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Quality of Earnings Reports

It is clear that the economy is growing stronger and investment dollars are flowing more freely, particularly in certain industries such as HealthCare. Accordingly, many enterprises are evaluating if they should sell their business or expand through acquisitions. Human nature is to explore the sell side first. However, no matter which side of the fence an enterprise is on (i.e., buyer, seller, or in the process of determining which side their enterprise should be on), relying on an external professional analysis is one of management’s most valuable tools to help arrive at an answer and to provide third party comfort to interested parties. Accordingly, many enterprises are arranging to have Quality of Earnings Reports prepared for their own business enterprise or for the acquisition targets.

What is a traditional Quality of Earnings Report?

A Quality of Earnings Report (“QER”) traditionally would measure the degree to which earnings are generated from internally developed initiatives, as opposed to external forces. For example, if an enterprise has — increased earnings year-over-year from improved cost efficiencies, sales generated from marketing (or high-end customer service campaigns), or if its revenues are quickly converted into cash in steady amounts, it has a high quality of earnings. If an enterprise’s earnings are — attributed to outside sources such as increasing commodity prices for their goods and services, involves large amounts of estimates, is non-recurring, has revenue contracts that have future step-downs, or if it involves long periods to turn it revenues into cash flow, this is seen as a lower quality of earnings.

A traditional QER would include other analysis, only some of which are set forth below:

• Review of trailing (historical) disaggregated revenue by customer, product lines, location, trends, by month, financial well-being of major customers and vendors, etc.
• Determine what is the key industry specific data and then compare that data to public and proprietary databases for financial and non-financial metrics.
• Comparison of underlying financial data to contracts and the like.
• QER reviews for HealthCare would also include information by seat, bed, doctor, visit, CPT code, insurance carrier, patient visits, referral process, FTE’s, claim history and coverages, compensation arrangements, aftercare, and more.
• Assist in transaction negotiations by supplying expertise for tax efficiencies and minimization, GAAP treatments, industry comp’s, etc.
• Provide tax and other diligence in an acquisition.

What have QER’s currently morphed into?

In recent years, QER’s have also expanded into Merger & Acquisitions consulting and/or due diligence engagements. These are often requested by a board of directors/managers of a strategic buyer, frequently being from a Private Equity firm, or by the selling enterprise. One of the new primary objectives of a QER is to not only assess the sustainability and accuracy of historical earnings but to determine the achievability of future projections by vetting assumptions in detail and reviewing the accuracy of prior years’ projections.

Some additional tasks might include (not all inclusive):

• Revenue recognition compliance with both the sellers and buyer’s schemes along with underlying GAAP literature.
• Assess specific and general risks and isolate concentrations.
• Scrutiny of balance sheet matters along with a determination if revenues and expenses belong in the proper year ends.
• Measuring the buy/sell compensation features from the contract to GAAP.
• Arrange for, vet and/or assist in valuations.
• Assist in purchase price allocations. If working capital purchase price adjustments exist, a review of those components and trends would be in order.
• Assistance, preparation and/or vetting of forecasts, proforma adjustments, normalization of earnings adjustments for overhead and other matters, and more.
• An understanding of the already existing and the transaction’s impact on debt covenants and on other legal arrangements including compensation arrangements and plans.
• Status of related parties and their financial relationships whether it be contractual or otherwise.
• Assess competency of a target’s administrative staff and reliability of their external auditor.
• Provide any due diligence task arranged for, such as – assistance with the buy/sell disclosure lists, war room setup, verification of financial and non-financial information to underlying documentation, etc.
• Binding accounting arbitrator on purchase price adjustments.

One size does not fit all QER engagements – they should be tailored to the specific needs of the parties. It is understood that a QER is not an audit. However, accountability and risks must be understood and be properly assigned. Accordingly, QER engagements can be structured as consulting arrangements, due diligence studies, or agreed-upon-procedures engagements. All arrangements should be documented and agreed to in an engagement letter.

Should you have any questions, please contact Eric Lerner (author) at elerner@gettrymarcus.com or Lee Ferber (practice lead partner for HealthCare and Consultative services for the firm) at lferber@gettrymarcus.com.

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