Quality of earnings

An independent review of a business's earnings: every add-back tested against the general ledger, the revenue proved to the bank deposits, and the earnings a lender can rely on — with the support for each number attached.

A seller's recast is an assertion. A quality of earnings is that assertion tested, line by line, against the records that would exist whether or not anyone was selling: the ledger, the bank statements, the payroll reports, the Forms W-3 and the agings. Where an add-back is supported, the report says what supports it. Where it is not, the report says so and removes it.

A fixed fee, quoted in writing from the document list before any work starts. Fifteen business days from complete information. Half on signing, half on delivery — and the fee never depends on whether the transaction closes or on what the report finds. Reviewed and signed by a US CPA.

What SOP 50 10 8.1 now asks a lender for

Three words in that paragraph do the work. Independent rules out the company's own accountant and anyone whose fee moves with the outcome. Ordered by the lender rules out the report the seller already has, however good it is — and a seller frequently does already have one, which is the most common surprise on these files. And proof of cash rules out a recast built from the income statement alone: deposits have to be reconciled to recorded revenue across the trailing twelve months and the two fiscal years before it, which is the single procedure a thin report most often omits.

The consequence for the file is that the earnings figure in front of credit has to be one the lender procured. The Baratelli Credit Services desk also reads eligibility, size, use of proceeds and the change-of-ownership conditions against the SOP as a separate engagement, so the exceptions on a file can be named before it reaches committee.

Who ordered the report changes what it is for

What actually gets tested

The organizing principle is that nothing is accepted because it appeared in a summary. Every figure that survives into the report is a figure traced to a document that exists for a reason other than this transaction — a bank statement, a filed payroll return, an aging the company runs to collect money.

This list is the standing scope. The engagement letter names the procedures performed on a specific file, and a procedure not listed in that letter was not performed — see the scope section below.

Three documents, and one of them has live formulas

A US CPA reviews and signs every report before it is delivered.

A fixed fee, quoted in writing before anything is signed

• Fixed, and fixed before work starts. The quote comes from the document list — what records exist, how many entities, how many years, what state the ledger is in — and it is in writing before anything is signed. It does not move afterwards because the file turned out to be harder than it looked. That risk belongs to the Institute, which is the point of quoting from the documents rather than from the purchase price.
• Half on signing, half on delivery. The fee never depends on whether the transaction closes, on whether a credit is approved, or on what the report finds. A fee that moves with the answer is not an independent fee, and the SOP's independence requirement is the reason to say so rather than leave it implied.
• Turnaround runs from complete information, not from the engagement date. The intake list below is what complete means, and the clock starts when the last item on it arrives. Fifteen business days at every size: the procedures are the same procedures, and only the volume moves.
• Why there is no price list here. The purchase price bands above set the scope of the testing, not the fee. Two $4 million businesses can be a week apart in work — one with reviewed statements and a clean ledger, one with three entities, commingled accounts and a year of unreconciled cash. A single published number for both either overcharges the first or underprices the second, and the second is where a quality of earnings earns its keep. The band sets what gets tested; the document list is what prices it.

Four steps, and the intake list is the whole schedule

The intake list — what “complete information” means

The fifteen business days run from the day the last of these arrives. It is published here rather than sent after signing so that a lender, a buyer or a broker can tell in advance whether a company is in a position to be reviewed at all — which is frequently the real question.

• General ledger for the period under review, in a form that can be filtered and totalled rather than as a printed report.
• Bank statements for every account, covering the trailing twelve months and the last two fiscal years — this is what the proof of cash is built from, and a gap here is the most common cause of a stalled engagement.
• Sales by customer, which is what concentration is measured from.
• Payroll reports and Forms W-3, which is what a wage add-back is tested against.
• Receivable and payable agings, for working capital and for the collectibility question underneath it.
• Financial statements and tax returns for the periods under review.
• The seller's recast or add-back schedule, where one exists — it is the assertion being tested, so it is useful to have it, and its absence does not stop the work.

Stated plainly, not buried in the letter

• One engagement letter, signed before anything is sent. It names who engaged this desk, confirms independence from the buyer, the seller and the company, and fixes the fee.
• The fee never depends on the outcome. Not on whether a transaction closes, not on whether a credit is approved, and not on what the work finds.
• Baratelli Bankable is disclosed, not relied on. Bankable is a free accounting program from the Institute, and some companies keep their books in it. Where that is the case the engagement letter says so, and the testing still runs against source documents — bank statements, payroll reports, Forms W-3, agings — rather than against anything the program produced.
• This desk does not also represent the company. Where the Institute has an existing relationship with a party to the transaction, the work is declined rather than disclosed around.
• A US CPA reviews every report and signs it.

A non-attest consulting engagement

A lender relies on the earnings figure to make a credit decision, so the character of the engagement belongs on the face of the page rather than only in the letter. A quality of earnings is a non-attest consulting engagement. It is not an audit, a review, a compilation, an examination or any other attestation engagement, and it is not performed under the AICPA attestation standards.

• No opinion is expressed on the financial statements, and none should be inferred. The report presents computations, the documents each one rests on, and the exceptions found — so the reader can judge the figures rather than rely on an assurance that was never given.
• The procedures are those the engagement letter names. They are not designed to detect fraud, to reach every error, or to constitute a complete examination of the records. A procedure not listed was not performed.
• Information supplied by management is identified as such. Where a figure could not be tested against a source document, the report says that it could not — which is the point of the management representation letter.
• The credit decision is the lender's and the price is the buyer's. This desk computes and supports; it does not approve, decline, price or recommend, and nothing in a report is a commitment by any lender or a prediction of what a lender will do.
• Nothing on this page is tax, legal or accounting advice. Orientation on a service is not the service. Advice arises under a signed engagement letter and nowhere else.

Four answers worth having before you call

Ask for the Delta Fastener sample report

The sample quality of earnings report and its workbook are available on request. Reading an actual deliverable is a better basis for a decision than reading a page about one.

Philip A. Baratelli, CPA
philbaratelli@gmail.com
904-846-3011
baratelliinstitute.com