A Quality of Earnings (QofE) report has become a necessity in most M&A deals. Yet business owners may not be familiar with the report or the value it provides during the selling process.

A QofE from a trusted, third-party advisor is a crucial piece of the diligence puzzle. It provides business owners with insights into the true nature of their earnings, what their business will look like after a transaction, and how to maximize valuation through negotiations. Additionally, QofEs present sellers with an assessment of potential concerns that can be mitigated prior to marketing their business to buyers, creating more credibility and the ability to close faster.

Harris Williams senior bankers Bill Watkins, Larissa Rozycki, and Kevin Harper interviewed Carlos Ferreira, a managing director at Grant Thornton, on the essentials business owners should know about QofEs.

Watkins: For some company owners, the difference between a QofE report and an audit or review can be confusing. How do you differentiate a QofE from an audit?

Ferreira: Financial statements are based on a regulated method of reporting business results known as Generally Accepted Accounting Principles (GAAP). An audit verifies that a company’s financial statements are accurate and in line with GAAP. However, audited financial statements are not necessarily indicative of the future earnings of a business.

A QofE report starts with audited financial statements and creates an economic view of the business. For example, if a business sells a fixed asset, GAAP requires recording a gain or loss on the sale of that equipment. However, the company is not going to sell fixed assets each year. Therefore, a QofE adjustment would deduct the gain, or add back the loss, to negate the impact of this event. In essence, the QofE report bridges the historical, GAAP-based financial statements and the projections that are prepared by management.

Watkins: In our experience, companies that haven’t had audits can still engage in M&A as long as they have detailed QofE reports. What’s your perspective on this? 

Ferreira: For privately held businesses with the in-house capabilities to do so, I would strongly recommend moving forward with an audit. This means they'd need an accounting environment with established policies and practices, as well as a team that can prepare financial statements in accordance with GAAP. Many buyers, particularly private equity funds using third parties to acquire these businesses, have a set rule on requiring audited financial statements.

If it's a very small business run by an owner, a compilation is often what will be used. The cost of obtaining financial statements that will withstand order procedures is typically not worth the benefit. In this scenario, the seller would need to understand that they may give up a discount in the pricing and valuation of the business.

Rozycki: We’re often asked about adjustments to earnings. What are some of the most common examples from your experience?

Ferreira: One very common adjustment right now is related to Paycheck Protection Program (PPP) loan forgiveness. Many companies received money under PPP and subsequently were able to have those balances forgiven. GAAP forces the business to recognize forgiven PPP loans as income, and that looks like a windfall on the income statement, so that’s now a common QofE adjustment. 

There are also QofE adjustments warranted based on how a company fared during the pandemic. For example, during COVID-19 lockdowns, a parking garage in New York City may have been largely empty and laying off people, but it still had to pay rent. The QofE report would normalize rent and payroll expenses and adjust for lost revenue. This adjustment would account for the return of people driving into New York City and would represent the quality of earnings on a pro forma basis, which would be indicative of the go-forward operations of the business.

The most frequent adjustments are related-party activities—for instance, when the owner of a business also owns the real estate on which the business operates. The owner may not have a lease that's indicative of fair market value of the rental, and the property may not be part of the transaction. A QofE adjustment would reflect the fair market lease value. 

Compensation adjustments are also common. In an owner-operated business, the owner may draw as much income as wanted. In a private equity-owned business, the CEO would draw a market-based salary. The difference between what was expensed as a draw under the owner-operated business and what a go-forward CEO salary would be is an adjustment. Similarly, such an adjustment would be appropriate for any other executive salaries determined on variable terms.

Harper: What’s your view on pro forma adjustments, especially concerning acquisitions or new clients?

Ferreira: It's important to differentiate between annualizing the impact of an investment and realizing the future value of activities still to occur. For example, if you close a transaction and you've realized two months’ worth of EBITDA, that is not a pro forma adjustment but a true due diligence adjustment. You would then annualize and restate the prior period’s financials so that you have comparable run-rate EBITDA, which should be fully supportable and accepted by buyers and lenders as a run-rate EBITDA adjustment.

Pro forma adjustments, on the other hand, are subject to future execution risk. An example is having a pipeline of two or three acquisitions where you are under LOIs but haven't closed yet. Here, there is a level of execution risk that exists, which forces the adjustment to be a pro forma one. That's the key difference between a hard diligence adjustment that you get full credit for and a pro forma adjustment that's negotiated from a credit perspective.

Watkins: Can you also provide insight into how net working capital adjustments impact earnings, and how you review and normalize NWC for a QofE?

Ferreira: What you're trying to do with working capital is assess what a normalized level is for the current state of the business. When a buyer acquires the business, it can then continue operating with a level of receivables, payables, and operating assets that fund the ongoing activities of the business in normal costs.

Historical net working capital is used as a basis for what your future working capital will be. Outliers, such as deferring receivables for a unique or unusual situation, might skew these numbers. Other types of working capital that we take out are nonoperating items like income taxes or interest accruals.

It's a closely negotiated and scrutinized number because it impacts the cash flow of the business in the weeks after acquisition. Buyers are keenly focused on ensuring they get the right amount of working capital at close.

Rozycki: The COVID-19 pandemic, supply chain disruptions, and war in Ukraine have all had significant impacts on the economy, and, by extension, on company performance. When you have a market event like those, how do you distinguish between a lasting change in revenue and an episodic upward or downward movement?

Ferreira: Ultimately, decisions can be subjective. Two very smart people could have two very different points of view on something, given the same facts. What we try to rely on is subsequent activity. Is there a meaningful change in the trajectory of a particular financial statement line item?

Undisputable evidence, such as signed contracts, make it much easier to extrapolate revenue over the course of 12 months. Other times, there are subjective adjustments. For instance, when a manufacturing organization goes through a process improvement or six-sigma project, the company may incur consulting fees that are nonrecurring and warrant an adjustment. In addition, once the company starts to see margins improving as a result of the process improvement, the QofE can extrapolate those over the historical period to indicate, had the company had these initiatives in place, what the financial statements would have looked like.

Overall, the QofE report can provide background and explanation to help buyers and sellers understand the activities that have happened in the business during the period being evaluated. There are no prescribed rules about what one can and cannot report in a QofE report.

Harper: How do you ensure impartiality? Depending on who asks for the QofE report, isn't there a certain interest at stake to either inflate or deflate the earnings of the company?

Ferreira: The rules and processes that we follow are exactly the same whether the report is asked for by the buyer or seller.  If the report is done for the seller, it does present the opportunity for management to provide evidence regarding areas that a buyer may question. 

We have very high documentation standards. When buyers or sellers try to be a bit aggressive on adjustments, our argument is that the minute one starts stepping over the line of reasonableness, every adjustment comes into question. The investment community is smart. They see the details in a QofE report and know if adjustments are reasonable. They're not going to stretch.

Rozycki: How many adjustments do you typically see on a deal?

Ferreira: Coming out of the pandemic, we're seeing some fairly large adjustments because businesses were significantly impacted. Typically, there are between three and a dozen adjustments, but with a privately held business, it's not uncommon to see 30 to 50 adjustments. Our goal is to try and parse those adjustments into categories, so that they’re much easier to understand.

Sometimes, a seller attempts a “kitchen sink” approach and proposes a laundry list of QofE adjustments. From a buyer's perspective, this can put into question the credibility of the process. You may begin to consider the integrity, validity, and underlying support for all the other adjustments. Because of this, it's typically better to present a more solid and credible adjusted EBITDA number and get a confident buyer with a higher multiple. If you try to get every penny of EBITDA and then go through a diligence process, you could get knocked down and be on the back foot from a negotiation perspective.

Watkins: What’s your advice to business owners as they approach a third party to create their QofE reports?

Ferreira: As a business owner, if you've thought about taking actions that would make the business more profitable, start on them.  If you can demonstrate that the activity has started and the company is beginning to see the benefits, there will be a valuation benefit. Similarly, any execution risk that can be handled before the close date should be. Think about, for example, non-compete agreements with key sales people. Often, this is something the owner has been thinking about doing for a long time, but hasn’t executed. Now's the time to do it.

Some clients have hired Grant Thornton to do a QofE report 12 to 18 months before they go to market so that they can learn what adjustment opportunities are possible. This gives owners a lead-time to start to implement and document benefits of those changes so there are trends to acknowledge going forward. There’s value in preparing early.

About Harris Williams
Harris Williams is an investment bank specializing in M&A advisory services. Our firm advises and advocates for clients worldwide through critical milestones and during the lives of their businesses to strategically create value—with passion, flexibility, and a commitment to detail.

About Grant Thornton, LLP
Grant Thornton LLP (Grant Thornton) is one of America’s largest audit, tax and advisory firms—and the U.S. member firm of the Grant Thornton International Ltd global network.

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