certainty and precision.
• It can help align the projected return on investment based on the purchase price with the estimated risk level.

There are a few critical considerations regarding whether earnings are of more excellent or less quality, lower or higher risk, respectively.

Cash transactions that will likely continue recurring are usually rated as higher quality. On the other hand, if most of the transactions are paid in cash but might not occur again, these earnings are of higher risk and less quality. The same goes for non-cash but recurring transactions.

Typically the lowest quality or highest risk earnings are those primarily composed of non-recurring and non-cash transactions.

In regards to the financial statements, there should be consistency, integrity, and quality/accuracy in:

• Accounting policies
• The degree of estimation in financial statements
• Transparency of financials and footnotes
• The complexity of management decisions and analysis (MD&A)
• The ratio of net income to operating cash flow

Researched and authored by Brandon Fausto | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Acquiree
• Control Premium
• Defense Mechanism
• Pitchbook
• Tender Offer