During an acquisition, the buyer must conduct exhaustive due diligence to ensure that they have a complete picture of the company they are seeking to buy. This involves many steps, but perhaps one of the most important is producing a quality of earnings report.
As the name suggests, this report is created to analyze the past earnings of the seller and ensure that they are an accurate predictor of future performance. Typically, the buyer will either produce this report themselves if they have the human capital to do so or outsource the task to an accounting firm.
The value of any company is determined based on its past performance and expected future performance, so it is clear why having the most complete picture of these figures is so essential. Imagine a company that for the past two years has reported large spikes in its earnings, leading to a much higher valuation than it would otherwise merit. Without a quality of earnings report, a potential buyer might see this and assume that this trend is to continue, and thus pay a premium for the company. If we look deeper, however, we might see that these large revenue increases are not due to some miraculous turnaround in the business, but rather irregular events that are not likely to occur again. Such irregular events can include the one-time sale of a fixed asset, the closing of a multi-year deal that will not recur, the collection of a massive account receivable, or any other large windfall of cash into the business.
A quality of earnings report allows buyers to discriminate the large or irregular inflows of capital into the business from the regular revenue that the business produces, and thus get an accurate picture of the likely future performance of the business.
The elementary example laid out above demonstrates the indispensability of a quality of earnings report and the serious potential financial ramifications for a buyer who chooses not to produce one. In such a case, it is possible for the valuation to fall up to 20%.
A quality of earnings report allows buyers to discriminate the large or irregular inflows of capital into the business from the regular revenue that the business produces, and thus get an accurate picture of the likely future performance of the business.
Quality of earnings reports, however, can cause price adjustments in both directions. When the buyer audits the revenues of a seller and sees that there are many strong clients, no few clients make up too large a portion of the business, or inflationary factors, it is possible that the valuation will actually increase. If there is a large inflation adjustment to be made based on high-quality past earnings, the value of a business could increase substantially.
In a recent case, in fact, The Beringer Group was representing a seller for whom the quality of earnings report ultimately resulted in a 50% increase in the sale price of the company. For our client and TBG, this is an obvious win that was only possible through both parties on either side of the deal conducting due diligence and being extremely prudent in the execution of their duties in every facet of the deal. An important note is that such a case is not a loss for the buyer, because the QOE report illuminated to them a fifty percent increase in the value of what they were purchasing, so the sale price increase reflected a proportional scaling of the previously agreed upon fair price.
With both possible scenarios in mind, buyers and sellers alike have a vested interest in producing a robust quality of earnings report for every deal in order to ensure that the exchange is actually fair and both parties are getting what they bargained for.
