quality of earnings case study

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Quality of Earnings: A Key Pillar of Financial Due Diligence

Financial due diligence is the process of making sure the price of an asset is in line with its operating performance “under the hood.” Assessing the quality of earnings is one of its key tests: How sustainable is the business’ reported financial performance?

By Saveen Kumar

Saveen is a qualified chartered accountant in the UK with an MBA from the University of Oxford.

Before entering into any transaction with another party, it’s important to do your own financial due diligence to confirm the facts. Are you really getting what you think you’re getting? Or have you found the next Luckin Coffee?

During financial due diligence (FDD), three pieces of analysis are key to determining the right price to pay for the deal:

• Quality of earnings (QofE)
• Net working capital (NWC)

I refer to these tests as the three pillars of financial due diligence . At a high level, we are trying to locate items that relate to the normal course of business, capture material cash flows not captured in financial statements, verify the consistent accounting treatment of items, and ensure that items are recognized in the correct time period.

More often than not, an adjustment in any one of the pillars will impact items in the other two. As a rule of thumb, every balance sheet item related to lines above EBITDA should be part of NWC, while every item removed from QofE and NWC, with any actual cash impact in the current year or in near-term future, should be considered for net debt.

In a series of articles, I will delve deeper into how to perform these tests, starting here with quality of earnings.

Assessing Quality of Earnings in Due Diligence

Quality of earnings answers the salient question of whether a topline or cost line from the current year is from a principal business activity, or is just a one-off. Due diligence practitioners are therefore looking to ascertain what the normal and sustainable level of earnings is so as to ensure the multiple-based price being paid in the transaction is fair.

Of all the analyses in an FDD report, quality of earnings is perhaps the most closely watched, as enterprise value is often driven by FDD-adjusted EBITDA rather than the figure reported by management. A successful $100k reduction to EBITDA would translate to a $1 million reduction in price for a deal going at a 10x EBITDA multiple. Therefore, adjustments normally deemed immaterial are all under scrutiny due to their potential impact on price.

Examples of Quality of Earnings Adjustments

When looking at the types of adjustments that would be made during QofE analysis, the following are the most prominent that I have encountered in my work:

As you can see, there are elements in the table that correspond with the annual race to meet budgeted targets. Yet, when it comes to a transaction, the buyer is, more often than not, only concerned with the ongoing core operation of the business. Hence the need to strip out anything that is not a core component of “business as usual” activity.

Case Study: Fashion Retail

Let’s show the adjustments in action by walking through a case study example for a fashion retailer.

The acquisition target is Fashion X, a small retailer with 10 stores across the region. During the due diligence process , the following factors were determined:

• The company has a December year-end and adheres to IFRS accounting standards.
• 20% increase in EBITDA from last year
• Expected deal value to be 10x EBITDA
• The setup time for stores, from when stores are opened to when they get profitable, is estimated at six months. All setup costs are expensed above EBITDA.

Three stores were opened at end of Sep-18 with the following details:

• One unprofitable store was closed at the end of Jun-19. The total loss of the store and the cost of closure was $100k in FY19. The store lost $10k in FY18.
• Year-end provisions summary shows unused contingency accrual reversed in current year, increasing EBITDA by $100k.

Breaking Down the Case

Due diligence is a forensic exercise where practitioners must parse information and focus on key points that emerge. Here are the key insights drawn from the case data that impact quality of earnings.

1. One-off store setup costs

For any business that can increase revenue by adding a discrete revenue-earning unit (e.g., a restaurant, retail outlet, production unit), it is fairly common for the unit to have a one-time setup cost. Often, these costs, to the extent they are expensed to P&L above EBITDA, are reversed within QofE as they are considered a one-off. In this case, the total setup cost over six months was $20k (10+5+5). Of these six months, three (Oct-Dec) are in FY18 and the other three in FY19 (Jan-Mar), therefore, the cost in FY18 and FY19 are both reduced by $10k.

In a deal, everything eventually boils down to negotiation, nothing is in black and white. If the business is expanding and it is normal to add 2-4 stores a year (i.e., it has been doing it consistently over the last few years), the buyer can argue that these are not one-off costs but are incurred in the normal course of business. This would knock off $100k from the deal price.

2. Six-month loss for new stores

Similar to setup costs, it is fairly common for a new unit to have a “ramp up” time and operate under loss during that time. This could be due to time spent in marketing, getting production to a minimum level, or putting together a successful store team. These initial losses are also reversed within QofE. The total loss over six months from Sep-18 was $100k (50+40+10), therefore, the costs in FY18 and FY19 are both reduced by $50k.

3. Annualized profit for new stores

Even though the retail unit lost money in the first six months of operation, it is an investment in the business that is expected to yield higher revenue, as is demonstrated by the stores being profitable subsequently. QofE numbers are adjusted to reflect this.

4. Loss-making store sale

The business that the buyer will get won’t have the loss-making store. Therefore, the cost incurred and the losses related to the business are reversed (FY19: $100k; FY18: $10k).

5. Contingent consideration timing

Businesses often end up under- or overestimating accruals, which can overflow into next year at year-end. When the actual invoice comes in, the management may need to adjust the accrual, leading to some cost recognition in the wrong period. This is perfectly acceptable from an audit or accounting point of view, but in FDD, we would adjust for it.

Why adjust for previous years when the final price would be based on the current year? This is done to get a better idea about the underlying growth story. Note that while the underlying earnings of the business are better than reported, the adjusted earnings grew only by 1.5%, compared to the 20% reported growth.

Taking the above into account, the quality of earnings table would look like:

As you can see, there are material changes to the “business as usual” figures as a result of the store expansion. The adjusted earnings show an uptick as these costs are added back, which in the resulting negotiations would give consideration toward a higher expected sale price.

A Word of Caution

Financial due diligence is not an audit and will not completely protect you against misinformation and fraud. However, it will make your case stronger and help you to negotiate a better price. On many occasions, deals are done on the basis of a strategic rationale, with FDD being of limited importance in such scenarios.

This walkthrough is intended to give a practical example of why QofE is vital during deal negotiations and how financial due diligence works in practice. In subsequent articles, I will explore net debt and working capital in a similar manner to complete the three pillars.

This should give you some idea about these value drivers in a deals scenario. However, these would need to be adapted to specific needs of a deal or a business, for which it would help to engage specialized consultants to chalk out a custom plan and put your best foot forward in deal negotiation.

Further Reading on the Toptal Blog:

• How Forensic Accounting Can Supercharge Your Financial Risk Analysis

Understanding the basics

What is a good quality of earnings.

Good quality earnings are consistent and transparent numbers that are likely to continue on an ongoing basis. Thus, they are likely to exclude activities related to: discontinued operations, one-off revenues/costs, and items not related to the current year.

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Quality of Earnings: A Case Study Collection

"Earnings Quality" has been a subject of investigations by regulators in many countries, articles in most, if not all, business publications, and significant debate in recent years. It is a matter of importance in the financial reporting and regulatory communities, and it impacts the confidence of investors in global financial markets. For this reason, the American Institute of CPAs in the U.S. engaged authors and experts to assemble this collection of case studies, to put the reader in the seat of executives making decisions that could impact the future of their company, and their own and their employees' livelihoods.

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What Is Quality of Earnings?

The bottom line.

• Corporate Finance
• Financial statements: Balance, income, cash flow, and equity

Quality of Earnings: Definition, Why It’s Important, and Analysis

A company’s quality of earnings is revealed by dismissing any anomalies , accounting tricks, or one-time events that may skew the real bottom-line numbers on performance. Once these are removed, the earnings that are derived from higher sales or lower costs can be seen clearly.

Even factors external to the company can affect an evaluation of the quality of earnings. For example, during periods of high inflation, quality of earnings is considered poor for many or most companies. Their sales figures are inflated, too.

In general, earnings that are calculated conservatively are considered more reliable than those calculated by aggressive accounting policies. Quality of earnings can be eroded by accounting practices that hide poor sales or increased business risk .

Fortunately, there are generally accepted accounting principles (GAAP) . The more closely a company sticks to those standards, the higher its quality of earnings is likely to be.

Several major financial scandals, including Enron and WorldCom , have been extreme examples of poor earnings quality that misled investors.

Key Takeaways

• A company’s real quality of earnings can only be revealed by spotting and removing any anomalies, accounting tricks, or one-time events that skew the numbers.
• Quality of earnings is the percentage of income that is due to higher sales or lower costs.
• An increase in net income without a corresponding increase in cash flow from operations is a red flag.
• Tracking activity from the income statement through to the balance sheet and cash flow statement is a good way to gauge quality of earnings.

Importance of Quality of Earnings

One number that analysts like to track is  net income . It provides a point of reference for how well the company is doing from an earnings perspective. If net income is higher than it was the previous quarter or year, and if it beats analyst estimates, it’s a win for the company.

But how reliable are these earnings numbers? Due to the myriad of  accounting conventions , companies can manipulate earnings numbers up or down to serve their own needs.

Some companies manipulate earnings downward to reduce the taxes they owe. Others find ways to artificially inflate earnings to make them look better to analysts and investors.

Companies that manipulate their earnings are said to have poor or low earnings quality. Companies that do not manipulate their earnings have a high quality of earnings. This is because as a company’s quality of earnings improves, its need to manipulate earnings to portray a certain financial state decreases. However, many companies with high earnings quality will still adjust their financial information to minimize their tax burden.

As noted above, companies with high quality of earnings stick with the GAAP standards. The fundamental qualities of those standards are reliability and relevance. That is:

• Reliability : The metric is verifiable, free from error or bias, and accurately represents the transaction.
• Relevance : The metric is timely and has predictive power. It can confirm or contradict prior predictions and has value when making new predictions.

Analysis of Quality of Earnings

There are many ways to gauge the quality of earnings by studying a company’s annual report.

Analysts usually start at the top of the income statement and work their way down. For instance, companies that report high sales growth may also show high growth in credit sales. Analysts are wary of sales that are due only to loose credit terms. (Changes in credit sales, or accounts receivable, can be found on the balance sheet and cash flow statement .)

Working down the income statement, analysts then might look for variations between operating cash flow and net income. A company that has a high net income but negative cash flows from operations is achieving those apparent earnings somewhere other than sales.

One-time adjustments to net income, also known as nonrecurring income or expenses, are another red flag. For example, a company may decrease expenses in the current year by refinancing all of its debt into a future balloon payment. This would lower debt expense and increase net income for the current year while pushing the repayment problem down the road. Naturally, long-term investors don’t care for that move.

Example of Earnings Manipulation

A company can manipulate popular earnings measures such as earnings per share (EPS) and price-to-earnings (P/E) ratio by buying back shares of its own stock, which reduces the number of shares outstanding. In this way, a company with declining net income may be able to post EPS growth.

When earnings per share go up, the price-to-earnings ratio goes down. This should signal that the stock is undervalued . It doesn’t, though, if the company changed the number by simply repurchasing shares.

It is particularly worrisome when a company takes on additional debt to finance stock repurchases. Companies might do this to artificially inflate the per-share price of their stock by reducing the number of shares available for purchase on the open market, thus giving the impression that the value of the stock has increased.

Which Earnings Calculation Is Considered More Reliable?

Earnings that are calculated conservatively are considered more reliable than those calculated by aggressive accounting. Quality of earnings can erode when accounting practices hide poor sales or increase business risk.

What Does Quality of Earnings Say About a Company?

Companies that stick with generally accepted accounting principles (GAAP) standards are said to have high quality of earnings. Companies that manipulate their earnings are said to have poor or low earnings quality.

What Are Red Flags in Annual Company Reports?

Matters of concern to analysts in a company’s annual report include:

• If high sales are due only to loose credit terms
• If there is high net income but negative cash flows from operations
• If there are one-time adjustments to net income, also known as nonrecurring income or expenses

A company’s real quality of earnings is revealed by spotting and removing any anomalies, accounting tricks, or one-time events that may skew the real bottom-line numbers on performance. After they are removed, the earnings that are derived from higher sales or lower costs can be seen clearly.

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What Are Quality of Earnings Reports & Why Are They Needed?

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Companies considering buying, selling, or investing in a business are often advised to obtain a quality of earnings (QOE) report. Doing so has become commonplace as part of due diligence procedures in private company merger and acquisition (M&A) transactions to ensure investors are not misled by inaccurate earnings.

But what’s meant by quality of earnings? While most companies have externally prepared financial statements (e.g., audit or review), such statements assess the company’s c ompliance with generally accepted accounting principles (GAAP) rather than the perceived quality of its earnings.

In this article, we’re here to discuss what quality of earnings means and what a standard earnings report or analysis looks like. Ultimately, we’ll help you determine if you need one when merging or acquiring a business.

What Does Quality of Earnings Mean & Why is It Needed?

Quality of earnings is an assessment of a company’s earnings that accurately removes distortions or anomalies such as one-time events that may skew the true bottom line of a business’s financial performance.

Quality of earnings refers to an evaluation of a company’s financial performance to identify items such as:

• Nonrecurring transactions
• Revenue sources
• Customer concentrations
• Unusual or cyclical trends
• Significant estimates
• Consistency in the application of accounting policies

Evaluating all of these factors and more helps a financial professional calculate a business’s adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) .

A QOE assessment involves delving into the above details to ensure that what is presented represents an accurate financial picture of a business’s earnings.

What is Shown in a Quality of Earnings Report/Analysis?

When determining your quality of earnings, an accountant or valuation specialist will typically organize their findings in a concise quality of earnings report after conducting a thorough analysis.

The typical QOE report is comprised of five sections, as well as some exhibits. The five-section checklist includes:

• Executive Summary
• Quality of Earnings Analysis
• Income Statement Analysis
• Quality of Net Assets (Balance Sheet) Analysis
• Working Capital Analysis

The procedures are tailored to the user of the report and may be enhanced or limited depending on the results/needs of the engagement.

Each provides the user with an assessment of the business based upon inquiries with management, review of supporting documentation, and analyses of the information provided.

How Long Does a Quality of Earnings Report Take?

Depending on the size of the transaction and requested procedures, a typical QOE report can be completed in 45-60 days.

How Does a Quality of Earnings Report Differ From an Audit or a Review?

Although many consider accounting to be a science, it is closer to an art, where significant estimates are made by management and reflected in the company’s financial statements.

There are several differences between a QOE report vs. audited or reviewed financial statements:

1. Reviewed or audited financial statements are often the beginning of a quality of earnings report.

Since the financial statements reflect past performance, they provide a historical perspective for the company and the accountant’s assessment of their compliance with GAAP .

A potential buyer is interested in the future performance of the company and, therefore, is concerned about the length/term of customer contracts, unusual or nonrecurring income or expense items, trends, backlog/pipeline analyses, etc.

2. Quality of earnings reports are often done during an interim period.

These analyses reflect the trailing twelve months (TTM) of financial performance compared to year-end and the comparable prior TTM periods. Additionally, they may provide a forward-looking analysis of the business.

Are Quality of Earnings Reports Only Prepared for a Buyer of a Business?

There are both buy-side and sell-side reports that may be prepared.

The buy-side report focuses on providing the buyer or investor with a thorough understanding of the operations, assets, and cash flows of the target.

In a sell-side QOE engagement , the focus is to identify issues that could hinder a transaction and/or result in a reduction in the sales price. It provides the potential seller with the opportunity to identify the company’s warts, address any concerns, and potentially accelerate the due diligence process. Explore more benefits of a sell-side QOE report here.

When Would You Need a QOE Report?

M&A transactions are rarely conducted without the preparation of a QOE report.

However, while the buyer generally completes quality of earnings reports during a transaction, a strong case can be made to have a QOE review (reverse due diligence) completed in advance of a transaction when a company’s stakeholders anticipate a future sale. This strategy has several advantages that we explore in our Why Wait For a Sale? article .

Get a Thorough Quality of Earnings Report from Kreischer Miller

Whether you are a buyer, seller, or investor, a quality of earnings analysis and the resulting report provide the information necessary to make an informed decision.

Obtaining a quality of earnings report is a crucial step in buying and selling a business, as well as mergers — helping all parties obtain peace of mind in the true accuracy of the business’s earrings.

Creating a QOE report is just one of the many examples of services we offer in our M&A/ Transaction Advisory department to help with business transitions. Contact us today to learn more.

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Contact the author, mark g. metzler, cpa, cgma, cepa.

Director, Audit & Accounting

Employee Benefit Plans Specialist, Owner Operated Private Companies Specialist, Private Equity-Backed Companies Specialist

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What is Quality of Earnings?

Quality of earnings report example, quality of earnings conclusion, additional resources, quality of earnings report.

Assessing how a company accumulates its cash

A quality of earnings report is a routine step in the due diligence process for private acquisitions. The report assesses how a company accumulates its revenues – such as cash or non-cash, recurring or nonrecurring.

Net income is not necessarily a 100% accurate indication of financial performance for a business. If a company reports large net income figures but negative operating cash flow , for example, then it may not be as financially sound as it appears.

There are many key details that are not outlined in a company’s income statements – therefore, a breakdown of cash sources is very important. Quite simply, if a company reports a positive net income but poor quality earnings, then acquiring the company may be a more risky investment than the company’s financial statements indicate. This assessment often affects whether or not an acquirer decides to pursue a private acquisition.

The following is an example of an abridged version of a hypothetical due diligence quality of earnings review conducted when fictional company, XYZ Capital Partners, decides to acquire the privately held ABC Co and partially acquire DEF Co (ABC’s sister company).

The review is being completed by external auditors QRS LLP. It is separated into three sections: (1) an executive summary, (2) income statement, and (3) the balance sheet.

1. Executive Summary

Business overview.

ABC Co. is based in Buffalo, NY and was founded in 2000 by James Smith. ABC provides nationwide moving services that include labor, hauling, and moving. There are five managers who are part of senior management and the company hierarchy is as follows:

In this deal, XYZ will also purchase components of ABC’s sister company, DEF, in order to gain control of certain fixed assets pertinent to the acquisition.

Transaction Overview

XYZ’s letter of intent includes an acquisition of all the assets of ABC and some other operating assets by DEF for the sum of $6 million. The $6 million represents a 4.23x multiple on EBITDA before adjustments for Amazon-related revenue (a large non-recurring revenue source that appeared when they moved to their Buffalo, NY office over a three-year period), the multiple is 4.39x adjusted EBITDA.

Summary of Key Issues and Recommendations

2. Income Statement

Revenues and “Amazon Project”

• In 2017, ABC saw a large spike in revenue due to the Amazon project; Amazon needed assistance in expanding into their Buffalo office.
• Excluding Amazon, revenues increased by $195,000 – 26% – in 2017 and $153,000 – 14%, – in 2018.
• “A” was the largest customer, generating revenue of $135,000, 12% of total revenues in 2018.

QRS Issues/Recommendations

• QRS reviewed revenues for 2018 to determine if any large, one-time revenues occurred, similar to the revenues from Amazon in 2017, that would require a higher than normal amount of adjustments. QRS noted that there were no large revenue increases and that all customers in the top 10 as of 2018 had provided consistent revenues for ABC for at least 2 consecutive years.  

3. Balance Sheet

Purchase Price Allocation

• Under this proposal, ABC would be able to write up the assets purchased by $1 million from their original capital cost of $389,000. This would leave an additional $3 million in goodwill for which no tax cost base will be created.
• XYZ should determine the real fair market value for the assets to be purchased and see if it can negotiate any further value to be allocated to the tangible assets in order to increase the tax shield created through this transaction.

The above example is merely an executive overview of how a quality of earnings review appears and the type of financial statement analysis involved. Other possible issues and recommendations an external auditor may bring up include things such as normalizing earnings, addressing payroll inefficiencies, or implementing a new IT system.

Notice the important issues here. In 2017, a large proportion of ABC’s net income came from a single large order from Amazon. Without a quality of earnings report, ABC’s value could appear greatly inflated.

Many acquisition transactions fail during the due diligence process as the reviews highlight the key failings of a target company that would not have been discovered without an external audit. Consulting services are of critical importance because they also provide recommendations on how to hedge potential business risks and take advantage of potential gains (such as tax benefits).

Note that this assessment is purely recommendation-based. The recommendations in a quality of earnings report constitute professional analysis and advice but are not required to be followed by either the acquirer or the target company.

Thank you for reading CFI’s guide to the quality of earnings report. CFI is the official provider of the Financial Modeling & Valuation Analyst certification . To continue learning and advancing your career, these additional CFI resources will be helpful:

• Earnings Volatility
• Private Company Valuation
• Financial Modeling Guide
• M&A Glossary
• See all valuation resources
• See all equities resources
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How to Get a Quality of Earnings Report [& Why You Need One]

Are you toying with the idea of selling or purchasing a business? Before you go any further in the process, you and any potential investors will want to know one thing: The reality of the company’s financial performance and well-being.

The quickest way to figure that out is with a quality of earnings report. Let’s find out what this report is—and the process to get one.

What Is a Quality of Earnings Report?

A quality of earnings report (also referred to as a QofE, QOE, or financial due diligence report) is an analysis and report of accounting and business records to not only evaluate the accuracy of historical earnings and financial position but also to assist in the identification of any risks or opportunities that may or may not be reflected in the financial statements.

A QofE report is most often used as a form of due diligence to arrive at a basis for a company’s valuation amidst a potential ownership transition, although the report can also be prepared to provide insights to your CFO or financial team .

Once engaged by a prospective seller or buyer, a third party prepares a report that reviews, normalizes, and summarizes a business’ performance for items such as:

• Sources of revenue
• Customer and vendor concentrations
• Non-recurring transactions
• Executive compensation or personal expenses
• Unusual or cyclical trends
• Compliance with U.S GAAP
• Accounting policy changes
• Significant estimates

The QofE report, therefore, attempts to tell the true story of a business’s earnings and financial position and provides insight into prospective performance (i.e. potential for future earnings or risks).

QofE Report versus Audit

It’s easy to confuse the purpose behind a quality of earnings report versus an audit because they are interconnected. The simplest way to explain the difference is this: Audits explain the what of financial statements, while QofE reports explain the why.

A quality of earnings report is a financial analysis that evaluates the quality and reliability of a company’s earnings and profitability. It aims to provide a comprehensive understanding of a company’s financial performance and earnings potential by reviewing key financial metrics such as revenue, operating expenses, and cash flow.

On the other hand, an audit is a comprehensive review and examination of a company’s financial records and operations. The purpose of an audit is to provide an independent assessment of a company’s financial statements to ensure that they are accurate, complete, and in compliance with accounting standards and regulations. An audit is typically performed by an independent auditor who assesses the internal controls, financial reporting processes, and financial statements of a company.

Why Do I Need a Quality of Earnings Report?

The primary reasons to seek a QofE report are to understand your business, prepare for a buy-side transaction, or prepare for a sell-side transaction:

• Understand your business: You should never enter the market blind to the value of either your company or the company you wish to purchase. You may have some projections or estimations of your value, but these shouldn’t be the basis of your price. Getting a QofE report gives you as accurate an estimate as possible so you can enter the market confidently and become aware of any problems in your financials.
• Prepare buy-side: Using your QofE report, a purchasing party can more accurately calculate projections of a business’s future earnings. The report can also reveal how well the two companies will synergize with one another.
• Prepare sell-side: QofE reports ensure your financials are organized enough to initiate a sale. If your report reveals inefficiencies in your business’s revenue cycle, you can correct those issues before entering the market.

Questions Answered in a QofE Report

With a completed QofE report at your disposal, you’re ready to answer the following questions:

• What are the earnings of the business and how are they earned?
• How well-positioned is the company for a sale?
• Are historical earnings sustainable?
• Is your revenue non-recurring or frequent?
• Have your accounting practices changed, and were those changes for the better?
• Are there any off-balance sheet liabilities?
• Do the two businesses have similar customers or vendors (applicable for mergers and acquisitions)?
• What are the cost of goods sold (COGS) (if applicable)?
• What are the potential risks of purchasing the business?
• What are the potential future earnings?
• Are there any deviations from GAAP standards?

How Long Does It Take To Get a Quality of Earnings Report?

The amount of time required to complete a quality of earnings report correlates with the complexity of the sale and the size of the company.

For smaller companies, QofE reports can be delivered within 1–2 weeks depending on the accuracy and availability of current financial figures and supporting documentation.

For larger companies, it can take 1–2 months to complete the entire QofE. This depends on numerous variables, including the complexity of the organization’s inventory, related party transactions, and management’s proposed adjustments.

What Information is in a Quality of Earnings Report?

A quality of earnings report generally covers four major categories: quality of earnings, financial statements, financial performance, and working capital. Within these sections, the following information is revealed:

• Adjusted EBITDA: This stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. The EBITDA is often considered the “real” income of a company after deducting and adjusting for these considerations.
• Recast Income Statement Analysis: This goes over measurements such as percent of total sales and year-over-year fluctuations.
• Recast Balance Sheet Analysis: This discusses current assets, liabilities, long-term debt, and other factors that impact the company’s financial performance.
• Proof of Cash: This compares the cash deposits recorded on bank statements to the cash collections reported on financial statements.
• Net Working Capital: This measures a company’s liquidity and short-term financial health, calculated as the difference between current assets and current liabilities.

Can This Information Come from My Accounting System?

All the above information can be pulled from your accounting system—as long as that system is accurate and up-to-date. Additional information may be needed from the client such as access to bank statements, payroll, invoices, contracts, etc.

If you’re not sure your financials are up to snuff, using a fractional CFO can be paramount in verifying your organization’s readiness for a merger and acquisition. A qualified CFO can get your financials in order and thereby produce an accurate quality of earnings report.

What’s the Process of Getting a Quality of Earnings Report?

While many variables determine the nitty-gritty details, every process generally follows the same four steps when working with Amplēo.

1. Engagement Letter

When a company is interested in getting a QofE from Amplēo, they will be sent an engagement letter that specifies the entities that will be covered, the analysis period, and the diligence procedures and pricing. Once the engagement is signed, our team will send the client a diligence request list.

2. Diligence Request List

To lay the groundwork for the upcoming QofE report, Amplēo will send out a diligence request list to go over some high-level details with the selling company. This looks at how the company was established, its operations, and how it generates revenue. If the company allows, we’ll also access its financial systems to pull financial records to ensure the QofE report meets the highest level of detail.

3. Analysis

With the diligence request list in tow, we can start our analysis. This involves looking at income statements and balance sheets to discover any unusual fluctuations or other concerning variables. Amplēo may reach out to the company’s management if anything concerning arises during the analysis. The management may also communicate any adjustments they wish to propose during this interaction.

4. Report Delivery

While reports come in many forms, Amplēo compiles all of our findings into the following sections.

• Executive Summary: Information regarding the company’s background and systems while summarizing the key findings.
• Other recommendations around accounting policies/procedures
• Quality Of Earnings: Overview of the company’s EBITDA net income and a discussion of adjustments and other considerations.
• Financial Statements: Analysis of income statements and balance sheets.
• Financial Performance: Information regarding the company’s proof of cash and cash collection processes.
• Working Capital: Discussion of trends and unusual fluctuations surrounding working capital
• Appendices: A summary of the scope of the company’s processes and monthly adjustments to EBITDA.

Our reports typically range from 25-50 pages depending on the size of the Company and the scope of diligence work requested.

Get Your QofE Report with Amplēo

You must be proactive when seeking to sell or purchase a company. You want to put your best foot forward when you enter the market, and Amplēo can help you get your footing with our QofE reports.

If you’re ready to get a Quality of Earnings Report, reach out to Amplēo today .

View an example of Amplēo’s final deliverable for a quality of earnings report.

Want to learn how Ampleo can address your biggest business challenges? We’d love to hear from you.

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Earnings Management and Earnings Quality: Theory and Evidence

We study a dynamic model of earnings quality and earnings management in which firms take into account both long- and short-term considerations when reporting earnings. In addition to providing predictions about time series properties of earnings quality and reporting bias, the model offers a distinction between two components of investors’ uncertainty: (i) fundamental economic uncertainty and (ii) information asymmetry between the manager and investors due to reporting or accounting distortions. We also structurally estimate the parameters of the model, to separate these two components of investors’ uncertainty. This allows us to address existing concerns about archival studies on earnings quality, such as the concerns raised by Dichev et al. (2013) that “archival research cannot satisfactorily parse out the portion of managed earnings from the one resulting from fundamental earnings process.” We compute the ratio of the variance of noise introduced by the reporting process per period, to the variance of economic earnings innovation per period, and find that, on average, it is around half, suggesting that the noise added by the reporting process significantly contributes to investors’ uncertainty about firm values.

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Case Study: Construction Acquisitions Gone Awry – a Quality of Earnings Story

By: Damien Strohmier, Senior Manager, CPA, CCIFP

Failed transactions can happen for a variety of reasons.

This article explains one potential reason for a failure, which is the inherent risk in reporting and understanding a construction company’s accounting transactions in accordance with generally accepted accounting principles (GAAP). This example, while construction-centric, will highlight the importance of accurate accounting records in any transaction or industry.

The contractor in question engaged an accounting firm to perform a Quality of Earnings (QoE) engagement to support the adjusted EBITDA. The contractor maintained the books in QuickBooks and engaged an outside accountant for CFO services.

During the meeting with management and the outside accountant, it was evident the contractor had experienced significant growth in the past several years, demonstrating greater than 10% revenue growth over each of the past five years. The contractor also experienced positive growth in margin and EBITDA over the three-year QoE period. Specifically, EBITDA increased from $1.2 to $2.7 million over the three-year period.

Based on discussions with management, the increases in margin and EBITDA were the result of several factors, including reaching an optimum capacity with the labor crews that were in force, and new and expanded customer relationships that provided logistical improvements for crews in both the installation and monitoring of jobs.

The contractor’s jobs were generally short-term in nature, as they dealt primarily with the residential market. Because of the short-term nature of the jobs, a work-in-process schedule was not created for any closing periods. Furthermore, management believed their billing process, which was driven by the actual completion of installations or receipt of materials, would not produce any significant cut-off issues.

This fact pattern had already directed management’s decisions not to investigate any cut-off issues. Management, under the impression that the most recent $2.7 million EBITDA would be representative of the range of future performance, had already engaged an investment banker to assist with the identification of, and marketing to, potential buyers.

The result: an excited owner thinking about multiples of $2.7 million, a management team ready for a closing bonus, and external investment banker actively seeking buyers in the market. What could go wrong?

The simple procedure of evaluating the margin on all jobs performed and in-process over the QoE period at the cut-off dates provided a different picture of the company’s results. Cut-off errors were experienced across the range of residential work and the limited commercial jobs the contractor performed. The residential job errors, while small in nature at the individual job level, did create a significant cut-off error because each tended to incur cost in one period and not bill until the subsequent period. During periods of growth, this adjustment similarly grew because of the amount of outstanding work at the cut-off periods. Overall, this wasn’t a deal breaker, but did represent an adjustment of nearly 10% to EBITDA in the third year of the QoE period.

Unfortunately, there was a deal breaker, and it was the result of an adjustment related to two commercial contracts. These contracts were started near the end of the first year of the QoE period. The majority of the work under the contracts was completed during the second year of the QoE period, but a work-in-process adjustment was not made to recognize earned revenue on the contract that was consistent with the progress on the contracts. This adjustment resulted in the final bills on the commercial contracts that were issued in the third year – which totaled over $1.1 million – being reclassified to the second year of the QoE period. More than 30% of expected EBITDA, which had been based on the third year of the QoE period, was gone with one adjustment.

Anyone familiar with the income approach of valuing a business also knows this $1.1 million is amplified by the multiple seen in similar transactions in that industry, thus greatly impacting the estimated value of the business. On the lender side, the deal structure will have to be changed to meet the new expected debt service coverage, which means the seller is likely to have to take on a seller note for a larger piece of the transaction.

This example highlights the importance of maintaining accounting records in accordance with GAAP. Owners that may be considering an external sale should evaluate their own accounting records to understand potential adjustments that may exist. A thorough evaluation will provide an accurate starting point for marketing the business for sale and will establish a realistic value at which a transaction could be consummated.

Learn more about QoE:

Case Study: Normalization Adjustments and the COVID-19 Pandemic

Understanding the Need for Quality of Earnings Report in a Transaction

If you have any questions, please reach out to your local Blue & Co. advisor.

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Please note you do not have access to teaching notes, measuring the quality of earnings.

Managerial Auditing Journal

ISSN : 0268-6902

Article publication date: 1 December 2005

Although the academic research on the quality of earnings has been improved by presenting different approaches of measurement, there is no agreed‐upon generally accepted approach to measure the earning quality. Aims to present results of an empirical study measuring the quality of earnings on companies listed in NYSE.

Design/methodology/approach

Uses a sample of 90 companies listed in the NYSE. The analysis is directed to reach a general assessment of the quality of earnings if there is a complete consistency among the three approaches, and if not, the quality of earnings is questionable and needs further analysis and investigations.

The results show that different approaches of measuring the quality of earning lead to different assessment, and one industry or one company can not be labeled as having low or high quality of earning based on the result of one approach only. The results also suggest that the stakeholders before making any financing, investing decision or taking any corrective action, have to use more than one approach to assess the quality of earnings.

Originality/value

Indicates that financial analysts and governmental agencies dealing with companies should apply more than one measure for the quality of earning in order to have strong evidence about the level of quality before taking any corrective action or making any decision related to those companies.

• Financial analysis
• Measurement

ElMoatasem Abdelghany, K. (2005), "Measuring the quality of earnings", Managerial Auditing Journal , Vol. 20 No. 9, pp. 1001-1015. https://doi.org/10.1108/02686900510625334

Emerald Group Publishing Limited

Copyright © 2005, Emerald Group Publishing Limited

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• DOI: 10.2308/IACE.2002.17.4.335
• Corpus ID: 153603438

Quality of Earnings: An Introduction to the Issues in Accounting Education Special Issue

• Walter R. Teets
• Published 1 November 2002
• Business, Education
• Issues in Accounting Education

34 Citations

The effect of pension income on the quality of corporate earnings ibm: a case study, an interconnection between earnings quality and earnings management in the business environment, board characteristics and financial reporting quality: evidence from jordan, effects of board diversity on the earning quality of non-financial firms listed on the ghana stock exchange, the impact efficiency of using assets to enhance earnings quality in the jordanian industrial companies listed in the amman stock exchange: an empirical study, financial market pricing of earnings quality: evidence from a multi-factor return model, does earnings quality affect companies’ performance new evidence from the jordanian market, earnings' quality and smoothing, earnings quality: how to define, earnings quality and earnings management, 2 references, accounting subjectivity and earnings management: a preparer perspective, earnings management: reconciling the views of accounting academics, practitioners, and regulators, related papers.

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Confusion between Financial earnings quality and Financial reporting quality

I thought that everything related to accuracy, reliability, of the reported information was linked to "Quality of reporting", and not "Quality of earnings". Now this Kaplan guys are telling me that it is "Quality of earnings analysis".

Even in the curriculum i've found this definition:

So i guess they're playing on words. "Quality of earnings", relates to the sustainability of earnings, as we've been told since Level 1. But "Quality of earnings analysis ", also includes scrutinizing if there is any balance sheet management (which means giving inaccurate financial information).

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Case Study: Wesco Boosts Fan Experience Opportunities With High-Quality Workflows

By SVG Staff Wednesday, August 28, 2024 - 9:00 am Print This Story | Subscribe

Story Highlights

A new $1.4 billion multipurpose sports venue was looking to incorporate advanced connectivity, audiovisual, and security technologies to draw larger event crowds, and Wesco helped the stadium create an immersive fan experience while saving time and money.

What Do Fans Want?

In a world of 4K UHD televisions and ever-growing in-home conveniences, event venues are challenged with getting people out of their homes and through the doors at live events. One venue looking for innovative ways to get more people in its seats was the new $1.4 billion multipurpose venue that would be home to an NFL team and a professional soccer club. The venue would also host a variety of events year round, including concerts and NCAA football games.

Among the reasons event attendance is declining is simply that fans can watch the event from home and for a much lower price. Not only has this led venues to seek out ways to create one-of-a kind experiences that cannot be replicated at home, but it has also led them to find solutions to the challenges of attending a live event, such as traffic and long restroom lines, and incorporate more of the comforts and conveniences of home into the venue.

Driven by the demand and expectation for enhanced fan experiences and by the potential revenue that analytics have proven such experiences can generate, the end user wanted to incorporate technologies that would appeal to fans, including advanced Wi-Fi and cellular networks to keep them connected, an engaging audiovisual system, and advanced security measures to provide a safe and pleasant environment.

A project of this size and scope is inherently challenging. However, it is made even more complex when being constructed in a busy urban environment with little space for staging and storage. Additionally, cities impose strict safety, delivery, and noise regulations, requiring more oversight and planning than would be necessary in a rural construction project. The stadium needed a partner who not only understood and had experience with these challenges but could also ensure the project complied with city-mandated regulations.

Building the Stadium of the Future

After initial discussions about the project, the local Wesco team began building relationships with local engineering teams and learning the logistical landscape of the area, so when the project was awarded, they were ready to hit the ground running. Wesco worked in tandem with the IT general contractor to win the project by offering an all-inclusive fiber-based solution that offered both time and cost savings. Wesco’s ability to supply the complete bill of materials enabled the contractor to provide a single-source solution with advanced supply chain capabilities, putting them ahead of the competition.

Wesco leveraged its supplier relationships to source products and build a proof of concept network that would simulate the stadium environment demonstrating to the customer how the solution would work. Furthermore, Wesco provided recommendations for expert wireless contractors in the area to test the design and made product and infrastructure recommendations to help the stadium become LEED certified.

With products from industry-leading manufacturers, Wesco supplied the complete stadium infrastructure and connectivity network materials, including:

• Fiber network, passive optical LAN equipment hardware, cable, racks, and cabinets
• DAS/Wi-Fi hardware, antennas and infrastructure
• Security cameras, video surveillance system, and video storage system which are critical to the safety of fans and personnel
• POS systems for shops and concessions, the stadium’s main source of revenue
• A/V cabling and connectivity to provide fans with the highest quality video and sound available

Logistics were key to project success. Wesco provided a project coordinator to be an inventory management and logistics liaison between the IT contractor and numerous subcontractors. The stadium’s urban location meant that job site storage was a challenge, so Wesco staged and managed inventory out of its local warehouse to feed the job. With approximately 900 different products being delivered to the job site, it would be easy to lose or misplace material, therefore delaying construction and racking up costs as installation crews wait for items to be found or reordered. Wesco provided kitting, labeling, serial number capture, and regular product reporting to simplify installation, keep track of material, and ensure it would be delivered to its intended location within the stadium. These efforts, along with maintaining open communication with all parties involved, helped ensure a successful deployment and kept the project on track.

Delivering an Immersive Fan Experience

The stadium was completed on schedule, just in time for NFL season kick-off. With advanced networking capabilities, a audio/visual system, and even an app that could tell fans the quickest traffic routes and where the shortest restroom and concession queues were, the stadium offered an enhanced fan experience that draws people out of their homes and into the stadium. These technologies are having a positive impact on revenue streams and profitability from sales, merchandising, advertising and more. The new stadium saw a 3% increase in average attendance over the previous year in the old stadium.

By partnering with Wesco, the contractor saved time and costs associated with sourcing, inventory management, and logistics. Wesco provided immeasurable value for the contractor by recommending and sourcing products for the various applications and obtaining samples for the proof of concept network. Wesco also assisted with research on what local resources were available to help manage fan data traffic that comes from each game. Additionally, Wesco introduced the contractor to the local police department to ensure they could seamlessly integrate their security system into the stadium’s system.

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Assessing the impact of straw burning on pm 2.5 using explainable machine learning: a case study in heilongjiang province, china.

1. Introduction

2. materials and methods, 2.1. fengyun-3 series global active fire products, 2.2. land cover, 2.3. auxiliary data, 2.3.1. climate-related variables, 2.3.2. dem and aod data, 2.3.3. chinahighpm 2.5, 2.4. feature selection, 2.5. random forest model, 2.6. interpretable analysis, 2.7. data preparation for temporal and spatial models, 3. results and discussion, 3.1. comparison with modis fire points, 3.2. spatial distribution of fire points, 3.3. temporal patterns and variations, 3.4. monthly variations in crop fire points, 3.5. correlation and collinearity analyses of input features, 3.6. accuracy of the temporal and spatial models, 3.7. impacts of straw burning and other influencing factors on pm 2.5, 4. discussion, 5. conclusions, author contributions, institutional review board statement, informed consent statement, data availability statement, conflicts of interest.

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Share and Cite

Xu, Z.; Liu, B.; Wang, W.; Zhang, Z.; Qiu, W. Assessing the Impact of Straw Burning on PM 2.5 Using Explainable Machine Learning: A Case Study in Heilongjiang Province, China. Sustainability 2024 , 16 , 7315. https://doi.org/10.3390/su16177315

Xu Z, Liu B, Wang W, Zhang Z, Qiu W. Assessing the Impact of Straw Burning on PM 2.5 Using Explainable Machine Learning: A Case Study in Heilongjiang Province, China. Sustainability . 2024; 16(17):7315. https://doi.org/10.3390/su16177315

Xu, Zehua, Baiyin Liu, Wei Wang, Zhimiao Zhang, and Wenting Qiu. 2024. "Assessing the Impact of Straw Burning on PM 2.5 Using Explainable Machine Learning: A Case Study in Heilongjiang Province, China" Sustainability 16, no. 17: 7315. https://doi.org/10.3390/su16177315

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