Quality of earnings (QoE) reports are pivotal in assessing the reliability and sustainability of a company's earnings before finalizing a transaction. They delve deeply into whether earnings are expected to continue in their current trajectory, and they distinguish between recurring revenue, which is dependable, and non-recurring income, which could potentially skew the financial outlook.
The essential components of QoE reports include revenue recognition practices, the impact of any non-operating income, and an examination of accounting policies to ensure they're in line with industry standards. Analyzing expense recognition is also crucial, as improper timing or categorization can artificially inflate profits.
One of the most overlooked parts of the report is the effect of one-time events, such as the liquidation of assets, litigation settlements, or acquisitions and divestitures, which might temporarily boost earnings. Such boosts need to be isolated to present an accurate view of core earnings.
Furthermore, cash flow analysis within QoE reports often goes unnoticed despite its significance. It unveils whether a company’s reported earnings are genuinely backed by cash or simply accounting entries. The proficiency in recognizing accruals, deferred revenue, or other balance sheet items that could impact future cash flows is crucial.
Another frequently neglected area is the review of the company's accounting methods, particularly changes that could influence earnings. Companies may alter depreciation methods or inventory accounting methodologies to make financial statements appear more favorable.
Beyond these technical aspects, the management's credibility and historical financial integrity should be assessed to determine the trustworthiness of the financial representations. Management biases in reporting are often unreported but provide insights into potential risk areas.
Ultimately, quality of earnings reports often remain underutilized until due diligence processes are nearing completion, even though they afford a comprehensive understanding of the qualitative aspects of earnings that go far beyond what traditional financial statements reveal. Skimming these reports or undervaluing their insights can lead to misinformed decision-making in mergers and acquisitions.