Written by Matthew Marconcini, CPA
Selling your company can be an exciting time, filled with potential opportunities for growth and new horizons. Whether your company is accrual based, following GAAP, or it reports on a cash basis, proper preparation for the sale of your company is extremely important. This journey often involves a complex web of financial transactions and negotiations, with numerous parties at the table. Among the critical elements in this process are financial due diligence and performing a quality of earnings (QOE) analysis. The QOE process is a critical aspect of financial reporting and analysis that helps stakeholders, like investors and creditors, assess the reliability and sustainability of a company’s reported earnings.
The QOE analysis can play a pivotal role in shaping the outcome of the sale and can significantly impact the perceived value of your business. Therefore, as management, it is essential to be well-prepared and proactive in assessing and evaluating the quality of your business’ earnings, as it influences the selling price and builds trust and confidence among potential investors and other stakeholders. We have outlined eight steps management can take to best prepare for the QOE process.
1. Understand the Quality of Earnings Concept
Management should have a clear understanding of what QOE means. It assesses the underlying economic substance of reported earnings, ensuring they are not distorted by accounting manipulations or one-time events.
2. Maintain Accurate and Timely Financial Records
Accurate financial record-keeping is fundamental to high-quality earnings. Management must ensure that financial statements are free from material misstatements and that all transactions are properly recorded.
3. Ensure transparent Financial Reporting
Transparency is crucial. Ensure all material transactions, both positive and negative, are adequately disclosed in the financial statements and related footnotes.
4. Report Consistently
Maintain consistency in financial reporting practices. Frequent changes in accounting policies can raise questions about the QOE. If policies do change, explain the rationale behind it and the financial impact of the change.
5. Ensure Proper Revenue Recognition
Recognize revenue in accordance with accounting standards only when it’s earned and realizable. Avoid prematurely recognizing revenue or engaging in overly aggressive practices. If your company reports on a cash basis, pulling together the proper data that will show revenue based on date of service rather than the collection date will be key.
6. Examine One-Time Events
Clearly distinguish between one-time or non-recurring events and ongoing operations in financial reporting. Disclose the nature and impact of such events to prevent misinterpretation.
7. Complete Management’s Discussion and Analysis (MD&A)
Be prepared to provide a comprehensive and honest analysis of the company’s financial results. Explain the drivers of earnings, changes in accounting policies, and potential future risks and uncertainties. The more support you can provide related to both historical performance and future growth initiatives, the more accurate and comprehensive your analysis.
8. Understand Data Sources, Abilities, and Limitations
Take the time to review the various systems used to operate the business and start pulling data together. If certain systems are maintained by third parties, informing them of the situation and discussing what they need to do will create a smoother process. If certain reports don’t have the necessary inputs or data, be prepared to discuss that and what alternative information would be useful.
Preparing for Success
By considering these guidelines and implementing the underlying thought processes, management can best prepare for the QOE process, demonstrating a commitment to transparency, accuracy, and integrity in financial reporting. This, in turn, builds trust and credibility with investors and other stakeholders, creating a smooth transaction process for management.
