Our Quality of Earnings scope is consistent with what we learned at the Big 4, we simply scale the output to match the transaction size. Here is high level summary of our approach:

• Financial statements - Obtain monthly detailed financials for the last two years and year-to-date period and gain an understanding of the nature of activity in each account (through general ledger analysis and discussions with the Seller).
• Customers – Obtain a detail of monthly revenue by customer (ideally a database of transactions), reconcile to the financials, understand the collection cycle and fluctuations in revenue by customer/product as most relevant.
• Vendors – Obtain a summary of monthly expense by vendor, reconcile to the financials and understand the billing cycle and fluctuations in vendor.
• Employees – Obtain payroll reports by employee, reconcile to the financials, understand the payroll cycle including bonus & commission plans and turnover.
• Proof of cash – Reconcile the financial statements to the underlying bank statements for the last 12-month period.
• Tax returns – Obtain tax returns, reconcile to the financials, and understand book to tax differences

Fundamental to our financial diligence process is gaining an understanding of the customers, vendors and employees and reconciling that knowledge to the financial activity. We attempt to avoid any accounting lingo with the Target and focus on understanding the business – not passing judgment on how the accounting was done.

We will expect to have a conversation with the key person who is operating the business. Often that is the Seller. We will also want to speak with the person who leads the day-to-day accounting activities. Typically, discussions with an outside CPA are not necessary unless we are performing tax diligence.

We will prepare a detailed file and have a call with the Seller and key accounting personnel to walk through the financial statements and related information live. This is a very important step to get the voice over of what we see in the financial information. We attempt to avoid any question lists as it requires more time of the Seller and, importantly, live responses tend to be more valuable than prepared responses.

The diligence process is a significant burden on the Seller. We attempt to make the process as streamlined as possible. As such, we would suggest that you never send standard requests to a Seller. We will access the dataroom or download of information provided and tailor a request list specific to the Target and the information that has been provided to date. That way the request list is tailored to the business and gets us off to a good start with the Seller.

The need for tax diligence depends on the transaction structure and risk factors specific to the Target. In a stock acquisition, you inherit the historical liabilities of the Target and tax diligence is generally advised. In an asset acquisition, typically only liabilities associated with payroll and sales and use tax are at risk of transitioning to the Acquiror. It is also important to consider the requirements of investors and lenders regarding tax diligence. Of note, if reps & warranties insurance will be purchased, tax diligence will be required regardless of the transaction structure.