Introduction
Buying or selling a business involves far more than agreeing on a purchase price. Both parties need confidence that the company’s financial performance accurately reflects its true earning potential. While financial statements provide valuable information, they don’t always tell the complete story. A business may report strong revenue and healthy profits, but those numbers may include one-time events, unusual expenses, accounting adjustments, or owner-specific costs that won’t continue after the sale.
This is where a Quality of Earnings (QoE) report becomes an important part of the transaction.
A Quality of Earnings report evaluates whether a company’s reported earnings are sustainable and representative of its ongoing operations. Rather than focusing solely on how much profit a business earned, it examines how those earnings were generated and whether they are likely to continue after ownership changes.
For buyers, a QoE report helps reduce the risk of overpaying for a business based on inflated or temporary earnings. For sellers, it provides an opportunity to present transparent financial information, address potential concerns before they become issues, and build credibility with prospective buyers. Banks, private equity firms, and investors also rely on these reports when evaluating acquisition financing and investment opportunities.
If you’re considering purchasing a business, our guide to buying a business explains the overall acquisition process and how financial due diligence fits into each stage. Likewise, business owners preparing for an exit can benefit from understanding the steps involved in selling your business in Florida before bringing their company to market.
What Is a Quality of Earnings (QoE) Report?
A Quality of Earnings (QoE) report is a financial due diligence report that analyzes the accuracy, sustainability, and consistency of a company’s earnings. Its purpose is to determine whether the reported financial results accurately reflect the ongoing performance of the business.
Unlike a traditional financial statement review, a QoE report looks beyond the numbers presented on the income statement. It evaluates the factors that produced those results, identifies unusual transactions, and determines whether reported earnings are likely to continue after the transaction closes.
In many middle-market mergers and acquisitions throughout the United States, buyers use a Quality of Earnings report as one of the most important tools for validating a company’s financial performance before completing an acquisition.
The report seeks to answer several important questions.
- Are reported revenues recurring and properly recognized?
- Are expenses recorded consistently from year to year?
- Were there one-time gains or losses that affected profitability?
- Does EBITDA accurately represent the company’s operating performance?
- Are there financial risks that could reduce future cash flow?
- Are accounting practices consistent and reasonable?
The answers to these questions help buyers determine whether the business is worth the negotiated purchase price and whether additional adjustments should be considered before closing.
Why the Quality of Earnings Matters
Two businesses may report identical annual profits, yet one could be significantly more valuable than the other.
Imagine two manufacturing companies that each report annual EBITDA of $1 million.
The first company has diversified customers, recurring contracts, stable operating expenses, and predictable cash flow. Revenue has grown consistently over the past five years, and the financial statements accurately reflect normal business operations.
The second company also reports $1 million in EBITDA, but a closer review reveals that a portion of those earnings resulted from an insurance settlement, deferred maintenance, temporary payroll reductions, and several unusually large customer orders that are unlikely to occur again.
Although both companies report the same earnings, their future earning potential is very different.
A Quality of Earnings report helps identify these differences by separating recurring operating performance from one-time financial events. This allows buyers and sellers to negotiate using normalized earnings rather than relying solely on reported accounting profits.
Because many privately held businesses are valued using an EBITDA multiple, even relatively small adjustments can have a meaningful impact on valuation. A $200,000 reduction in normalized EBITDA could translate into a purchase price adjustment of more than $1 million, depending on the valuation multiple used in the transaction.
Business owners who are preparing to sell often begin by understanding what their company may be worth. Our business valuation services can help establish a realistic starting point before entering the market.
Why a Quality of Earnings Report Is Important
Every business acquisition involves a degree of uncertainty. Buyers want confidence that the financial information they receive accurately reflects the company’s ongoing performance, while sellers want to demonstrate transparency and minimize surprises during due diligence.
A Quality of Earnings report helps accomplish both objectives.
For buyers, the report provides an independent evaluation of the company’s earnings, helping identify potential financial risks before the transaction closes. It may uncover issues such as customer concentration, inconsistent revenue recognition, declining gross margins, excessive owner add-backs, or unusual operating expenses.
For sellers, preparing a quality of earnings report before marketing the business can improve buyer confidence and reduce delays during negotiations. Addressing financial issues in advance often creates a smoother transaction process and may reduce the likelihood of purchase price adjustments later in the deal.
Lenders and investors also benefit from quality of Earnings reports because they provide greater confidence that future cash flow will support loan payments and investment returns.
Many business owners choose to complete seller due diligence before listing their company for sale. Identifying financial issues early allows sellers to resolve questions before buyers begin their own review.
How a Quality of Earnings Report Fits Into Due Diligence
A Quality of Earnings report is one component of the broader due diligence process that takes place during most business acquisitions.
Due diligence is the buyer’s opportunity to verify the information provided by the seller before completing the transaction. It typically includes reviews of financial records, legal documents, tax filings, customer contracts, employee matters, operations, intellectual property, and regulatory compliance.
The Quality of Earnings report focuses specifically on the financial performance of the business.
While attorneys review contracts and legal risks, accountants evaluate tax matters, and operational specialists assess business processes, the QoE report analyzes whether reported earnings accurately represent the company’s long-term earning capacity.
This financial review often becomes one of the most influential documents in the transaction because it helps buyers determine whether the negotiated purchase price is supported by the company’s actual operating performance.
Businesses preparing for an acquisition frequently engage professional due diligence services to coordinate these reviews and identify potential issues before they become obstacles to closing.
What Does a Quality of Earnings Report Review?
Although every engagement is different, most Quality of Earnings reports examine several core financial areas that directly affect the value of a business.
These commonly include:
- Revenue recognition
- Historical revenue trends
- Gross profit margins
- Operating expenses
- EBITDA adjustments
- Cash flow
- Working capital
- Customer concentration
- Vendor concentration
- Accounting policies
- Financial reporting consistency
- Non-recurring income and expenses
Each of these areas helps determine whether the company’s reported earnings accurately reflect its long-term earning potential rather than temporary financial performance.
What Is Included in a Quality of Earnings Report?
Although every transaction is unique, most Quality of Earnings reports follow a similar structure. The goal is to provide buyers, sellers, lenders, and investors with a clear understanding of the company’s financial performance and identify any issues that could affect the value of the business.
A typical report begins with an executive summary that highlights the most significant findings. This section gives decision-makers a high-level overview of the company’s financial health, identifies key risks, and summarizes any adjustments made to reported earnings.
The report then moves into a detailed analysis of the company’s financial statements. Historical income statements, balance sheets, and cash flow statements are reviewed to identify trends and determine whether the business has demonstrated consistent financial performance over time.
From there, the review focuses on revenue quality, operating expenses, EBITDA adjustments, working capital, customer concentration, vendor relationships, and cash flow generation.
Rather than accepting the financial statements at face value, the report examines the story behind the numbers.
Revenue Recognition
Revenue is often the first area reviewed during a Quality of Earnings analysis because it directly affects profitability and business valuation.
The objective is to determine whether revenue has been recorded properly and whether sales represent recurring business activity.
Questions commonly addressed include:
- Is revenue recognized according to generally accepted accounting principles (GAAP)?
- Are there unusual spikes in revenue near year-end?
- Are sales dependent on one-time projects?
- Has the company accelerated revenue recognition?
- Are customer returns or credits properly recorded?
For example, a business may report unusually strong fourth-quarter revenue because it invoiced customers before products were delivered. While that may increase reported earnings, it may not accurately reflect the company’s ongoing operations.
The QoE review helps determine whether reported revenue truly represents completed business activity or whether adjustments are necessary.
EBITDA Normalization
One of the most valuable parts of a Quality of Earnings report is the normalization of EBITDA.
EBITDA is frequently used when valuing privately held businesses because it measures operating performance before interest, taxes, depreciation, and amortization. However, reported EBITDA often includes expenses or income that will not continue after the transaction closes.
Normalization removes these items to present a more accurate picture of recurring earnings.
Common adjustments include:
- Owner compensation above or below market rates
- Personal expenses paid through the business
- One-time legal settlements
- Non-recurring consulting fees
- Relocation expenses
- Startup costs for new locations
- Insurance proceeds
- Pandemic-related assistance
- Unusual bonuses
- Litigation expenses
Not every adjustment increases EBITDA.
Sometimes the review identifies expenses that were intentionally delayed or omitted. Deferred maintenance, underfunded payroll, or below-market rent may require negative adjustments because future owners will likely incur those costs.
The purpose is not to inflate earnings. The goal is to present a fair representation of the company’s true operating performance.
Working Capital Analysis
Working capital is another important part of the Quality of Earnings review because it measures the company’s ability to operate on a day-to-day basis.
Working capital generally includes current assets such as accounts receivable and inventory, less current liabilities like accounts payable and accrued expenses.
Buyers want to understand whether the business has sufficient working capital to continue operating after closing without requiring an immediate cash infusion.
A QoE report may analyze:
- Historical working capital levels
- Seasonal fluctuations
- Collection periods for accounts receivable
- Inventory turnover
- Vendor payment practices
- Outstanding liabilities
In many acquisitions, the purchase agreement includes a target working capital amount that must be delivered at closing. A Quality of Earnings report often provides the analysis used to establish that benchmark.
Cash Flow Analysis
Profitability and cash flow are not always the same thing.
A company may report significant profits while experiencing cash flow challenges due to slow collections, excessive inventory, or large capital expenditures.
For this reason, a Quality of Earnings report examines how efficiently earnings are converted into cash.
Areas commonly reviewed include:
- Operating cash flow
- Capital expenditures
- Debt service requirements
- Accounts receivable collections
- Inventory management
- Accounts payable trends
Businesses with consistent operating cash flow are generally viewed as lower-risk acquisition opportunities because future earnings are more likely to support debt payments and business growth.
Customer and Vendor Concentration
Revenue diversification plays an important role in business valuation.
If one customer represents 60 percent of annual revenue, the business carries considerably more risk than a company with hundreds of customers spread across multiple industries.
A Quality of Earnings report identifies customer concentration and evaluates how dependent the business is on its largest accounts.
The same analysis is performed for suppliers.
If one vendor provides a critical product or service, the buyer needs to understand what would happen if that relationship ended.
Concentration risks do not necessarily reduce business value, but they often become important discussion points during negotiations.
Accounting Policies and Financial Reporting
Consistency matters.
A Quality of Earnings report reviews accounting policies to determine whether financial reporting has remained consistent over time.
Examples include:
- Revenue recognition methods
- Inventory valuation
- Expense classification
- Depreciation methods
- Capitalization policies
- Accrual practices
Inconsistent accounting policies can make it difficult to compare financial performance from one year to the next.
The report identifies these differences and explains how they affect reported earnings.
Quality of Earnings Report vs. Financial Audit
Many business owners assume that an audited financial statement eliminates the need for a Quality of Earnings report.
While both reviews examine financial information, they serve very different purposes.
A financial audit is designed to determine whether the company’s financial statements fairly present its financial position in accordance with generally accepted accounting principles.
A Quality of Earnings report focuses on the sustainability of earnings and the financial factors that influence business value.
An audit asks whether the numbers are presented fairly.
A Quality of Earnings report asks whether those numbers accurately represent the future earning power of the business.
Because of these different objectives, many acquisitions include both an audit and a Quality of Earnings review.
Common Red Flags Found During a QoE Review
One reason buyers invest in a Quality of Earnings report is to identify potential risks before completing the transaction.
Some of the most common issues uncovered include:
- Declining gross profit margins
- Customer concentration
- Aggressive revenue recognition
- Significant owner add-backs without documentation
- Inconsistent financial reporting
- Poor internal controls
- Large unexplained journal entries
- Deferred maintenance
- Weak cash flow despite strong reported profits
- Significant fluctuations in working capital
Finding one of these issues does not necessarily mean a transaction should end.
In many cases, the concerns can be explained or addressed during negotiations. However, identifying them early allows buyers and sellers to negotiate based on accurate information rather than assumptions.
For sellers, proactively addressing these issues before taking the business to market can create a smoother transaction process. Business owners looking to maximize value often begin by reviewing maximizing business value and organizing their financial records before entering due diligence.
When Should a Quality of Earnings Report Be Performed?
The timing of a Quality of Earnings report can significantly influence the success of a transaction. While many buyers commission a QoE report after signing a Letter of Intent (LOI), an increasing number of business owners choose to complete a seller-side report before listing their company for sale.
Completing the review early allows sellers to identify financial issues, organize supporting documentation, and answer buyer questions before negotiations begin. This often reduces delays during due diligence and helps create a smoother transaction process.
A buyer typically performs a Quality of Earnings review after reaching preliminary agreement on price and terms. The report provides an independent assessment of the company’s financial performance before the acquisition moves toward closing.
A QoE report may also be appropriate when:
- Raising capital from investors
- Applying for acquisition financing
- Bringing in new business partners
- Recapitalizing an existing business
- Planning for succession or ownership transition
The earlier potential financial issues are identified, the easier they are to address before they become obstacles during negotiations.
How Much Does a Quality of Earnings Report Cost?
The cost of a Quality of Earnings report depends on several factors, including the size of the business, the complexity of its financial records, the number of operating entities involved, and the overall scope of the engagement.
Smaller privately held businesses generally require less time to review than multi-location companies with several years of complex financial reporting.
Typical pricing in the United States often falls within these general ranges.
| Business Size | Estimated Cost |
| Small businesses | $15,000 – $30,000 |
| Lower middle-market businesses | $25,000 – $60,000 |
| Larger middle-market transactions | $60,000 and above |
These figures are only general estimates. Every transaction is different, and pricing can vary depending on the provider and the level of analysis requested.
Although a Quality of Earnings report represents an additional transaction expense, many buyers and sellers view it as an investment. Identifying a significant financial issue before closing can save substantially more than the cost of the report itself.
How to Prepare for a Quality of Earnings Review
Good preparation helps the review move efficiently and minimizes delays during due diligence.
Business owners should begin by organizing several years of financial information, ensuring that supporting documentation is complete and readily available.
Items commonly requested include:
- Historical financial statements
- Federal income tax returns
- General ledger reports
- Bank statements
- Accounts receivable aging reports
- Accounts payable aging reports
- Payroll records
- Customer contracts
- Vendor agreements
- Equipment schedules
- Lease agreements
- Debt schedules
It is also helpful to prepare explanations for unusual transactions that occurred during the review period. One-time legal settlements, insurance claims, owner distributions, major capital expenditures, or temporary operational disruptions should all be documented before buyers begin asking questions.
Well-organized financial records demonstrate professionalism and often increase buyer confidence throughout the transaction.
How a Quality of Earnings Report Can Increase Business Value
A Quality of Earnings report does not automatically increase the value of a business. Instead, it helps ensure that the company’s value is supported by accurate and credible financial information.
When buyers have confidence in the financial reporting, negotiations often become more productive because there are fewer surprises during due diligence.
A seller-side Quality of Earnings report may also identify legitimate EBITDA adjustments that were previously overlooked. These adjustments can help buyers better understand the company’s actual earning power and support a higher valuation when appropriate.
Additional benefits include:
- Greater transparency
- Faster due diligence
- Fewer purchase price disputes
- Improved buyer confidence
- Better financing opportunities
- More efficient closing process
Many successful transactions begin months before the business is officially listed for sale. Business owners who prepare their financial records in advance are often in a stronger negotiating position than those who wait until due diligence begins.
Frequently Asked Questions
Is a Quality of Earnings report required to sell a business?
No. A Quality of Earnings report is not legally required. However, it is commonly used in middle-market transactions, private equity acquisitions, and larger privately held business sales where buyers want additional confidence in the company’s financial performance.
Who prepares a Quality of Earnings report?
Quality of Earnings reports are typically prepared by accounting firms, transaction advisory professionals, financial due diligence specialists, or Certified Public Accountants (CPAs) with experience in mergers and acquisitions.
Is a Quality of Earnings report the same as a business valuation?
No.
A business valuation estimates what a company may be worth based on several financial and market factors.
A Quality of Earnings report evaluates whether the earnings used to support that valuation are sustainable and accurately reported.
The two services often complement one another during a business sale.
How long does a Quality of Earnings review take?
The timeline varies depending on the complexity of the business and the availability of financial records.
Many engagements are completed within three to six weeks, although larger or more complex transactions may require additional time.
Can small businesses benefit from a Quality of Earnings report?
Yes.
Although QoE reports are most common in middle-market acquisitions, smaller businesses may also benefit, particularly when the transaction involves outside financing, multiple buyers, or significant purchase prices.
What is the difference between buyer-side and seller-side Quality of Earnings reports?
A buyer-side report is commissioned by the buyer to verify the seller’s financial information before closing.
A seller-side report is prepared before marketing the business and is used to demonstrate financial transparency while reducing surprises during buyer due diligence.
Conclusion
A Quality of Earnings report provides far more than a review of historical financial statements. It helps buyers, sellers, lenders, and investors understand whether a company’s earnings accurately represent its ongoing operating performance.
By examining revenue quality, normalized EBITDA, cash flow, working capital, accounting policies, and other financial factors, the report provides valuable insight into the true earning capacity of a business.
For buyers, this information reduces acquisition risk and supports more informed investment decisions.
For sellers, it creates transparency, improves credibility, and can streamline negotiations by addressing potential concerns before they become obstacles.
Whether you’re preparing to acquire a company or planning your exit strategy, understanding the quality of a business’s earnings is an important step toward making informed decisions.
If you’re considering buying or selling a business, KMF Business Advisors offers guidance throughout the transaction process, including due diligence services, business brokerage, exit planning, and transaction advisory services to help clients navigate complex business sales with confidence.
Disclaimer
This article is provided for general informational and educational purposes only. KMF Business Advisors is not a law firm, accounting firm, or licensed tax advisory practice. Nothing in this article should be interpreted as legal, accounting, tax, financial, or investment advice. Every business transaction is unique, and readers should consult qualified attorneys, Certified Public Accountants (CPAs), tax professionals, or other licensed advisors regarding their specific circumstances before making decisions related to buying, selling, financing, or valuing a business.