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5 issues a quality of earnings engagement can help identify

Quality of Earnings - M&A

By Christopher Hatten

With the anticipated pick-up in middle market mergers and acquisitions (M&A) work for 2017 and 2018, having a detailed quality of earnings (QE) report as part of the due diligence process will be key in getting any deal across the finish line. Though a QE 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. Below are some fundamental points of the QE reporting process:

  1. It is beneficial to note that middle market companies being sold often have not had their financial statements audited or reviewed. Some may also 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. With the above being said, a QE report does not constitute an audit.
  1. Identification and due diligence of risk areas is key. In particular, it is essential to assess those areas subject to management estimation, 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. These risk areas often are not made on a recurring basis, which results in misstated assets and liabilities.Specifically, the assessment period should cover 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.
  1. Though earnings before interest, taxes, depreciation and amortization (EBITDA) is commonly recognized as a preferred metric, there are limitations regarding 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 QE procedures could help identify other metrics to take into account as part of the purchase negotiations.
  1. 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.
  1. 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 U.S. 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 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 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 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 multiple of revenue or EBITDA, the increase or reduction in the deal size can differ significantly.

Christopher Hatten, CPA, CMAA, is a director of Audit and Transaction Advisory Services for PKF Texas. Contact him at chatten@pkftexas.com.