A quality of earnings report is a financial due diligence analysis that strips accounting noise out of a company’s reported profits to show what the business actually earns on a repeatable basis. The report converts reported earnings into Adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and that adjusted figure becomes the number both sides use to price the deal. In middle-market mergers and acquisitions, a QoE report typically runs between $20,000 and $100,000 depending on the company’s size and complexity, and its findings routinely move purchase prices by hundreds of thousands or millions of dollars.
How It Differs From an Audit
Audited financials don’t answer the question a buyer needs answered. An audit checks whether financial statements follow Generally Accepted Accounting Principles: did the company apply the rules correctly, do reported numbers tie to supporting records, is anything materially misstated? The output is a pass/fail opinion on GAAP compliance.
A QoE report asks something different. If you bought this business tomorrow, what would it actually earn? GAAP-compliant numbers can still mislead a buyer. A company can book revenue from a one-time government contract, run the owner’s car payments through the business, or lease its headquarters from the owner at double the market rate. All of that can sit inside clean audited statements and still make the company look more profitable than it will be under new ownership. The QoE identifies each of those items, quantifies the effect, and produces a normalized earnings number reflecting standard, arm’s-length operations.
Audits focus on annual periods and net income. QoE reports typically analyze monthly data across two to three years, looking for trends, seasonality, and performance patterns that annual snapshots hide. That granularity is what makes the QoE the most consequential financial document in most deals.
Normalizing Adjustments to EBITDA
The core of any QoE is the schedule of normalizing adjustments: line-item changes to reported EBITDA that strip out anything distorting the company’s true operating profitability. Some adjustments raise EBITDA by adding back expenses the new owner won’t incur. Others reduce it by removing income that won’t recur. The result is Adjusted EBITDA, meant to represent what the business should earn under normal conditions.
Non-Recurring and Extraordinary Items
The first sweep catches one-time events. A large legal settlement, a gain on selling unused equipment, a restructuring charge, damage costs from a natural disaster. The analyst adds back the unusual expense or removes the unusual gain so the earnings picture reflects a typical year. If the company spent $400,000 settling a lawsuit two years ago, that expense gets added back. If it booked a $250,000 gain from selling a warehouse, that gain comes out.
Judgment matters here. Analysts have to decide whether something is truly one-time or just infrequent. A company that settles a lawsuit every three years has a pattern, not an exception. Experienced QoE providers push back on sellers who try to classify recurring costs as one-time to inflate Adjusted EBITDA.
Non-Operational Items
This category captures income and expenses from activities outside the core business: investment income, rental income from a side property, foreign currency gains, interest earned on excess cash. The buyer is purchasing the operating business, not the owner’s investment portfolio or real estate holdings. Those items get stripped out.
Owner and Related-Party Adjustments
Most of the action in private company deals sits here. Owners often route personal expenses through the company or structure transactions with related parties in ways that distort profitability. Common adjustments include:
- Above-market owner compensation. An owner paying herself $800,000 when a replacement executive would cost $300,000. The $500,000 difference gets added back.
- Personal expenses such as vehicle leases, club memberships, and family travel.
- Related-party rent above fair market value, adjusted to reflect what the buyer would actually pay.
- Family members on the payroll who do little or no actual work.
These adjustments usually increase Adjusted EBITDA because they add back expenses the new owner won’t have. For many private companies, owner-related adjustments make up the single largest bridge between reported and adjusted earnings.
Revenue Quality and Sustainability
Adjusting expenses only tells half the story. The QoE also examines whether the revenue driving those earnings is real, correctly timed, and likely to continue. Deals often get repriced or collapse here, because revenue problems are harder to fix than expense problems.
Revenue Recognition Practices
Under GAAP, revenue recognition follows Accounting Standards Codification Topic 606, which requires companies to recognize revenue when they transfer control of goods or services to the customer. QoE analysts look for practices that accelerate revenue into earlier periods. A classic example is a bill-and-hold arrangement where the company invoices a customer but hasn’t shipped the product. If recognition criteria aren’t met, the QoE pushes that revenue into the correct future period, which lowers normalized historical earnings.
Other red flags include channel stuffing (pushing excess inventory onto distributors near period end to hit sales targets), booking long-term contract revenue upfront rather than as services are delivered, and inconsistent policies that shift between periods. Each of those means the buyer may be inheriting a future revenue shortfall that’s already been booked as past income.
Customer Concentration
Revenue sustainability also depends on where the money comes from. A business drawing a large share of revenue from a single customer carries real risk: if that customer leaves, a big chunk of earnings vanishes. Most QoE reports flag any customer representing 15% to 20% or more of total revenue as a concentration risk. The report quantifies the exposure and usually recommends the buyer factor it into the valuation multiple. A company with three customers generating 60% of revenue almost always commands a lower multiple than a diversified peer with the same Adjusted EBITDA.
Deferred Revenue in Subscription Businesses
For software, SaaS, and other subscription businesses, deferred revenue deserves special attention. It represents cash the company has collected for services it hasn’t yet delivered. QoE analysts focus on churn rates, renewal trends, and whether the deferred revenue balance is growing or shrinking, since those patterns predict future cash flow directly.
Reserves and Allowances
The QoE also tests whether the company’s reserves for sales returns, allowances, and bad debt are adequate. If the allowance for doubtful accounts has historically run below actual write-offs, the report recommends an upward adjustment. That keeps the income statement in line with what the company actually collects, not what it hopes to collect.
Working Capital Analysis
EBITDA adjustments get the headlines, but working capital is where post-closing disputes most often erupt. Net Working Capital is current operating assets (mainly accounts receivable and inventory) minus current operating liabilities (mainly accounts payable and accrued expenses). The QoE evaluates whether the company has enough operational liquidity to sustain current revenue without the buyer injecting cash right after closing.
Inventory and Receivables Quality
The two largest current assets get the most scrutiny. For inventory, the analyst looks for obsolete, slow-moving, or damaged stock that’s overvalued on the balance sheet. A distributor carrying $2 million in inventory might have $300,000 in products that haven’t moved in over a year and would need to be liquidated at a steep discount. That write-down reduces enterprise value.
For accounts receivable, the analysis ages every outstanding invoice and assesses collectibility. Receivables over 90 days old carry a significantly higher default risk. If the company’s historical allowance for doubtful accounts hasn’t kept pace with actual write-offs, the QoE marks the receivable balance down to a realistic collectible value.
Target Working Capital and the Peg
One of the most important outputs is the Target Working Capital, sometimes called the peg: the normalized level of NWC the business needs to operate day-to-day, typically calculated as a trailing 12- to 24-month average to smooth seasonal swings. The target gets written into the purchase agreement.
After closing, actual NWC delivered gets compared to the target. If the seller delivered less, the price drops dollar-for-dollar. If more, the price goes up. This mechanism exists because sellers have an incentive to strip cash out of the business in the weeks before closing by collecting receivables aggressively, delaying vendor payments, or running down inventory below sustainable levels. The working capital adjustment catches it.
How Adjustments Shape the Purchase Price
The reason QoE adjustments carry so much weight is the multiplier effect. In most middle-market transactions, the purchase price equals Adjusted EBITDA times a negotiated valuation multiple, often somewhere between 4x and 8x depending on industry and growth profile. Every dollar of EBITDA adjustment gets amplified by that multiple.
Take a business valued at 6x EBITDA. If the seller claims $5 million in EBITDA but QoE analysis reduces that to $4.5 million, the $500,000 difference translates into a $3 million reduction in enterprise value. In middle-market deals, QoE adjustments of 10% to 25% in either direction are common. That math is why a $40,000 QoE report can be the highest-return investment a buyer makes in the entire transaction.
The adjustment schedule also becomes a negotiation document. Sellers rarely accept every buyer adjustment without pushback. Each contested line item gets debated, and the resolution moves the purchase price. Experienced advisors on both sides understand that the QoE is really a pricing document dressed up as an accounting analysis.
Buy-Side vs. Sell-Side Reports
Most people associate QoE reports with buyers, but sellers increasingly commission their own.
A buy-side QoE is the traditional engagement. The buyer hires an independent accounting firm after signing a letter of intent and entering the exclusivity period. The report’s job is to validate or challenge the seller’s earnings claims before the buyer commits. Buy-side reports tend to be more skeptical, because the buyer’s advisors are looking for risks and overstatements.
A sell-side QoE is commissioned by the seller, usually two to three months before going to market. The goal is to identify and address weaknesses before a buyer’s team finds them. If the QoE shows reported EBITDA dropping by 15% after adjustments, the seller has time to either fix the underlying issues or build a credible explanation into the offering materials. Sell-side reports give sellers control over the narrative, cut the risk of late-stage price reductions (called retrading), and often speed up the buyer’s due diligence because the heavy analytical work is already done. They also broaden the buyer pool, since some institutional buyers won’t engage without third-party financial validation.
Neither report is inherently more trustworthy. Buyers should still conduct their own analysis even when a sell-side report exists, because the seller’s firm was hired to present the business favorably within honest bounds. The two reports frequently disagree on specific adjustments, and those disagreements become negotiation points.
Role in Debt Financing and Insurance
QoE reports don’t just inform the purchase price. They also determine how much debt a buyer can raise. Commercial lenders use the Adjusted EBITDA figure to calculate debt service coverage ratios and set the maximum loan amount they’ll extend. A lower Adjusted EBITDA means less available financing, which can force the buyer to restructure the deal or walk. In SBA-backed acquisition loans, lenders frequently conduct their own quality-of-earnings analysis during underwriting, even when the buyer has already commissioned a separate report.
The QoE also plays a role in obtaining representations and warranties (R&W) insurance, which has become standard in middle-market deals. R&W insurers evaluate the quality of the buyer’s due diligence when pricing coverage. A thorough QoE satisfies one of the insurer’s primary requirements: evidence that the buyer did serious financial diligence. A sloppy or incomplete QoE can lead to higher premiums, broader exclusions, or a refusal to underwrite.
Cost, Timeline, and Choosing a Provider
For lower middle-market companies (generally under $25 million in revenue), a QoE report typically costs between $20,000 and $60,000. Larger or more complex businesses with revenue above $25 million can expect fees ranging from $40,000 to over $100,000. Cost depends on the company’s size, the state of its financial records, the number of entities involved, and how quickly the seller’s team responds to information requests.
Most engagements take three to six weeks from kickoff to final delivery. That timeline can compress when the seller has clean books and answers data requests quickly, or stretch when records are disorganized, the accounting is done on a tax basis rather than GAAP, or multiple business entities need untangling.
QoE reports are prepared by CPA firms with transaction advisory practices. The work takes a different skill set than audit or tax, and the strongest providers are teams focused exclusively on deal-related financial diligence. Regional and national accounting firms with dedicated transaction advisory groups handle the bulk of middle-market QoE work. Industry experience matters: a provider who understands SaaS metrics will catch things a generalist could miss in a software deal.
Independence also matters. The firm preparing a buy-side QoE should have no existing relationship with the seller or the seller’s accounting firm. Sell-side providers should be independent from the buyer’s advisory team. When lenders run their own analysis, they typically hire a separate firm entirely.
Red Flags That Commonly Sink Deals
Certain QoE findings reliably kill deals or trigger major repricing. Both sides benefit from knowing what they are:
- Customer concentration. Heavy dependence on one or two customers is the single most common valuation killer. When 20% or more of revenue comes from a single customer, buyers usually demand a lower multiple or build earnout protections into the deal.
- Declining margins or revenue. Shrinking gross margins or year-over-year revenue declines require explanation. If the decline is structural rather than temporary, the buyer reprices.
- Messy financial records. Inconsistent accounting policies, unreconciled accounts, months-late closes, and commingled personal and business expenses create uncertainty, and buyers discount for uncertainty.
- Aggressive revenue recognition. Evidence that revenue was pulled forward from future periods raises integrity questions and signals a likely earnings shortfall ahead.
- Undisclosed liabilities. Off-balance-sheet obligations, pending regulatory disputes, or unrecorded tax exposure erode trust and cause deal terms to deteriorate sharply.
- Working capital manipulation. Signs that the seller has been collecting receivables aggressively or delaying vendor payments to inflate the closing cash position suggest the buyer will need to inject capital post-close.
A clean QoE doesn’t guarantee a closed deal. A dirty one almost guarantees trouble.
What a QoE Report Does Not Cover
A QoE is a financial analysis, not a comprehensive due diligence review. It doesn’t replace the other workstreams a buyer needs before closing. Legal due diligence covering pending litigation, regulatory compliance, and contract risks requires separate counsel. Environmental assessments identify contamination or remediation liabilities. Intellectual property reviews confirm ownership and enforceability of patents, trademarks, and trade secrets. Tax due diligence examines historical compliance and potential exposure from prior positions. Operational due diligence evaluates management depth, technology infrastructure, and supply chain risks. The QoE report’s value lies in its focused depth on one question: what does this business actually earn? Buyers who treat it as a substitute for the full diligence package are taking on risks the report was never designed to address.