Page 17 - NBIZ Magazine August 2023

Accounting Policies: The choice of accounting policies Validate earnings and projections: A comprehensive
can impact the quality of earnings. Companies have some QofE analysis verifies the accuracy and reliability
discretion in applying accounting rules, and different pol- of reported earnings. This validation is particularly
icies can lead to different earnings outcomes. Transparent crucial when presenting historical financial statements
and conservative accounting policies tend to enhance the and projecting future earnings to potential buyers. By
quality of earnings. substantiating the earnings figures and highlighting
any adjustments made during the analysis, the
Non-recurring Items: Earnings can be affected by non- company can strengthen the credibility of its financial
recurring or one-time events, such as gains from the sale information and support the future earnings projections
of assets or restructuring charges. These items should be provided to buyers.
properly disclosed and excluded from the assessment of
ongoing earnings quality. Identify and address earnings risks: A QofE analysis
helps identify any potential risks or inconsistencies in the
Cash Flow Analysis: Analyzing the company's cash financial statements. By conducting an internal review,
flow statement can provide insights into the quality of the selling company can proactively address these issues,
earnings. Positive operating cash flow that aligns with rectify any errors, and provide explanations or disclo-
reported earnings suggests healthier earnings quality, sures for any non-recurring items or accounting policies
while significant disparities may raise concerns. that may impact the earnings. This process helps reduce
uncertainties and potential deal roadblocks during buyer
Financial Ratios: Assessing financial ratios, such as due diligence.
return on equity (ROE), return on assets (ROA), or
gross margin, can help evaluate the sustainability and Enhance financial transparency: The QofE analysis in-
profitability of earnings. Consistent performance and volves a thorough examination of the company's financial
improvement in these ratios over time indicate better statements, accounting practices, and underlying busi-
earnings quality. ness operations. By conducting this analysis, the com-
pany can enhance its financial transparency and provide
Transparency and Disclosure: Companies that provide clear explanations for its revenue recognition, expense
transparent and comprehensive financial reporting, management, and overall financial performance. Trans-
including clear footnotes and explanations, inspire confi- parent financial reporting instills confidence in potential
dence, and enhance the quality of earnings. buyers and helps build trust during the sale process.
It's important to note that evaluating the quality of
earnings requires a thorough and independent analysis
of financial statements, including the income statement,
balance sheet, and cash flow statement, as well as an
understanding of the specific industry dynamics and
accounting standards.

The Role of a QofE Study in Selling a Company
For many years, buyers contemplating acquiring a
company often would commission a QofE study as part
of their deep due diligence on that target acquisition
before closing on the sale. Potential buyers used the
QofE study to generate an accurate understanding of the
company’s historical earnings, create confidence (or lack
of) in the target company’s forecasted future earnings, It's important to note that evaluating
and reduce their risk in the transaction. In some the quality of earnings requires a
situations, potential buyers may use the QofE study’s
results to reduce their offer price or proposed terms if thorough and independent analysis
their study claims the company’s true earnings were less of financial statements, including the
than originally stated.
Given the importance that buyers were placing in income statement, balance sheet,
the QofE, it did not take long for sellers to catch on. and cash flow statement, as well as an
In what is often called “seller due diligence”, business understanding of the specific industry
owners contemplating a sale of the company are often
commissioning their own QofE study prior to marketing dynamics and accounting standards.
the company for sale. By doing their own QofE study,
potential sellers can:

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