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Quality of Earnings (QofE) has largely replaced audits for buyers of businesses. Each analysis can differ, depending upon the criteria set by buyers. At the same time, the primary focus is to evaluate the reliability and sustainability of the seller’s reported earnings. Even comprehensive audits usually do not address this critical focus.

The following factors are normally part of a QofE:

  1. Revenue Recognition Policies: Understanding how revenue is recognized by the company is crucial. Companies may employ different methods, such as recognizing revenue upon delivery, completion of services, or over time.
  2. Expense Recognition: Similar to revenue, the timing and method of expense recognition can significantly impact earnings.
  3. Accounting Principles and Practices: Assessing whether the company follows Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) is vital. Non-standard accounting practices may indicate potential earnings manipulation.
  4. Quality of Assets: Analyzing the composition and valuation of assets on the balance sheet is important. High-quality assets are more likely to generate sustainable earnings.
  5. Non-Recurring Items: Identifying and understanding non-recurring or one-time items in the income statement helps in assessing the underlying profitability of the business. It is also critical in the computation of adjusted EBITDA.
  6. Changes in Accounting Policies: Any recent changes in accounting policies can affect reported earnings.
  7. Operating Cash Flow: Evaluating the correlation between reported earnings and operating cash flow provides insights into the cash-generating capability of the business.
  8. Revenue and Expense Trends: Analyzing the trends in revenue and expenses over time helps in identifying any anomalies or irregularities.
  9. Industry Comparison: Benchmarking the company’s earnings against industry peers can provide context and highlight any deviation that may require further investigation.
  10. Management Commentary: Management’s discussion and analysis (MD&A) accompanying financial statements can provide valuable insights into the factors influencing earnings, such as analysis of product profit margins.
  11. Legal and Regulatory Environment: Considering the legal and regulatory environment in which the company operates is important, as it can impact earnings through compliance.