Quality of Earnings Report

What Is Quality of Earnings?

When a company is considering an acquisition, a certain level of due diligence must be done. A critical step in due diligence is the quality of the earnings report. The quality of earnings report breaks down the financials of a target firm and rates its earnings as “high” or “low” quality.

As you may or may not know, net income is not always the best metric and certainly not the only metric by which a company can be valued. Net income can be manipulated through various means; it may be skewed and does not show the whole picture.

The quality of earnings report analyzes the financials of the company, including how revenue and net income are earned. 

The report looks to break down the sources of cash, which is a crucial aspect to consider. The report also aims to assess the quality and sustainability of reported earnings.

While not all line items on the income statement contribute equally, they do impact the business's overall financial health, influencing the money taken in by the business at the end of the fiscal year.

Understanding Quality of Earnings Report

These are some of the questions regarding risk, which the quality of earnings reports answers. The report seeks to:

• Dismiss anomalous earnings
• Account for accounting tricks
• Make considerations for one-time events

Anomalous earnings, accounting tricks, or one-time events can skew or manipulate what is recorded on the bottom line.

The quality of earnings reports is concerned with finding the natural bottom line of a business. When a quality of earnings report is made, it seeks to provide a clearer and more accurate picture of the actual financial numbers.

For example, external market factors can influence revenue and earnings. However, Markets change, and certain events may not continue indefinitely or have the same effect on the business over time. 

Factors that might be considered could be:

• Inflation
• Rapid expansion or contraction of a nation
• Sudden, one-time changes in consumer behavior
• Trends that are not likely to continue, or which the effects of change over time

Evaluating Quality of Earnings Reports

During high inflation, companies might charge more this year than the last for their product or service. This price increase will earn more revenue and potentially more earnings. But costs cannot be increased at this rate indefinitely, and COGs may catch up.

Many people have recently switched to online video chat platforms for work, school, etc. But this growth, or even the new customers attained during this time, may not be reliably considered long-term sources of revenue.

The report may also consider specifics of the operation, including:

• Specific clients and their level of risk
• Industry trends and risks
• Product lines or services’ economics and trends
• Other specific yet relevant metrics

Specific clients may be analyzed due to the company’s reliance on particular business(es). REITs, for example, may have one or a few clients that rent many units. SRU.UN, for example, relies heavily on Wal-Mart and other superstores, which rent many large units from them.

Accounting practices can also affect business risk. For example, your country may use GAAP (generally accepted accounting principles) or IFRS (international financial reporting standards) based on the country’s regulatory framework. 

The more closely these standards and principles are followed, the lower the risk associated with earnings. However, due to historical events, we know that poor accounting practices can lead to significant issues with company financials down the road, thus increasing the risk of earnings.

​However, the quality of earnings reports can go beyond just the income statement and earnings and analyze the actual value of items on the balance sheet. But, again, this falls back on ensuring accounting practices are being followed correctly. 

Management also affects the report since it can influence company policy and keeping accounting records. This is a further reason to go beyond the income statement and analyze the balance sheet.

It is also of concern if the business has very high net earnings but very little operating cash flow. This could increase the risk of payments for the company in the long term.

The riskiness of cash flows is not solely subject to accounting records. As we discussed, accurate recording and transparent accounting play a significant role in reducing the riskiness of earnings, but sometimes, payments can be risky for reasons outside the business itself.

Enhancing Quality of Earnings Reports

Despite net earnings not being the only metric used in analyzing a company, this does not take away the importance of its accuracy. Many investors use metrics that rely on net earnings in one manner or another; hence, the accuracy and reliability of its quality must still be considered.

In accounting, there are many considerations they can and must make when recording the company's financials. As we mentioned, a potential investor or acquirer should look at a deeper analysis of earnings to gain clearer insights.

Why would an accountant be interested in adopting accounting policies that result in higher or lower reported income?

On one end, a company may try to reduce its net income to pay fewer taxes. For example, P.P.E. might be depreciated more aggressively to reduce EBIT and, therefore, reduce the taxes paid by the business. Yet this would not materially affect its cash position.

More applicable to companies considering an acquisition, net earnings may appear higher when adopting specific accounting policies. As a result, a corporation may seem more attractive to a potential acquirer due to the perceived significant increases in net income.

Example of Earnings Manipulation

If a firm is caught adopting unusual policies, this can cause the quality of earnings to be deemed poor or of low quality. This is why it is essential for businesses, even private ones, to follow either GAAP or IFRS closely and with integrity.

One of the most common reasons specific policies are adopted is to reduce a business's tax burden. However, we mentioned that the third-party examiner conducting the quality of earnings report might look at the balance sheet. Here is an example of why:

Suppose something is not appropriately depreciated (for example, property, plant, and equipment is depreciated over a timeline more significant than its useful life).

In that case, the third-party examiner conducting the quality of earnings report will identify this and deem the earnings riskier due to this practice.

While IFRS fundamentals are worth following, IFRS is a principle-based framework, allowing for flexibility and interpretation. It is recommended that GAAP be followed for more rigidity.

As GAAP is rules-based accounting and was made to create continuity and standardization in how financials are recorded, it can contribute to more reliable and higher-quality financial recordings.

How the quality of earnings report works

The quality of the earnings report works to solidify business valuations. Of course, the word itself does not provide valuation estimates for the business, but it can help remove any confusion or ambiguity in the financial statements.

The report includes, in great detail, aspects of the business's finances that the acquirer might not have considered an issue or information that the acquirer overlooked.

If used properly, the quality of the earnings report will improve the acquirer's understanding of the acquirer. With a clearer understanding of the target firm's financials, negotiations run smoother as buyers and sellers better understand risk.

But the buy-side and sell-side both have unique benefits to the report:

1. Sell-side benefits

• Areas of concern can be identified before seeking acquisition, and remedies for these concerns can be implemented before purchase.
• A third-party perspective can identify organizational norms that might cause concern to investors and catch issues management might not be aware of
• If issues can be identified and remedied, this may lead to higher-quality earnings. This can improve the speed of due diligence during acquisition, and with higher-quality earnings, the business might receive a higher valuation.

2. Buy-side benefits

• The acquirer has more certainty regarding understanding the target firm's financials.
• The acquirer's risk of losing capital unnecessarily is reduced by understanding the quality of the acquirer's earnings.
• With a better understanding of risk, the future performance of the acquiree can be projected with more certainty and precision.
• It can help align the projected return on investment based on the purchase price with the estimated risk level.

Evaluating Earnings Quality and Risk in Financial Statements

There are a few critical considerations regarding whether earnings are of more excellent or less quality, lower or higher risk, respectively.

Cash transactions that will likely continue recurring are usually rated as higher quality. On the other hand, if most of the transactions are paid in cash but might not occur again, these earnings are considered of lower quality and higher risk. The same goes for non-cash but recurring transactions.

Typically, earnings primarily composed of non-recurring and non-cash transactions are considered of lower quality and higher risk.

In regards to the financial statements, there should be consistency, integrity, and accuracy in:

• Accounting policies
• The degree of estimation in financial statements
• Transparency of financials and footnotes
• The complexity of management decisions and analysis (MD&A)
• The ratio of net income to operating cash flow

Researched and authored by Brandon Fausto | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Due Diligence
• Financial Synergy
• Purchase Price Allocation
• Reps and Warranties
• Transaction Risk