Quality of Earnings vs. Financial Statement Audits – What’s The Difference?

In almost every middle-market M&A transaction, at least some level of financial due diligence is conducted to validate the accuracy, reliability, and sustainability of the target company’s financial information. Most middle-market business owners have limited familiarity with this process before pursuing the sale of their company. The term “audit” is often tossed around when referring to the validation of the company’s financial statements. However, a “Quality of Earning report”, or “QoE” is distinctly different than a financial statement audit and it is important for middle-market business owners to familiarize themselves with QoE’s before pursuing a transaction. While financial statement audits can be a useful tool for many purposes, QoE’s are arguably much more relevant during a middle-market M&A transaction. Buyers rarely rely on audited financial statements to satisfy their financial due diligence. If audited financial statements are available, they are considered; but audited financial statements are almost never required to execute a middle-market M&A transaction.

In this article we will explore the main differences between QoEs and audits and highlight why QoEs are more important in a middle-market M&A transaction.

What does an audit provide?

A financial statement audit is an examination of a company’s financial statements that is conducted for compliance requirements. In the middle-market, the requirement for a financial statement audit is usually driven by lenders, investors, customers, or simply out of good corporate governance from a company’s board of directors or management. Audits aim to ensure that the historical financial statements are materially correct and (typically) presented in accordance with generally accepted accounting principles (GAAP) to assure stakeholders that the financial statements offer a true representation of the company’s historical financial results and financial position.  An audit focuses on reported financial results.  The focus on reported financial results is a key differentiator from a QoE, which we will circle back to later.

Key highlights of an audit include:

• Reporting Periods: Financial statement audits generally focus on annual periods that align with the company’s fiscal year. They are meant to examine the company’s annual internal financial statements and trial balance.
• Focus Areas: Auditors perform substantive analytical and transactional level testing to gain comfort over a company’s reported balance sheet and income statement amounts. They assess the completeness, accuracy, and presentation of financial information to ensure it aligns with accounting standards. Auditors will often include third-party confirmation of cash, accounts receivable, and debt balances to support their testing.
• Deliverables: Auditors provide a formal audit opinion that financial statements were prepared in accordance with GAAP. Auditors also comply with professional standards by issuing formal letters to communicate their audit approach, audit findings, and considerations of a company’s internal controls.

What does a QoE provide?

A QoE is a formal third-party analysis that evaluates the true economic earnings of a company by adjusting the reported earnings for various non-recurring, unusual, or one-time items that may distort the financial performance of the business. A QoE is typically conducted by an independent accounting firm with extensive M&A experience. QoEs are typically conducted during an M&A process. They can be initiated on the sell-side prior to going to market or on the buy-side after the execution of a letter of intent, but before the signing of a purchase agreement.

Key highlights of QoE include:

• Reporting Periods: The QoE evaluates monthly financial data over a “Historical Period” of typically the most recent three (3) fiscal years and trailing-twelve-months (“TTM”). The monthly Historical Period must be a period sufficient for the independent accounting firm to identify trends and any “unusual” items captured in the company’s historical financial statements.
• Focus Areas: The QoE will help identify or validate adjustments to reported EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to reflect the normalized earnings of a company. It is important to note that EBITDA is not a term defined under GAAP and is therefore NOT specifically evaluated in an audit. QoE analyses concentrate on historical normalized EBITDA and include an analysis of the balance sheet for working capital and net debt considerations.
• Deliverables: QoE providers will typically provide a PowerPoint slide deck (containing financial analyses and narrative), as well as an Excel databook (containing monthly financial analyses) upon completion of a QoE. Unlike an audit, a QoE deliverable does not provide an opinion on the financial statements or monthly financial analyses in accordance with professional standards.

Key Differences

• The purpose of an audit is to provide assurance that a company’s financial statements are prepared in conformity with GAAP. The purpose of a QoE, on the other hand, is to analyze and normalize historical results by removing non-recurring, unusual, or one-time items (and perhaps account for changes in the business during the Historical Period).
• Audits focus on a company’s reported financial results, while QoEs focus on a company’s adjusted/normalized financial results. In other words, audits typically focus on net income, while QoEs typically focus on EBITDA.
• Audits typically focus on annual results, while QoEs include an analysis of monthly results. In addition, QoEs typically report on a longer time-period.
• QoE’s typically attempt to identify and report on specific business risks that may be relevant to the buyer, while audits do not.
• QoE’s typically report on specific items relevant to the proposed M&A transaction, such as adjusted working capital and an analysis of indebtedness (as defined), while audits do not.
• Audits typically include detailed testing of account balances and transactions, while QoE’s typically rely on a more analytical approach.

• An annual financial statement audit is typically a compliance exercise, while a QoE is geared toward helping the buyer analyze the potential risks associated with an M&A transaction.

• Buyers in an M&A transaction will almost always rely on a QoE as part of their financial due diligence related to a proposed target and will rarely rely (solely) on a financial statement audit.

Key Takeaways

For business owners in the middle-market who are considering a future M&A transaction, it is important to know the differences between a QoE and an audit. Most businesses in the middle-market transact at a valuation represented by a multiple of adjusted EBITDA. A QoE will tell you what a company’s adjusted EBITDA is, while an audit will not.   Because of this, a QoE is needed whether the company already receives an annual audit or not. While an audit focuses on compliance with GAAP, accounting errors or noncompliance with GAAP are often identified by a QoE.

Having a QoE performed before going to market in an M&A transaction can bring significant value to a business owner. By validating the company’s historical and normalized financial results on the front-end, a business owner can form better expectations of the overall enterprise value of the company pre-M&A transaction. This validation cannot occur by relying on audited financial statements alone.

If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.