Quality of Earnings Report: What Is It & Why Is It Important in a Cannabis M&A Deal?

CannaBlog by Cory Parnell, COO of Bridge West CPAs & Advisors to the Cannabis Industry

Audited financial statements provide a window into the health of a cannabis business. But when a cannabis business is about to go on the market, the seller and potential buyers should want a better view than they can get just by looking through a window. That’s where the quality of earnings (QoE) report comes in.

What Is a Quality of Earnings Report?

If the audited financials are the window into the business, then getting a QoE report is like opening the door and getting a guided tour. Essentially, quality of earnings is a more diligent type of due diligence.

When completed by a respected firm that understands the cannabis industry, the QoE report gives buyers an extra layer of confidence in their potential purchase. Alternatively, it gives sellers a third-party’s view of potential red flags or areas of concern that they can clean up in order to maximize the company’s market value.

The quality of earnings report can be requested by either the seller, in which case it’s called a “sell-side QoE,” or the buyer, which yields a “buy-side QoE.” The contents of the report are the same no matter who requests it.

What Is Usually Included in a QoE Report?

The overall intent of the quality of earnings report is to compile a single document that objectively presents the accuracy and quality of a cannabis company’s assets and historical earnings, as well as the sustainability of future earnings.

While the report’s contents can vary based on the type of cannabis operations being analyzed and market conditions at the time, there is usually a set of “core” features in any QoE report. This core often includes:

  • An executive summary highlighting what the cannabis business does, its location, market, products and services, customer base, and other basic information
  • Breakdown of revenue by categories and customers
  • Income statement analysis
  • Examination of the condition and value of balance sheet assets
  • Working capital analysis
  • Summary of EBITDA (earnings before interest, taxes, depreciation and amortization) before adjustments
  • Adjustments for capital expenditures
  • Identification of debt
  • Examination of tax filing positions and reporting

In addition to an analysis of these “hard numbers,” the quality of earnings report considers the cannabis company’s internal controls and a discussion of other key observations noted during the due diligence process.

These items may not be reducible to numbers or charts, but they are important in giving a full picture of how the business operates. For example, the QoE can discuss:

  • Abnormal accounting policies
  • Changes made to accounting procedures and practices over time
  • Transactions with related parties
  • Unusual trends in how the cannabis company prepared its income statements

What Makes QoE Reports Different From Audited Financial Statements?

Audits are by definition backward-looking. They evaluate whether a company’s past financial statements comply with generally accepted accounting principles (GAAP). The QoE report, on the other hand, provides broader insight into key aspects of the cannabis company’s operations to help identify how the business might perform on a go-forward basis.

Perhaps the most important differentiator between QoE and an audit is that a QoE includes “normalizing adjustments.” This means that the firm creating the quality of earnings report will correct (adjust) for expenses and revenues that are not expected to occur in future years.

For example, in an M&A situation, the acquirer may want to adjust for certain items that they do not expect to continue after the transaction, such as:

  • Revenues from lines of business that will cease to exist
  • Salary expenses of employees who will not continue working with the new company
  • Facilities that will no longer be needed
  • Above-market compensation the target’s management was paying themselves
  • Loans and leases that may be paid off or terminated during the acquisition process

Why Sellers Might Request a Quality of Earnings Report

QoE reports allow sellers to get an honest look at their cannabis business in preparation for entering the market. The report highlights inconsistencies in financial data and areas of concern to address before selling. It also allows management to know what to fix in order to get the best price.

Essentially, it gives existing owners time to correct issues and puts them in a good position to discuss and explain issues to potential buyers. Most of all, the QoE helps eliminate nasty surprises that could reduce the sales price or derail the transaction entirely.

Why Buyers (or Lenders or Investors) Might Request a Quality of Earnings Report

QoE reports give buyers, investors, lenders, and brokers something to rely on beyond the financial statements. Quality of earnings reports offers a richer picture of how strong the cannabis business really is and whether that strong performance is likely to continue.

By evaluating everything from the nature of its cash flow to the underlying assets and liabilities, the QoE report truly offers a 360-tour of the inner workings of the cannabis company, not just the through-the-window view provided by financial statements.

BW Prepares Thorough Buy-Side and Sell-Side QoE Reports

Bridge West has extensive experience preparing QoE reports for companies in the cannabis industry. We pride ourselves on having an entrepreneurial spirit, and we’re here to help you complete the buying and selling transactions that help you achieve your own entrepreneurial dreams.

We invite you to reach out to our team anytime to initiate a conversation about QoE reporting and any related services Bridge West CPAs may be able to provide.