Quality of Earnings reports — commonly referred to as QoE reports — act as a critical tool in pre-deal due diligence during a merger, acquisition, or sale, providing comprehensive analysis of a company's financial performance, cash flow, and risks. Generally, these reports dive deep into business financials, going beyond accounting processes that are often used to hide poor sales and risks to assess a business’s worth.
Whether you're looking to buy or sell a business, the insights gained from a professional quality of earnings analysis can help you make informed decisions and navigate the transaction with confidence.
What is a Quality of Earnings Report?
A Quality of Earnings report is a third-party comprehensive assessment of a company's earnings and financial performance, typically prepared by an accounting or advisory firm. With this analysis in hand, buyers and sellers can determine if the transaction price is fair.
Because net income doesn’t provide a full picture of a business’s financial performance, a QoE report focuses on the sustainability and accuracy of a business’s earnings as well as its operational efficiency. Unlike traditional financial statements, which provide a historical snapshot of a company's financial position, a QoE report determines a business’s true net income with reliable and relevant metrics.
To complete a QoE report, accounting experts will need to review financials, bank statements, ledgers, customer lists, and any other relevant data. A completed report assesses the amount of revenue a company produces, the accuracy of its financials, and the consistency of revenue.
Quality of Earnings Report vs. Audit
While both a Quality of Earnings (QoE) report and an focuses on verifying the accuracy and completeness of financial statements based on Generally Accepted Accounting Principles (GAAP). Although items may be “correct” in GAAP procedures, these issues and adjustments may cause a skewed understanding of a company’s financial health. In contrast, a QoE report goes beyond the numbers to assess the quality and sustainability of earnings, identifying underlying factors that may impact future cash flow and profitability.
Benefits of a Quality of Earnings Report
Due diligence is essential to the buying and selling process. QoEs strengthen deals in many ways, including:
Identifying financial risks
A QoE report helps uncover potential financial risks and anomalies, such as irregularities in revenue recognition or unsustainable cost structures. By isolating these one-off events, the extent of a business’s financial risks will become much clearer.
Improving decision-making
By providing a clear understanding of a company's financial position and risks, a QoE report empowers stakeholders to make informed decisions about business transactions, investments, and strategic initiatives.
Enhancing due diligence processes
In a sale, the speed of the transaction is important to both buyer and seller. QoE reports streamline the due diligence process by providing comprehensive insights into a company's financial health, facilitating smoother negotiations and transactions.
Assessing business performance
QoE reports offer valuable insights into a company's operational efficiency, profitability drivers, and growth potential, helping stakeholders assess overall financial standing and identify areas for improvement.
What is Included in a Quality of Earnings Report?
Creating a QoE report is a nuanced process that varies from firm to firm. It involves the consideration of various factors, including client requirements, industry dynamics, regulatory considerations, and the firm's expertise and methodologies. As a result, different firms may produce QoE reports that vary in content, depth, and focus. However, when receiving a QoE report, buyers or sellers should expect:
- An executive summary, which highlights the business’s market, location, offerings, customer base, and any other basic information, valuation findings, and risks
- Summary of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
- Quality of earnings analysis with normalized EBITDA adjustments, margin trends and revenue quality
- Adjusted EBITDA analysis, removing one-time, nonrecurring, and owner-specific items from reported earnings to determine the company's true, sustainable earning power
- Revenue validation, including a review of reported vs. earned revenue, revenue timing issues, contract terms, customer concentration, churn, and revenue categories.
- Balance sheet review, liabilities assessment, deferred revenue treatment, and cash vs. revenue timing mismatches
- Debt analysis including off-balance sheet obligations and accrued liabilities
- Working capital analysis to determine whether a business has enough cash and operating assets to run normally after the transaction closes, analyzing seasonality and finding any unusual swings
- Free cash flow and cash analysis that compares cash coming into and going out of the bank with reported revenue, loan proceeds, expenses, distributions, and loan payments.
Alongside a QoE report is usually also an examination of tax filing positions and reporting, reviewing tax exposure and liabilities.
This chart shows the difference in buy-side vs. sell-side QoE and their purpose.
Buy-Side vs. Sell-Side QoE Reports
| Buy-Side QoE | Sell-Side QoE |
|---|---|
| Validate the acquisition target | Prepare the business for sale |
| Identify valuation risks | Reduce deal surprises |
| Support financing decisions | Support the asking price |
| Uncover hidden liabilities | Highlight business strengths |
No matter which side of a transaction you are on, a quality of earnings analysis from experienced transaction advisors is a powerful tool that leads to better outcomes.
How a Quality of Earnings Report Impacts Business Valuation
The findings during a transaction’s due diligence phase, highlighted in the QoE report, can significantly alter the deal. For example, EBITDA adjustments are a pressure point because they impact pricing. Sellers and buyers often have different viewpoints on adjusted EBITDA, with sellers focusing on the business’s strengths, while buyers and lenders want to see that it’s supported by evidence, realized, and traced back to financial statements.
EBITDA adjustments during due diligence are crucial to do before locking in on business valuation. Ultimately, buyers want to be sure the earnings will be sustainable after the transaction closes.
Why are QoEs Important in Mergers and Acquisitions?
Quality of Earnings reports are critical during due diligence because they analyze the sustainability of earnings, verify that the company’s reported performance is accurate, check whether revenue is repeatable, and help drive negotiations. QoEs look at cash flow generation and find any risks. Private equity firms, in particular, expect more thorough financial reporting, relying on QoE reports to validate a company's true earning power, confirm that earnings can be sustained after the transaction, and determine whether the business supports the valuation being proposed.
Lenders often review QoE findings because they want confidence that a company's earnings and cash flow are strong enough to make their debt payments. A QoE report helps them identify potential risks, confirm adjusted EBITDA, and verify whether the business can realistically meet its financial obligations after the transaction closes.
Common Red Flags Found During a Quality of Earnings Review
Certain risks tend to pop up during a quality of earnings review. Common issues include:
- Revenue recognized too early: If a company records revenue before it’s actually earned, work is completed, or services are delivered, it could lead to performance not representing actual results.
- Excessive customer concentration: If most of the revenue comes from a small number of customers and some decide to leave, this puts the business at risk.
- Declining gross margins: Inconsistent or decreasing margins can show inefficiencies, rising costs, pricing issues, or more competition in the market.
- Significant owner-related expenses: Personal owner expenses masked as operating costs, unsupported add-backs, or related-party transactions can be warning signs.
- Inconsistent financial reporting: Not adhering to GAAP standards can cause inaccuracies and decreased trust.
- Hidden liabilities: Any unstated debts, lawsuits, compliance risks, or other unreported liabilities can turn up during QoE work.
- Large working capital swings: Quick fluctuations could be a sign of accounting problems.
- Dependence on one-time revenue sources: Having one-time revenue like unusual, large sales listed as recurring revenue makes revenue quality look stronger than it actually is.
A comprehensive QoE analysis by experienced advisors is the key to uncovering potentially deal-killing risks.
What Happens After a QoE Report?
A completed QoE report often becomes the foundation for the next phase of the transaction. Once buyers, sellers, lenders, and advisors have a clearer picture of the company's true earnings, they can determine whether the original valuation still makes sense. If the report uncovers issues such as overstated earnings, one-time revenue, unexpected expenses, or working capital shortfalls, the purchase price may be adjusted or additional negotiations may take place.
The findings can also influence deal terms beyond price. Buyers may request changes to the purchase agreement, additional protections, or specific provisions to address risks identified during the review. At this stage, the parties typically establish a working capital peg, which is the target amount of working capital the business is expected to deliver at closing. This helps ensure the buyer receives a business with enough cash and operating assets to continue operating normally after the transaction.
The QoE report also helps lay the groundwork for post-close planning. By identifying operational, financial, and reporting issues early, buyers can better prepare for integration, implement necessary improvements, and avoid surprises after the deal closes. A QoE report helps all parties move forward with a clearer understanding of the business and greater confidence in the transaction.
Quality of Earnings Report Cost
Depending on a business’s size, record-keeping, and complexities, the cost of a QoE report varies greatly. Additionally, the more experienced the firm you choose is, the more likely you’ll incur higher fees — and more accurate work. Generally, QoE reports are priced based on hourly rates or fixed fees negotiated between the client and the consulting firm, with the typical report costing $20,000 to $30,000.
Working with Mowery & Schoenfeld on a Quality of Earnings Report
Mowery & Schoenfeld specializes in providing comprehensive QoE reports to help businesses navigate transactions with confidence. Our QoE engagement can be delivered either as a written report or as a detailed workbook, both with the same underlying analysis, key findings, and commentary. The difference is in presentation and cost. The workbook format is often more cost effective, as it allows us to focus our time on analysis rather than drafting a formal narrative report. This flexibility allows us to tailor the deliverable to project budget while still ensuring you get the insights you need to make informed decisions and move toward closing with confidence.
FAQs
How Long Does a QoE Analysis Take?
The quality of earnings process can about a month to complete. The timeline can vary based on parties’ responsiveness to requests, access to financial documents, and other factors.
Why Should a Seller Get a QoE Report?
Obtaining a sell-side Quality of Earnings report helps you control the narrative about any adjustments and find risks or potential issues before the buyer does. This shows you are transparent as a seller and can help protect your business valuation.
Do Private Equity Firms Require QoE Reports?
Yes, PE firms require a Quality of Earnings report during a transaction.
READ MORE: Search Fund Playbook: A Practical Guide to Navigating Acquisitions
This content is for general informational purposes only and does not constitute tax, legal, or professional advice. Readers should consult their tax advisor regarding their specific situation before making any tax-related decisions.