Quick answer: A quality of earnings report is a financial due diligence analysis, usually prepared by an accounting firm, that tests whether a company’s reported profit is accurate and repeatable. It rebuilds adjusted EBITDA from the underlying records, examines working capital and debt-like items, and flags anything that could change the price a buyer is willing to pay.
Key points
- It is not an audit. It tests how reliable and sustainable earnings are for the purpose of pricing a deal, and it does not provide an assurance opinion.
- Buyers and their lenders commonly request one. The findings often decide whether the price in the letter of intent holds.
- A sell-side report, commissioned by the owner before going to market, lets the owner find and fix problems on their own timeline.
- The areas that most often move price are add-backs, revenue recognition, customer concentration, margins by product or customer, and the working capital target.
What a quality of earnings report is
When a buyer is serious about a company, it hires accountants to examine the company’s financial records before the deal closes. The centerpiece of that work is usually called a quality of earnings report, or QoE. Its purpose is to answer one question: what level of profit can the new owner expect to earn from this business, and how confident can we be in that number?
The report starts with the seller’s financial statements and the adjusted EBITDA the seller has presented. It then rebuilds the figure from the general ledger, bank statements, invoices, payroll records and contracts. The result is the reviewer’s own version of adjusted EBITDA, along with an analysis of working capital, debt-like items and the trends underneath the totals.
It is easy to confuse with an audit, but the two have different jobs. An audit exists to give an opinion on whether financial statements are fairly presented. A QoE assumes the statements are the starting point and asks whether they reflect economic reality for a buyer. The first is about reporting, the second is about price.
What reviewers examine
Reviewers typically organize their work around a handful of questions.
Is the revenue real and recorded in the right period? They test revenue recognition, check whether sales near period end were recorded in the right month, and look at credit memos, refunds and unusual transactions. For service businesses, they examine how billings, work in progress and deferred revenue are recorded.
Which customers and products produce the profit? They look at margin by customer, product or service line. A business whose profit comes from a few accounts or a few lines looks different from one with an even spread. The guide to customer concentration explains how buyers react.
Are the add-backs supportable? They trace each adjustment to its documents and check whether it recurs. This is where the seller’s schedule meets the buyer’s skepticism, and the add-back guide lays out what usually survives and what does not.
Do costs look complete? They test for expenses that are missing from the books, such as unrecorded accruals, owner services the company does not pay for, or costs a buyer would need to add after closing.
Does cash match the story? A common test, sometimes called a proof of cash, compares what the books say was collected and spent with the bank statements. Differences get investigated.
What does working capital look like through the year? Seasonal swings, aging receivables, slow-moving inventory and stretched payables all influence the working capital target.
What obligations are not on the balance sheet? Reviewers identify debt-like items that will be deducted from the price. The guide to the enterprise value bridge lists the usual suspects.
How it changes the price
Because buyers multiply adjusted EBITDA to reach a price, any difference between the seller’s number and the reviewer’s number is magnified by the multiple. Findings can also change terms without changing the headline price: a larger escrow, a different working capital target, a portion of price moved into an earnout, or a stronger indemnity from the seller.
The effect is not only mathematical. A report that confirms the seller’s numbers raises a buyer’s confidence in everything else. A report that finds several surprises can lead the buyer to question the rest of the package and to re-price for risk.
Buy-side and sell-side reports
Most reports are buy-side: the buyer hires the firm and the seller supplies information. A growing practice among sellers is to commission a sell-side QoE before approaching buyers. The seller owns the findings and chooses how to use them. The benefits are plain. Problems are found before a buyer finds them, the seller can correct what is fixable, and the report gives buyers a basis for bids that will not be re-cut later. The trade-offs are cost, the time it takes, and the risk that the findings are lower than the owner expected, which is itself useful to know before negotiating.
A sell-side report does not prevent a buyer from doing its own diligence. Buyers often use the seller’s report as a starting point and test the parts they care about most.
How sellers prepare
The strongest preparation is routine. Monthly financial statements that close on a consistent schedule, prepared on an accrual basis, are easier to examine than annual statements assembled at tax time. A clear schedule of add-backs with documents attached shortens the review. Reconciled bank accounts, a current list of customers with revenue by period, and records for any unusual transaction answer questions before they are asked.
It also helps to decide in advance who inside the business will respond to requests, since the process involves many questions in a short time. The seller diligence checklist lists the materials buyers typically ask for.
Where a transactional valuation fits
A quality of earnings report tests earnings. A transactional valuation estimates price, and it does so using normalized earnings as an input. Owners who prepare a valuation before going to market can use its normalization schedule as the starting point for diligence, and can see in advance which adjustments a buyer is likely to challenge. The overview of transactional valuation explains how the two pieces of work relate, and the sale process guide shows where diligence falls in the timeline.
Frequently asked questions
Is a quality of earnings report required to sell a business?
No law requires one. Buyers, especially financial buyers and those using bank financing, commonly make it a condition of closing. A seller who has already done the work, or whose books are clean enough to support one quickly, usually has an easier time in diligence.
How is a quality of earnings report different from an audit?
An audit examines whether financial statements are fairly presented under accounting standards and results in an opinion. A quality of earnings report starts from the financials and asks a different question: how much profit would a new owner reliably earn. It adjusts the numbers instead of opining on them.
How is it different from a valuation?
A quality of earnings report tests the earnings figure. A transactional valuation applies market evidence, risk factors and buyer perspective to that figure to estimate a price. The two are complementary, because a valuation is only as reliable as the earnings it starts from.
What happens if the report finds lower earnings than the seller presented?
The buyer usually seeks a lower price, restructures the offer, or both. The seller can accept, challenge individual findings with documents, or walk away. Having tested the add-backs in advance makes that conversation much shorter.
Need a valuation you can use in a sale or acquisition decision?
The Impetus Group prepares transactional valuations from the standpoint of strategic and financial buyers. A valuation is a standalone engagement with its own scope and fee, and it can be the first step before a sale or acquisition process.
Related guides
- EBITDA Add-Backs: What Buyers Accept and What They Reject: Learn which EBITDA add-backs buyers accept in a sale, which they reject, and how adjusted EBITDA changes enterprise value, with a worked illustration.
- Net Working Capital Peg: How the Working Capital Adjustment Works: The working capital peg sets the level of working capital a seller must leave in the business at closing. See how it is calculated, negotiated and adjusted.
- Due Diligence Checklist for Sellers: What Buyers Ask For and Why: A checklist of the documents and answers buyers request in diligence on a company sale, grouped by area, with the reason each request is made.
- Transactional Valuation: What It Is and How It Works: A transactional valuation estimates what a strategic or financial buyer would pay for a business. Learn what goes into one and how it differs from an appraisal.
- How an M&A Sale Process Works: Stages From Preparation to Closing: A step-by-step view of a sell-side M&A process: preparation, marketing, bids, the letter of intent, diligence, the purchase agreement and closing.
- From Enterprise Value to Equity Value: What the Owner Receives: Enterprise value is the price of the business. Equity value is what owners receive after debt, debt-like items, cash and working capital. See the bridge.
This guide is general education. It is not a valuation opinion, appraisal, investment advice, or legal or tax advice. How these guides are made.