What is a Quality of Earnings Report?
Net income doesn’t always tell the whole truth of a company’s finances. Sometimes a company reports large net income, while also having negative cash flow.
While commonly used as an acquisition tool, a quality of earnings report is also helpful for revealing manipulation of a company’s true financial strength. Companies may manipulate earnings for tax reasons, to attract a buyer, or to increase their stock prices.
Why is a QoE report needed?
Quality of earnings reports are part of the due diligence process during an acquisition. The purchasing company hires a third-party auditor to verify the types and sources of income and expenses. The report is designed to verify the accuracy of reported income and analyze future potential.
The report determines how a company normally generates revenue. It determines whether income is recurring, and from cash or non-cash sources. It effectively looks at the normal, core operations and income of the company aside from temporary anomalies.
A company may have out of the ordinary sources of income in one year, for instance, if it wins a larger than normal contract. While the large contract can potentially lead to future large contracts, historically, the company has had much smaller ones.
What is included in a quality of earnings report?
The QoE report looks at the primary operating income and expenses of a company, aside from anomalies and one-time events. It determines the types of revenue the company normally generates, such as recurring, non-recurring, cash, and non-cash.
It looks at previous earnings and breaks them out into product basis, customer basis, and other useful categories. It breaks expenses into one time and ongoing, analyzes effects of management changes, and analyzes the accuracy of cash flow projections.
As part of the reporting process, companies must be fully transparent. They must specify all sources of earnings, and explain any potential changes they expect in the future from those sources.
The quality of earnings report concludes with noted observations and recommendations from the auditing party. The involved parties are not bound to follow the recommendations provided.
What causes low quality of earnings?
Low quality of earnings can be caused by several factors.
The most common issues are related to one-time income or expense events. A company may choose to defer debt payments, for instance, or reduce the appearance of the debt expense by arranging for a future balloon payment.
On paper, this makes the income and expense ratio look better, but in reality, that expense was only pushed further down the road.
Similar situations occur with unusually large sales contracts or a temporary surge in product popularity. Sometimes outside events trigger unexpected surges in sales. These surges are not normally recurring, but they may make the company’s income statement extremely attractive.
The same applies to companies that work with contracts. The company may win a contract that is much larger than its normal contract size, thus increasing the net income temporarily.
When short term income or expense events like these occur, the company’s net income looks much more attractive than it normally would. If they’re looked at in detail through the quality of earnings report, however, it becomes obvious that the numbers are skewed for temporary reasons.
When those reasons do not appear to contribute towards future continued income increases, the quality of earnings may be considered low.
In summary, a quality of earnings report is often used when one company wants to acquire another. Before doing so, the purchasing company may ask a third-party auditor to confirm the income and expenses reported by the target company. This report is especially useful when a company has good net income yet negative cash flow.
In some cases, the QoE report may show that whatever caused the discrepancy has the potential to last into the future. This is a positive result and can support profitability estimates for the future.
However, when the quality of earnings report shows income levels are only due to short-lived events, those earnings are considered low quality and the acquisition may fail.