Apple Growth Partners

AGP Advisory: A Quality of Earnings (QofE) is Not an Audit

By Brandon Frederics, CPA | AGP Advisory, Leader

Welcome to our series on financial due diligence. Over the next several segments, we would like to provide you with key aspects within the financial due diligence process, and how you can better prepare yourself, and business, for a transaction. 

The financial due diligence process is comprised of many parts, the focus being centered around the quality of earnings process. Many people hear this term and instantly think that a quality of earnings is simply an audit for the transaction.  However, that is not accurate. Let’s see how these two projects differ. 

An audit is defined by the American Institute of Certified Public Accountants (AICPA) by the highest level of assurance service that a CPA performs. The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with an applicable financial reporting framework. This process enhances the degree of confidence that intended users can place in the financial statements. Keep in mind that audits are also conducted to (a) a specific fiscal year-end date (e.g., 12/31/19) and (b) done with a degree of materiality.  

When we then compare to a QofE, the main focus of this project is to focus on the economic earnings power of the entity’s going concern. Focusing efforts to understand the sustainability and forward-looking performance of the business at a very detailed level. The beauty of the QofE is the flexibility of its scope. To really understand the potential business transaction, the QofE will allow an opportunity for our team to roll up our sleeves and really understand the business. These specific steps in getting to the details will be revealed later in this series. Also, keep in mind that quality of earnings is aligned directly with the transaction itself. What that means is the work performed is done ‘as of’ the transaction date. This is where the trailing 12months (TTM) concepts enters. Unlike the audit that is perfectly aligned with the year-end, the QofE is committed to understanding the earnings power moving forward from the transaction date. 

The QofE report stands alone from an audit, and for good reason. Many deals may discount the overall financial due diligence process, relying on other means, such as an audit. Hopefully this series will lay the groundwork for why a QofE is needed.