How Does a Quality of Earnings Analysis Differ from an Audit?
- February 21, 2023
Clients frequently ask whether there is a need to perform a quality of earnings (QofE) analysis when the subject company has already audited financial statements.
Although audited financial statements provide users with a reasonable assurance of a company’s historical financial reporting, a QofE analysis can give prospective buyers additional insights and a more comprehensive understanding of the company’s earnings and financial health.
QofE analyses differ from an audit in three ways.
QofE Considers Non-financial Aspects
Audited financial statements focus on whether the subject company’s historical financial statements comply with generally accepted accounting principles (GAAP). QofE analyses involve looking beyond the financial statements and considering underlying non-financial aspects of the company to help prospective buyers or investors understand the key operating and financial metrics of the subject company. To complete a QofE, a professional thoroughly reviews all relevant data, such as billing and productivity details, major contracts, staffing arrangements, and owner compensation.
QofE is Forward-Looking
Audits are backward-looking and focus strictly on the specific fiscal period examined. On the other hand, although QofE analyses are developed largely based on historical financial statements, the focus of a QofE analysis is on the economic earnings of the subject company, both on a historical basis and a normalized, go-forward basis.
Normalization and pro forma adjustments will be made to historical financial statements to help the buyer or investor derive a reasonable estimate of the subject company’s sustainable earnings. For example, revenue and expenses associated with discontinued service lines will stay on audited financial statements, whereas those will be removed in a QofE analysis.
QofE is a Tailored Approach
In some cases, an audit is mandatory and often required by law for publicly traded companies. Auditors must apply a rigorous audit process and be independent to ensure that they provide an unbiased assessment of a company’s financial statements. In contrast, QofE is a consulting engagement and thus allows for flexibility in the approach and scope of work. Depending on the client’s specific needs, a QofE analysis can be performed with different levels of depth and detail. Professionals can tailor the scope of QofE analysis to focus on items of concern. As deemed appropriate, certain buyer-specific considerations could be applied to provide insights that help the prospective buyer evaluate the deal in the context of their specific needs and objectives.
The scope of QofE analysis can also vary depending on the size and industry of the subject company. For healthcare specifically, certain special considerations should be taken into account when performing a QofE analysis. Examples of these considerations include reimbursement risks and government regulations. Further, the focus of QofE analysis could even be different for different healthcare provider specialties.
As we continue our series on QofE analyses, we will explore the different areas of consideration for healthcare entities.
Coker Group’s financial services team assists healthcare entities with buy- and sell-side QofE analysis. Contact us today to speak with our experienced financial consultants and see if a QofE analysis will meet your needs.
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Yong Zhang, CPA, ASA