Key Takeaways:

• Understanding the differences between QoE assessments and financial statement audits can help guide what may be needed or useful for a successful financial transaction.
• QoE assessments focus on evaluating historical earnings, particularly EBITDA, adjusted for factors like non-recurring activities, out-of-period accounting true-ups, and operational changes.
• Audits ensure compliance with accounting standards and provide assurance regarding the accuracy of financial statements.
• QoE assessments and audits are not mutually exclusive, and the choice between them depends on factors such as the transaction stage, regulatory requirements, and the quality of financial detail and financial reporting.
• QoEs should almost always be performed for the sale/purchase of a business, but the necessity of an audit is more dependent on the specific circumstances.

Table of Contents

• What Is a Quality of Earnings Assessment?
• What Is an Audit?
• QoE v. Audit: When Each Is Needed
• Key Differences Between QoE assessments and Audit
• Putting It Together: Choosing Between a QoE or Audit

As financial due diligence (FDD) professionals, we are often asked to explain the differences between a quality-of-earnings (QoE) assessment and a financial statement audit, as well as what is required from a financial perspective to facilitate a successful transaction.

This guide clarifies these distinctions, provides insight on the nuances between a QoE assessment and a financial statement audit, and shows what is needed to achieve a smooth transaction process.

A quality-of-earnings (QoE) assessment is an evaluation of a company’s historical earnings, specifically focusing on EBITDA (earnings before interest, taxes, depreciation, and amortization). This assessment involves adjusting EBITDA for the impacts of non-recurring or non-operational activities, out-of-period activities, accounting normalizations, and operational changes within the business.

EBITDA is often regarded as the most significant indicator of a company’s value during transactions and is used as a proxy for the operational cash flows of the business. Therefore, understanding its composition and historical performance is essential, and a QoE assessment aims to provide a clearer picture of a company’s EBITDA.

Key focus areas of a QoE assessment include:

• Historical Financial Statements: Emphasis is placed on the income statement and balance sheet, with a detailed examination of EBITDA performance monthly, typically covering the previous two to three fiscal years and the most current trailing or last twelve months (referred to as either TTM or LTM). This includes detailed reviews of monthly trial balances, balance sheet and subledger account details, employee census/headcount information, and various operational datasets (such as sales details by customer/product/job and purchasing details by vendor/type/product) that are utilized to understand and analyze the historical EBITDA performance.

Adjusted Income Statement

• EBITDA Adjustments: This involves understanding the composition and calculation methodologies of adjustments for non-recurring or non-operational activities, out-of-period activities, accounting normalizations, and operational changes which are applied to Reported EBITDA to arrive at Adjusted EBITDA.

Quality of Earnings - EBITDA Adjustments

• Balance Sheet Analysis: This involves identifying working capital and net debt considerations, which are crucial for the purchase agreement, as there are various financial terms (such as Cash, Indebtedness, Net Working Capital, and Income Taxes) included in the agreement that FDD providers assist in defining and quantifying.

Net Working Capital

Net Debt

• Audited Financial Statements: These may be used in a QoE assessment to reconcile the financial details provided to the amounts covered in the audit. Furthermore, the workpapers prepared by the auditors may be obtained and read by FDD professionals to provide additional insight on trends anomalies and key accounting policies adopted by the company.

A financial statement audit is an examination of a company’s financial statements conducted for compliance purposes. Audits aim to ensure that the financial statements are materially correct and presented in accordance with generally accepted accounting principles (GAAP) and/or other relevant accounting standards to assure stakeholders that the financial statements offer a true and fair representation of the company’s financial performance and position.

Key focus areas of an audit include:

• Financial Statements Examination: Auditors scrutinize the income statement, balance sheet, cash flow statement, and statement of retained earnings for the most recent fiscal year. They assess the completeness, accuracy, and presentation of financial information to ensure it aligns with accounting standards.
• Detailed Financial Information: Like QoE assessments, auditors may request key information such as monthly trial balances, balance sheet details, employee census/headcount information, and operational datasets. In certain instances, auditors may delve into more detailed financial information, possibly at the transactional level, when conducting substantive detail testing.

• Audit Opinion: Auditors provide a formal audit opinion that financial statements were prepared in accordance with a set standard of accounting policies and document their audit approach and processes for determining such in their audit workpapers.

It is important to note that EBITDA is not defined under GAAP and is often NOT presented in an audit.

Income Statement per Audit

Quality of Earnings

QoE assessments are typically conducted during transaction processes. QoEs are typically initiated on the sell-side prior to going to market and on the buy-side after the execution of a letter of intent or indication of interest, but before the signing of a purchase agreement. Additionally, QoE assessments may be necessary for refinancing purposes during lenders’ underwriting processes. These assessments focus on presenting the financials in accordance with GAAP but do not alter the accounting process of the business.

Is a QoE assessment needed if a company’s financial statements are audited? QoEs should almost always be performed for the sale/purchase of a business.

Key points regarding QoE assessments include:

• Timing: QoE assessments are performed during transaction processes with a focus on the last twelve months (compared to prior fiscal year periods). QoEs are typically performed in about a month (but could be longer for more complex businesses).
• Focus Areas: QoE assessments concentrate on historical financial statements and EBITDA performance, including balance sheet analysis for working capital and net debt considerations.
• Roll Forward: QoE assessments may be rolled forward (i.e., updated) through a more current period to analyze the recent performance of a business before the purchase agreement is signed.
• Judgment/Variability: QoEs are not universal and subject to the rationale, logic, and biases of the advisors performing the assessment. Different advisors performing a QoE on the same business may come up with a different result, which has led to the progression of most deals having separate QoE advisors that represent the buyer and seller.
• Increasing Relevance: While not as common as audits, QoE assessments are becoming more prevalent and are utilized by both buyers and sellers. In a competitive auction sale process, there may be multiple QoEs performed on the business (one performed by the seller’s advisors that is used in the marketing of the business and one for each buyer that progresses to later-stage bidding).

Audits

Audits are conducted annually after the fiscal year-end and are essential for regulatory compliance and maintaining financial credibility with stakeholders. The necessity of an audit depends on various factors, including costs, efforts required, and the need for audited financial records for a transaction.

Key points regarding audits include:

• Timing: Audits are performed on an annual basis as part of regulatory requirements and financial credibility maintenance. Audits often take multiple months to complete.
• Focus Areas: Audits review comprehensive financial statements (income statement, balance sheet, cash flow, and retained earnings) for the most recent fiscal year.
• Judgment/Variability: Audits are performed under set rules and regulations and provide an opinion that financial statements were prepared in accordance with a set standard of accounting policies. Therefore, in theory, all audits should result in the same result and are not generally subject to an auditor’s judgment.

Both QoE assessments and audits play vital roles in evaluating a company’s financial health, but they differ significantly in terms of who performs them, their independence, the nature of their deliverables, and their intended users.

Who Performs Them?

QoE assessments are conducted by FDD professionals, operating within both independent CPA and non-CPA financial services firms, specializing exclusively in transaction and M&A advisory services. In contrast, audits are performed by audit and assurance professionals within independent CPA firms only.

Additionally, QoE assessments are typically engaged by buyers (such as private equity firms or corporate sponsors) or sellers in a transaction, whereas audits are engaged by the company undergoing the audit process.

Independence

QoE assessment providers are generally independent entities but do not issue formal opinions and are not subject to regulatory oversight. In contrast, auditors adhere to stringent independence guidelines and issue formal audit opinions.

Providers of QoE assessments may have restricted access to company management and financial information, particularly when engaged by the buyer, whereas auditors have complete, unrestricted access to both company management and detailed financial information.

Access to Management and Financial Information

FDD providers generally have limited access during a QoE assessment to company management and financial information and comparatively less access when engaged by the buyer. This can be due to time constraints imposed by the transaction process or scope limitations imposed by the seller.

In contrast, auditors are typically granted full and unrestricted access to company management and information, as this level of access is required to obtain the necessary documentation and clarifications to perform an effective audit.

Deliverables

QoE assessments typically yield PowerPoint presentations and/or Excel Databook deliverables outlining their findings. QoE assessments are often ever changing as new or more recent information becomes available. In contrast, audits generate formal audit opinion and management representation letters, which accompany the company’s annual financial statements.

Who Uses Them?

Audits are primarily utilized by company management, current and prospective shareholders (both public and private), audit committees, regulators (e.g., the Securities and Exchange Commission), and lenders for annual compliance purposes.

QoE deliverables are prepared solely for the benefit of the engaging party, either the buyer or seller, and are shared on a non-reliance basis with other parties at the engaging party’s discretion. QoE assessments are often utilized by:

• Buyers utilize them to underpin their valuation of a business and identify transaction purchase agreement considerations.
• Lenders leverage them to evaluate earnings and cash flow generation for financing purposes.
• Sellers can use them to facilitate a more efficient sale process when engaging with potential buyers. In these circumstances, the QoE deliverable prepared on behalf of the seller is shared with the buyer’s FDD and other due diligence providers (as applicable).
• Reps & Warranty insurers use QoE assessments to examine the accuracy of a company’s representation regarding compliance with GAAP or specific policies.

Quality of Earnings - EBITDA Adjustments

Adjustments for Non-Recurring or Non-Operational Activities

Examples of adjustments for non-operational or non-recurring activities may include compensations paid to former shareholders or employees not actively involved in the business or professional fees paid to consultants for implementing a new ERP system. While these activities might represent legitimate expenses for the business and would be shown in an audit, they are typically excluded from EBITDA on an adjusted basis to determine a fair valuation of the business for a transaction.

i) Non-Recurring or Non-Operational Activities

Adjustments for Out-of-Period Activities

Often, companies use estimates to record expenses when the final amount will not be known until later. This can cause fluctuations in future periods when the actual expense becomes known and the expense is trued up.

For example, consider if a company expects to pay their employees a bonus of $120k at the end of the year. If they actually paid the employees $200k, there would be an extra expense of $80k presented at the end of the year that should get spread back to the months it relates to on an adjusted basis.

ii) Out-of-Period Activities

Adjustments for Accounting Normalizations

FDD service providers often utilize the benefit of hindsight or longer-term historical trends to present revenues or expenses in a manner more indicative of the normal course of operations for a given year. For instance, if a business incurred significantly higher bad debt expense in a particular year compared to historical averages, an accounting normalization may be necessary to present EBITDA at the historical average level of bad-debt expense.

iii) Accounting Normalizations

Adjustments for Recent Operational Changes

As businesses grow and evolve over time, there are often operational or strategic changes in the business that impact the underlying earnings. For example, if a company opens a new location that is expected to generate $400k of EBITDA on a full-year basis, an EBITDA adjustment may be considered for the periods prior to the new location opening to present EBITDA as if this new location had been open for the full year.

Note that adjustments for operational changes are typically the most subjective and often the most difficult to quantify. However, their impacts can have a material impact on the valuation of a business during a transaction process.

iv) Recent Operational Changes

The decision between a QoE assessment and an audit is influenced by factors such as cost, timing, disruption, and the specific needs of the business or transaction.

While audits ensure the accuracy of financial statements, they can be costly, time prohibitive, and disruptive. Further, audits provide no assurance to an investor relating to EBITDA of the company as audits do not address EBITDA or consider any forms of normalizations.

The necessity of either a QoE assessment and/or an audit depends on the risk associated with a company’s financial reporting, time, and resources available, and the specific circumstances surrounding the transaction.

Consulting with financial due diligence professionals can help you determine the most appropriate approach tailored to your specific objectives.