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Potential Red Flags in a Quality of Earnings Report

Potential Red Flags in a Quality of Earnings Report

Every M&A transaction is different, but all are complicated. Ultimately, you want to ensure the transaction you are hoping to conclude makes sound financial sense. A Quality of Earnings (QoE) is one way to gain additional comfort over a company's financial statements.

However, a QoE analysis can dive deeper into a business than just the company's financial statements. Through the QoE process, you may be able to gain a greater understanding of the company's management team, initial assessment of internal controls, key performance indicators, and factors that are unusual (one-time events or those that are not sustainable over time).

In an M&A transaction, there are reasons for both the buyer and seller to request a QoE report. The seller wants a deal to go through as quickly as possible, without surprises. The QoE will look at the business through the eyes of potential buyers. This process improves the likelihood of a successful close, maximizes value, and can accelerate the timeline due to getting ahead of matters that buyers may consider key issues.

From a buyer’s perspective, you want a QoE to give you greater confidence your purchase or investment will work out the way you expect it to and validate the earnings you based your offer on. The QoE can help you understand account balances, cash flows, and general operations in better detail. 

Identifying red flags in the QoE allows the seller, buyer, or investor to investigate further to learn the cause and, therefore, to adequately evaluate the ramifications. 

Potential Red Flags in QoE Reports 

There are several issues to look for when reviewing the QoE report, regarding both income and expenses. It is important to keep in mind these do not necessarily indicate intentional misrepresentations of information, there could be a reasonable explanation. However, failure to address red flags is critical because any or all of these can call the company’s valuation and future performance into question.

  • Aggressive accounting practices
    Some business owners take an aggressive account position to either inflate earnings or suppress earnings. Inflating earnings can occur prior to transacting while suppressing earnings can occur for tax purposes. A QoE may identify areas where this is occurring.
  • Improper revenue recognition
    This could result from complex accounting matters that are difficult to understand without the correct accounting team, unsophisticated accounting teams, or failure to capture revenue, rebates, discounts, or returns in the correct period.
  • Improper capitalization of expenses
    Capitalizing current costs even though they will provide no financial benefit in future periods can lead to understated expenses.
  • Non-GAAP accounting
    Adherence to Generally Accepted Accounting Practices ensures consistency and helps avoid accidental or deliberate misstating of the company’s financial status. 
  • Poor tracking of inventory and cost of goods sold
    Inaccurate inventory control affects productivity and skews COGS reporting. This could reflect lax business management practices, but it could also indicate failure to record the full cost (or any cost) of purchased inventory, inflating vendor discounts, or creating non-existent inventory.
  • Related-party transactions
    Many companies legitimately do business with other entities within their corporate family. However, these transactions can also make it easy to inflate income fraudulently. For example, the company could “sell” a product to its related entity (or to a non-existent entity), then cancel the transaction.
  • Unreported or contingent liabilities
    Bad debts, damaged goods accounted for as inventory, or a pending lawsuit are all examples of unreported or contingent liabilities that may represent future obligations for the company.
  • Large customers recently lost
    It is obvious that losing a major source of revenue is likely to negatively affect the company’s financials, at least in the near term and perhaps longer. But it may also indicate a deeper problem related to product quality or customer service that could spell even bigger trouble for the company.
  • Disengaged management teams
    If management does not regularly review (or understand) key financial reports, this makes it easier for someone to dishonestly manipulate revenue or misrepresent expenses. This affects the accuracy of transaction-related reports, and if the problem is ongoing, it may mean the company is in serious financial jeopardy.
  • Data that cannot be reconciled from the sub-ledger to the financial statements
    With proper accounting, the numbers should match up. If they do not, or transactions cannot be traced without apparent gaps, it is essential to find out why.

Sellers Seeing Through Buyers’ Eyes

Each of the items listed above may cause a buyer to pause if it comes up in a QoE report. This could delay a deal from going through. On the other hand, a seller who gets a QoE report has the opportunity to dig into any potential issues early on and disclose relevant information during the due diligence phase. M&A advisors, who have experience seeing deals through to close, can be very helpful in explaining information in ways that will minimize the potential impact on a deal’s chance for success.

At Redpath and Company, our M&A advisory team provides ongoing guidance and support from beginning to end, to help protect your interests so you can make well-informed decisions along the way. Want more information on potential red flags to avoid? Click the button below to download the PDF.

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