Conducting Quality of Earnings Due Diligence
Performing a Quality of Earnings review of the seller’s financial statements is one of the most important steps in buying a business. Here is where you verify the earnings of the underlying business and any “add backs” that the seller added to the earnings as a representation of what a new owner could expect to receive in cash flow.
There are 4 important questions to ask when conducting quality of earnings diligence:
For businesses larger than $500,000 – $1 million in earnings, buyers generally hire accounting due diligence firms. Their job is to get into the details and prepare spreadsheets and reports of their findings for the buyer. You can expect these firms to be extremely detail oriented and prepared to double-check everything for their client.
The diligence firm provides a request list of documents they will use to verify the earnings the seller has represented. Most likely, the firm will spend a few days to a week on site at the company to ask more questions, fine-tune requests, and ask follow-up questions as they get into the details.
Quality of Earnings reviews generally happen after a Letter of Intent is signed. It’s generally the first diligence project undertaken by buyers. You will want to verify the earnings power of the business before you spend money with attorneys to draft the legal documents required to close a deal.
Sellers often don’t represent their earnings power properly – not because of ill intent, but simply because they are not accounting experts. Financial statements need to be in proper accounting format so that all buyers and lenders understand them For businesses whose accounting is very well done and who don’t make any aggressive add-backs, this will be a “check the box” part of diligence, and should be relatively easy. If accounting is not well done, however, it could be more time consuming and problematic.
WHAT YOU MIGHT FIND IN A QUALITY OF EARNINGS REVIEW
Revenue or expenses in incorrect periods. It is sometimes easy for revenue or expenses to be accounted in an improper period. Those are easy for diligence firms to spot.
Improper accrual accounting. This is related to the first point, in that accrual revenue or expenses may not be done properly which results in revenue or expenses being in an incorrect period. Also, many businesses that have deferred revenue (customers pay before the service is delivered) do not properly account for it. Accounting for these funds too early causes earnings to be higher than accounting rules would allow.
Discontinued operations. If the seller closed a money-losing business, buyers will look at that as a nice gain for the future. On the other hand, if they had a money-making business that they are no longer operating, you don’t want to include that in the earnings power of the business going forward.
Open employee positions or missing expenses. Are there open positions on the org chart? If so, assume you will need those positions and reduce their earnings estimate to account for it. Is there an obvious expense that they were able to avoid historically, but will be needed in the future?
Improper add-backs. For obvious reasons, sellers want to make their earnings look as strong as possible. Some add-backs are logical and correct. Salaries for owners that are larger than what is needed to pay a professional manager, for example. Other add-backs are not as defensible.
Pro forma adjustments (may not be anything you can influence). While you may not be able to affect this, many buyers add in other expenses that they assume they will need, such as a budget to pay an audit firm to review financial statements. Or, maybe you want to expand the board of directors, in which case you would add budget for that.
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