Quality of Earnings Report: What It Is, What It Covers and When You Need One

When someone buys a business for a multiple of its earnings, every dollar of earnings is worth several dollars of price. So buyers want to know, with confidence, that the earnings are real, repeatable and correctly measured. A quality of earnings report, usually shortened to QoE, is how they find out.

This guide explains what a QoE covers, how it differs from an audit, what it tends to find, and how sellers can use one to their own advantage.

What a quality of earnings report is

A QoE is a financial due diligence report, normally prepared by an accounting firm's transaction services team. It analyses a company's historical earnings, usually over two or three years plus the trailing twelve months, to determine:

• whether reported earnings are accurate,
• which adjustments to EBITDA are justified,
• whether earnings are sustainable going forward,
• what normal working capital looks like,
• whether there are debts or debt-like items that should reduce the price.

The output is typically an adjusted EBITDA figure that buyers and lenders trust, along with a detailed explanation of how it was reached.

QoE vs audit

An audited company can still need a QoE, because an audit doesn't answer the question a buyer cares most about: what are the true ongoing earnings of this business?

What a QoE examines

Revenue quality

• Revenue recognition: is revenue recorded in the right period?
• Customer concentration and churn.
• Recurring vs one-off revenue.
• Pricing changes and their effect on margins.
• Unusual transactions near period ends.

Cost and margin analysis

• Gross margin trends by product, customer or location.
• Owner compensation and related-party expenses.
• Costs that have been deferred or are missing, such as underinvestment in maintenance or staff.
• Accruals that may have been understated.

Adjusted EBITDA

The QoE team reviews every adjustment proposed by management or the seller's adviser. Typical outcomes:

• Accepted: clearly supported, non-recurring items.
• Modified: partly justified, but the amount is adjusted.
• Rejected: not supported, or the cost is actually recurring.
• New adjustments: items the seller didn't propose, often reducing EBITDA, such as market-rate rent on owner-held property or missing management roles.

Proof of cash

Matching reported revenue and expenses to bank statements. This is a key check for smaller businesses whose books haven't been audited. It catches revenue that was recorded but never collected, or cash that doesn't appear in the accounts.

Net working capital

The QoE analyses monthly working capital to propose a normal level, the "peg", used to adjust the purchase price at closing. See our LOI guide for how the peg works in a deal.

Debt and debt-like items

Beyond bank debt, there may be items that buyers will treat as reducing the price: deferred revenue, unpaid bonuses, tax liabilities, customer deposits, deferred maintenance, legal claims and so on.

Typical QoE findings

That gap is why buyers commission QoEs and why sellers increasingly do one first.

Buy-side vs sell-side QoE

Buy-side QoE

Commissioned by the buyer after signing an LOI. Lenders often require one before funding acquisition debt. The buyer pays and the report is prepared for the buyer's benefit.

Sell-side QoE

Commissioned by the seller before going to market. Benefits:

• No surprises. The seller learns about problems before buyers do and can fix or explain them.
• Credible numbers. Buyers trust EBITDA that has already been tested by an independent firm.
• Faster process. Buyer diligence goes quicker when much of the work has been done.
• Fewer re-trades. The buyer has less room to argue the price down after the LOI.

Buyers usually still do their own QoE, but it tends to be faster and less contentious when a sell-side report exists.

What drives the cost

QoE fees vary widely. The main drivers are:

• size and complexity of the business,
• number of entities, locations and revenue streams,
• quality of the company's records,
• scope (some buyers add tax, IT or operational diligence),
• timeline.

For smaller deals, some firms offer scaled-down QoE reports. Get quotes from two or three providers with experience in your industry and deal size.

How sellers can prepare

1. Close the books monthly and reconcile bank accounts.
2. Use accrual accounting, not cash basis, at least for the years buyers will review.
3. Document every add-back with invoices, contracts or explanations.
4. Separate personal and business expenses well before a sale.
5. Clean up related-party arrangements such as leases at non-market rates.
6. Review revenue recognition for multi-period contracts.
7. Prepare monthly working capital data for at least 24 months.
8. Consider a sell-side QoE if the deal is large enough to justify it.

How buyers should use a QoE

• Agree the scope upfront, focusing on the areas of greatest risk.
• Share your concerns with the QoE team so they dig where it matters.
• Use the findings in negotiation, but be fair. Re-trading over immaterial items damages trust.
• Feed the results into your model for financing and value creation.
• Look beyond the number. QoE findings on margin trends and customer concentration can shape your integration and growth plans.

Red flags a QoE often uncovers

Beyond adjustments to EBITDA, a good QoE team will flag patterns that change how a buyer sees the business. Some of the most common:

None of these automatically kills a deal. Each needs an explanation. Often there's a perfectly good one, and the QoE simply documents it so buyer, lender and seller can move forward on the same facts.

How QoE findings change deal terms

When a QoE comes back with lower EBITDA than expected, the parties have several options beyond simply cutting the price:

• Price adjustment in proportion to the EBITDA change, usually at the agreed multiple.
• Earn-out covering the disputed amount, paid if the seller's view proves right after closing.
• Escrow or holdback to cover specific identified risks.
• Specific indemnities for known issues, such as a tax exposure.
• Seller note replacing part of the cash consideration.

Sellers who've done their own sell-side QoE are in a much stronger position in these conversations, because the numbers have already been tested independently and there's less room for surprise.