Quality of Earnings, or “QoE”, is a topic that all middle-market business owners contemplating an M&A transaction should be familiar with. A QoE is a formal third-party analysis performed by an independent accounting firm as part of an M&A transaction that, among other things, 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.
The QoE provides an assessment of recurring earnings and historical trends of the company. As part of this assessment, the QoE will calculate the company’s adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Adjusted EBITDA is a proxy for the company’s recurring earnings; and therefore, is an important metric that is typically analyzed when valuing a business in the middle-market. A QoE typically evaluates monthly financial data over a “Historical Period” (typically the most recent three (3) fiscal years and the trailing-twelve-months (“TTM”) period) to identify trends and any “unusual” items captured in the company’s historical financial statements.
There are various common EBITDA adjustments that are identified by a QoE:
GAAP Adjustments
When it comes time for an M&A transaction, accurate financial reporting in accordance with generally accepted accounting principles in the United States (“GAAP”) is critical to determining the value of a business. During a QoE, the company’s financial statements will be analyzed for compliance with GAAP and adjusted accordingly. The most common GAAP-related items that are scrutinized by a QoE include:
- Revenue Recognition. In accordance with GAAP, a company should recognize revenue when the performance obligations related to providing products or services to its customers are satisfied. Especially in cases where audited financial statements are not available for a company, it is not uncommon for a QoE to identify improper revenue recognition, or failure to report revenue in the correct period. For example: a company operates a business that sells annual service contracts to its customers. The company invoices its customers for the entire contract up-front before the service period starts. Internally, the company reports revenue for these service contracts, in full, when the customer is invoiced. For this type of revenue, GAAP normally requires the revenue to be recognized ratably over the service period as performance obligations under that contract are satisfied. A QoE will identify, quantify, and adjust revenue, and therefore EBITDA, to be compliant with GAAP.
- Inventory Valuation. For companies that sell products to customers (generally manufacturing and distribution businesses), the company’s inventory valuation methodologies are heavily scrutinized by a QoE. Inventory valuation methodologies generally require estimates on behalf of management, whether it be standard material costs, labor and overhead rates, or reserves for excess or obsolete inventory. A QoE also evaluates a company’s inventory controls related to costing, counting, tracking, and monitoring inventory levels. Inaccurate or improper inventory valuation methodologies and controls affect the company’s cost of good sold, gross margins, and therefore EBITDA.
- Cash-to-Accrual Adjustments. While middle-market businesses generally will record vendor expenses as accounts payable when invoiced (accrual-basis), it’s not uncommon for these businesses to report certain other operating expenses when paid (cash-basis). Examples of expenses that are commonly reported on the cash-basis are payroll and employee benefits (i.e., 401k and paid-time-off benefits), bonuses, commissions, property taxes, corporate insurance, corporate events, and corporate dues and subscriptions. A QoE will identify and quantify these cash-to-accrual adjustments. It’s also fairly common for companies to make certain “true-up” accounting adjustments for these items only at year-end. Since a QoE includes an analysis of monthly results, these adjustments typically need to be reallocated to the months to which they relate.
- Reclassification Adjustments. It’s common for a company’s internal financial statements to require certain reclassifications to accurately portray the company’s financial results in a QoE. For example, a company that operates a service business may not report a separate expense class on its income statement for Cost of Revenue, instead it reports all its expenses as Operating Expenses. In this case, a QoE will identify and quantify reclassifications to Cost of Revenue that represent the company’s payroll, materials, and other costs required to service its revenue. While these reclassifications may not have an impact on EBITDA, they will ultimately determine the company’s gross margins which are important to the users of a QoE who are evaluating the historical performance of the company.
Non-Operating and Non-Cash Income and Expense
As defined, “reported” EBITDA already removes the impact of interest, taxes, depreciation, and amortization. Other non-operating and non-cash income and expense are then removed to derive adjusted EBITDA. Common examples include investment income/loss and gains/losses on the sale of assets.
Non-recurring Items
It’s common for companies to experience one-time or unusual transactions that are isolated and otherwise do not occur throughout the normal course of business. Since these items typically do not affect the true recurring earnings capability of the company, they are typically removed to derive adjusted EBITDA. Common examples of non-recurring items that are adjusted include one-time legal, professional, or consulting fees, penalties or fines, refunds, credits, and settlements.
Normalizing Items
Company expenses naturally fluctuate over the Historical Period. It’s also common for “new, normal” expenses to begin later in the Historical Period. A QoE adjusts these items to show the effect on EBITDA had they existed consistently, at their current normal rate, over the entire Historical Period. A “normalizing” adjustment to EBITDA is recorded to “smooth” the expense over the Historical Period. Common examples include normalizing travel and entertainment expenses over the Historical Period, normalizing corporate insurance cost over the Historical Period, normalizing repairs and maintenance costs of the Historical Period, and normalizing bad debt or inventory write-offs over the Historical Period.
Owner-Discretionary Items
It’s not unusual for a company to pay for certain personal expenses of the business owner, resulting in “owner-discretionary” expenses being recorded in the company’s financial statements. Since these expenses are outside the normal course of business, and typically not expected to continue post-transaction, a QoE removes them from adjusted EBITDA. Common examples of owner-discretionary items include personal vehicle costs, travel, meals and entertainment, country club dues, and family members on the payroll even though they don’t work for the company.
Owner Compensation
It’s common for a company’s owner to pay his or herself compensation (through the company’s payroll) that is above or below market rates. For example, a business owner is the active President & CEO of the company and earns an annual salary of $500,000. A QoE considers what the current market rates are for that position. If current market rates for that position are $250,000, then the QoE will adjust historical compensation to $250,000 (the equivalent of the replacement cost for that position), which would have a positive impact on the company’s adjusted EBITDA. Alternatively, in that same scenerio, if the business owner primarily takes money out of the business through equity distributions, maybe they’re only taking an annual salary of $100,000 from the company. In that case, adjusting the historical compensation to $250,000 would have a negative impact on the company’s adjusted EBITDA.
Related-Party Transactions
Many companies do business with other entities owned by the same shareholders. In many cases, these transactions aren’t conducted at arm’s length and need to be adjusted as if the transaction were conducted with a third party. The most common related-party transactions in middle-market businesses relate to property leases. In this case, the company’s business owner also owns the property where the company conducts its business. The property is generally owned through a separate legal entity, and the company leases the property from that entity. Because the business owner is essentially “paying themselves” for rent, that rent may not be at market rates. A QoE will adjust historical rent expense as if the rent was paid at arm’s length at market rates.
Another example is a company that purchases goods or services from a sister company within the same “corporate family”. Because of that related-party relationship, the company may benefit from discounted pricing from its sister company that results in significant savings. Since the transactions are not conducted at arm’s length, and that favorable pricing would likely go away if the company was under new ownership, a QoE will adjust historical EBITDA had those goods or services been purchased at arm’s length market rates.
Pro-Forma Adjustments
Pro-forma adjustments are adjustments to past reported results, as if events that have occurred or are expected to occur took place at the beginning of the Historical Period. These items are expected to affect EBITDA on a go-forward basis and are adjusted in a QoE. Common items that are evaluated for pro-forma adjustments are: rent escalations, impacts of recent M&A transactions, payroll costs based on current headcount and compensation rates, impacts of recent significant customer additions or losses, impacts of recent significant changes in supplier costs, impacts of recent investments in production capabilities, impacts of recent organic business expansions (i.e., new locations or geographies).
Summary of Common QoE Adjustments
| Adjustment Type | Common Examples |
| GAAP Adjustments | · Revenue recognition · Inventory valuation · Cash-to-accrual adjustments · Reclassification adjustments · Allocation of annual items across relevant months |
| Non-Operating and Non-Cash Income and Expense | · Investment income/loss · Gains/losses on sale of assets |
| Non-Recurring Items | · One-time legal and professional fees · One-time consulting fees · One-time penalties and fines · One-time refunds or credits · One-time settlements |
| Normalizing Items | · Normalization of travel and entertainment costs over Historical Period · Normalization of corporate insurance costs over Historical Period · Normalization of repairs and maintenance costs over Historical Period · Normalization of bad debt or inventory write-offs over Historical Period |
| Owner-Discretionary Items | · Personal vehicle costs · Personal travel and entertainment costs · Personal country club or other membership dues · Payroll costs of family members who don’t work in the business · Management fees |
| Owner Compensation | · Adjustments to current market rates |
| Related-Party Transactions | · Adjustment to current, arms-length, market rates |
| Pro-Forma Adjustments | · Impacts of rent escalations · Impacts of recent M&A transactions · Impacts of recent significant changes in headcount and compensation rates · Impacts of recent significant customers additions or losses · Impacts of recent significant changes in supplier costs · Impacts of recent investments in production capabilities · Impacts of recent organic business expansions |
Final Thoughts
All middle-market business owners considering a sale of their business should be familiar with QoEs. Potential buyers will almost always require one, and potential buyers will almost always value the business for sale based on a multiple of adjusted EBITDA. So, it is important for middle-market business owners to anticipate the need for a QoE and have a basic understanding of what potential EBITDA adjustments may be proposed in a QoE.
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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.
