Issue link: https://nebusinessmedia.uberflip.com/i/527454
10 • June 2015 The quality of earnings report summarizes the adequacy of the various accruals and reserves within the financial statements of the target company. The report typically provides a bridge from net income in the target company financial statements to adjusted EBITDA — or earnings before interest, taxes, depreciation and amortization. In addition, the report will include an analysis of the proposed add-backs to EBITDA by the seller, culminating in adjusted EBITDA that the buyer and their related sources of capital can use to value the transaction. Companies vary widely in the way they calculate and report earnings. Therefore, a quality of earnings report will typically include an analysis of revenue recognition and, in certain instances, normalization of the earnings of the target. In short, a quality of earnings report attempts to cut through the confusion to present a true and meaningful representation of a company's cash flow. Factors that determine earnings quality, and which therefore must be carefully identified and evaluated, include: Financial reporting practices. How are earnings reported? What accounting methods are used? How are financial statements assembled? How do interim reports match up with annual audits? Governance and internal controls. What is the composition of the management team? Who has reporting and oversight responsibilities? What safeguards are in place against fraud? Company characteristics. What are the company's sales trends? How do they compare to competitors and to budget? Is the company growing? Is the industry growing or mature? Audit quality. Does the company's audit firm have adequate experience? Are audits thorough and detailed? Are there any management comments resulting from the audit? External factors. What is the company's tax position? Are any legal issues looming? Is the business subject to geopolitical influences? All of these considerations must be included in the examination and analysis of earnings in order to derive a true and meaningful analysis. To enhance our quality of earnings reports, we also assist with and document the projected working capital requirements of the business in order to inform the buyer, so that proper financing is in place post-acquisition. No two quality of earnings reports should be the same. The content of each report should vary depending on the needs and requirements of the specific buyer. These needs will vary according to whether the transaction is for the purchase of assets or stock, and whether the buyer is financial or strategic in nature. A quality of earnings report is a key tool for any- one contemplating a financial stake in a business. Care must be taken at the outset of a transaction to set proper expectations for the report as well as for the intended users, so that the report can be tai- lored appropriately. n James A. DeLeo, CPA, MBA, MST and Derrick Rebello, CPA Gray, Gray & Gray, LLP James DeLeo and Derrick Rebello are partners in the Merger & Acquisition Practice Group of Gray, Gray & Gray Certified Public Accountants in Canton, MA. (www.gggcpas.com) Cut through the confusion with a quality of earnings report O ne of the most important outcomes of financial due diligence related to a potential merger or acquisition is a quality of earnings report. Potential buyers, lenders and investors frequently use a quality of earnings report to more fully evaluate a company's financial health. James A. DeLeo, MBA, CPA, MST Partner Gray, Gray & Gray, LLP Derrick J. Rebello, CPA Partner Gray, Gray & Gray, LLP