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Audit & Assurance

Audit versus Sell-side Quality of Earnings

Audits Have their Place

Financial statement audits provide various users with a reasonable level of assurance regarding a company’s financial position and performance, as presented in historical financial statements. Audits are sometimes required for financing, regulatory, or investor needs, and they certainly hold their rightful place for reliance on financial statements worldwide. From an investor perspective, there is normally an increased level of comfort regarding the reliability of the target’s financial statements, and underlying data, if a target company has had audits of its financial statements issued for the last two to three years. Additionally, companies that have had annual audits performed are typically much more prepared for a sale and the impending buy-side due diligence, especially with respect to the historical financial information.

The Value of a Sell-side Quality of Earnings (QoE) Report

Having audited financial statements better prepares a company for a sale; however, an interested buyer typically requires additional information not contained in the audited financial statements. A QoE report serves this purpose as it compliments, rather than replaces, a financial statement audit. It provides information about the company’s value now and going forward, normalized and projected income and  earnings before interest, taxes, depreciation, and amortization (EBITDA), customer relationships, market drivers, margin and trend analysis, quality of earnings and working capital. The focus is on sustainability of the company’s earnings. They typically also contain qualitative information about ownership, management, information systems, the accounting team, and consistency of application of accounting policies that an interested buyer requests. Depending on the size and complexity of the deal, it is very common for potential buyers to utilize a financial due diligence team to perform a buy-side QoE engagement on the target company as a means to obtain all of this information.

Is it worth the time and cost to obtain a sell-side QoE report when the buyer may not rely on it and hire their own accounting team to perform buy-side financial due diligence? Here are several ways being prepared with a sell-side QoE report can add value when selling a business:

  • Helps investment bankers provide the value of and market for the business
  • Minimizes surprises that commonly occur in the buy-side QoE process
  • Identifies add-backs to earnings and EBITDA to increase sale price
  • Helps solidify the value of the business before the process begins
  • Decreases the chance of a value reduction during negotiation and due diligence
  • Allows the seller to control the process and the favorability of adjustments to EBITDA
  • Adds credibility to your financial statements and projections
  • Prepares a seller’s advisors for negotiations with the buyer’s due diligence team
  • Identifies normalization and non-recurring adjustments pre-buy-side due diligence
  • Identifies and corrects accounting issues in advance
  • Allows for an efficient transaction, since the seller is prepared in advance
  • Establishes a working capital target that minimizes the risk of unfavorable adjustments during buy-side due diligence, which could reduce the sale price

What does a sell-side QoE entail?

Each potential buyer has specific concerns and key risks, so the buyer would have the team tailor the due diligence work with more focus in those identified areas. Due diligence as a whole includes information technology, operational matters, legal issues, marketing strategies, personnel, and a wide range of other areas. Financial due diligence in the form of sell-side QoE focuses on providing investors with information about a company’s sustainable earnings, sales and expense trends, working capital trends and requirements, assumptions included in estimates, key personnel, and accounting systems.

Because businesses are often valued-based on a multiple of EBITDA, QoE reports are designed to provide more information about the quality or sustainability of a company’s earnings by looking deeper into a company’s financial statements and supporting data to adjust historical EBITDA to reflect sustainable earnings. EBITDA is a financial metric that is perceived to be more indicative of the value of a company than net income, since it is widely considered to be a good indicator of whether, and how much, a business can generate positive cash flow by removing the impact of financing and capital expenditures.

In a sell-side QoE engagement, normalizing and other adjustments to EBITDA are identified and documented, ideally before buy-side due diligence begins. Typical EBITDA adjustments include non-recurring income and expense items, assets and liabilities that are improperly stated, post-closing cost structure changes, and applying consistency of generally accepted accounting principles.

Trend analysis in QoE reports are focused on market drivers, sales strategies, customer relationships and churn, the company’s cost structure, and vendor relationships. The analysis is aimed at helping readers understand whether such trends are sustainable. QoE engagements can also assist with identifying post-transaction synergies and strategies.

Working capital is another important aspect of due diligence. A working capital target is negotiated between the buyer and seller, which is provided for at the close of the transaction. Such amount is often based on average working capital over the prior 12 months. However, a buyer might also consider growth or contraction of the industry and the company, seasonality of the business, and other factors. Buyers are at a disadvantage because specific details of working capital balances are not available to them. As such, buyers may place emphasis on the details of working capital near the close of due diligence.

Buyers are also focused on management’s forecasts, since they present the company’s ability to sustain and grow earnings. Therefore, they want to understand the key assumptions used in any included forecasts. Key assumptions used should be well documented to enable potential buyers to assess the feasibility of management’s forecasts. Having these prepared and vetted ahead of time will again provide for a smoother process during buy-side due diligence and build confidence in the reasonableness of the forecast.

A sell-side QoE engagement can provide many benefits, add significant value, and uncover potential issues with a path for remediation to help sellers obtain a higher value. Windes can work with business owners and their advisors to determine if a sell-side QoE report is right for them.

If you have questions or would like more information, please contact Jeff Parsell at or 844.4WINDES (844.494.6337).

Jeff Parsell
Jeff Parsell, CPA

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