Earnings Quality is More than Adjusted EBITDA

Buyers perform exhaustive pre-acquisition due diligence of target companies that spans financial, tax, legal, IT, operational, marketing, HR, and other matters. Central to financial due diligence is the target’s earnings quality. Discussion of earnings quality usually focuses solely on recent historical EBITDA, normalized by making various adjustments. Of course, normalized EBITDA is critical information. Buyers use it to develop forecasts needed to value a target, negotiate its purchase price and acquisition financing, and determine its capacity to service acquisition debt while generating an acceptable return on the buyer’s investment.

But earnings quality is not just a dollar amount, it’s a qualitative assessment of a company’s earnings:

Earn•ings qual•i•ty (noun) The extent to which a business’ economic performance during a recent historical period:

1. Is faithfully represented by its reported earnings during the period and

2. Can be sustained (will persist) in future periods.

As with other qualities, it is judged to be “high,” “medium” or “low.”

Normalizing adjustments help a buyer evaluate whether a target’s historical earnings meet the second condition (sustainability or persistence). But, figuring out whether a company’s earnings meet the first condition (faithful representation) is challenging. In addition to normalizing adjustments, buyers need answers to three questions:

1. Do reported revenues and expenses largely reflect cash receipts and disbursements, respectively, rather than accounting accruals?

2. Do those accounting accruals rely heavily on subjective judgments or difficult-to-make estimates?

3. Are there indicators of earnings management?

The third question, regarding earnings management, also begs definition:

Earn•ings man•age•ment (verb) To manipulate reported income statement amounts by:

● Accelerating sales using such unsustainable devices as channel-stuffing, bill-and-hold arrangements, unlimited customer right-of-return privileges, resale price protection, and customer “side agreements” that override normal terms of sale;

● Delaying discretionary, but necessary, expenditures such as facility and equipment maintenance, advertising, and product development – which increases earnings in the short term, but is unsustainable in the long run;

● Improperly applying accounting standards, such as that governing revenue recognition;

● Improperly capitalizing period costs, such as R&D, advertising or maintenance; and

● Basing accounting accruals on unreasonable or unsupportable estimates or assumptions.

Earnings management indicators are sorted into three categories (the same categories accountants use to describe the “fraud triangle”):

1. Pressures or incentives,

2. Opportunities, and

3. Attitude or ability to rationalize.

Not surprisingly, the likelihood that earnings management has affected a company’s financial statements increases (a) with the number and severity of indicators present and (b) if indicators from all three categories are present.

So, what are the indicators that a business’ financial statements are afflicted with earnings management? For nonpublic companies, here are the primary indicators:

1. Earnings management pressures or incentives:

● The target’s industry is highly cyclical or intensely competitive.

● The target’s products are subject to rapid technological change or physical deterioration, trendy or fashion-sensitive.

● The target’s debt agreements contain financial statement-based covenants, such as a minimum interest coverage ratio.

● The target’s reported earnings deteriorated recently, or it has had trouble meeting budgeted earnings.

● The target’s managers participate in incentive compensation arrangements based on accounting measures, such as pre-tax earnings.

2. Opportunities for earnings management:

● The target uses unusual or complex business arrangements or accounting methods that require significant use of judgment or estimates.

● Pre-tax operating cash flow is consistently less than EBITDA, suggesting possible cash flow difficulties or manipulation of working capital-related accounting accruals – and often both.

● The target changed accounting principles, with the effect of increasing reported earnings in the period of change and distorting period-to-period earnings trends (for example, changing from the LIFO inventory cost-flow assumption to FIFO during times of general rising production costs).

3. An attitude or ability to rationalize earnings management:

● Target has a weak control environment, lacks formal internal controls, or lacks risk-management policies and practices.

● The target’s accounting records include significant personal (non-business) expenses indicating tax fraud (and an apparent willingness to risk a tax audit that could result in payment of back-taxes, penalties and interest – or worse).

Financial due diligence of a target should identify earnings management indicators, make corresponding normalizing adjustments where relevant and practicable, and consider whether the number and breadth of such indicators indicate “high,” “medium” or “low” earnings quality.