What is a Quality of Earnings Report?

A Quality of Earnings (QofE) report is a financial analysis performed by an independent accounting firm during diligence on an M&A transaction. Its purpose is to verify the seller’s reported financials and produce a defensible ‘adjusted EBITDA’ (or SDE) number that both sides can rely on for valuation.

It’s not the same as an audit. An audit verifies that financial statements comply with accounting standards. A QofE goes deeper into the operating economics of the business: it tests revenue recognition, validates add-backs, normalizes one-time items, identifies hidden costs, and assesses earnings sustainability.

QofE is now standard on virtually every PE-led deal and most lower-middle-market transactions above ~$5M enterprise value. The cost ($25K–$100K+, paid by whoever commissions it) is small relative to the financial risk it manages.

What Happens During a QofE

The accounting firm typically does the following over 4–6 weeks:

• Reviews 3 years of monthly P&Ls, balance sheets, and cash-flow statements
• Tests revenue recognition (especially for businesses with multi-year contracts, percentage-of-completion accounting, or recurring revenue)
• Validates every claimed add-back — owner compensation, personal expenses, one-time items, family-on-payroll, etc.
• Analyzes gross margin trends and identifies any unusual changes
• Reviews customer concentration and revenue stability
• Examines working capital trends and identifies the true normalized working capital target
• Assesses recent operating changes that may not yet show up in reported earnings
• Identifies any ‘cookie jar’ reserves or one-time gains that inflate reported earnings

The output is a written report (often 50–150 pages) with a recommended adjusted EBITDA, identified diligence findings, and a list of items requiring further explanation.

Buy-Side vs. Sell-Side QofE

There are two flavors of QofE, depending on who commissions it:

Buy-side QofE

Commissioned by the buyer after LOI. The traditional approach. The buyer’s accountants scrub your books and almost always produce an adjusted EBITDA lower than what you (the seller) claimed — sometimes by 5%, sometimes by 25%. Any reduction is grounds for a price re-trade by the buyer.

Sell-side QofE

Commissioned by the seller before going to market. Increasingly standard for deals above ~$10M enterprise value. You commission your own QofE in advance, producing a defensible adjusted EBITDA number that’s much harder for buyers to push back on. Costs $25K–$60K typically; almost always pays for itself in avoided price re-trades.

If you’re considering a sale and your business is above ~$10M expected enterprise value, a sell-side QofE is one of the highest-ROI things you can do before going to market.

What QofE Discoveries Look Like (And How to Avoid Them)

Misclassified revenue

The single most common QofE finding. Examples: recognizing multi-year contract revenue upfront instead of ratably; treating customer deposits as revenue; counting deferred maintenance contracts as current revenue. Each reduces adjusted EBITDA.

Owner comp normalization

If the owner pays themselves $80K (below market) while distributing profits, the buyer’s QofE will adjust the owner’s salary up to a market rate (often $150K–$300K depending on business size), reducing adjusted EBITDA.

Disallowed add-backs

‘One-time’ expenses that turn out to recur every year. ‘Personal’ expenses that are actually business expenses. ‘Owner perks’ that the new owner will need to replicate (like a comp’d vehicle if it’s needed for client visits).

Hidden COGS or operating costs

Costs miscategorized as ‘below the line’ that should be in COGS or operating expenses. Underaccrued bonuses, vacation, or other employee liabilities. Lease expense paid below market because the owner owns the building.

Working capital surprises

The negotiated working capital target turns out to be wrong because seasonal swings weren’t accounted for properly. Triggers a working capital adjustment at close that reduces the cash to seller.

How to Prepare for QofE

Whether you commission your own sell-side QofE or just want to be ready for the buyer’s:

• Clean up your books before going to market. Categorize expenses consistently. Identify and separately label every personal expense.
• Document add-backs. Every claimed add-back should have supporting documentation (lease comparable for rent normalization, vendor invoices for personal expenses, dated correspondence for one-time items).
• Get monthly financials in order for the past 36 months — not just annuals. QofE works on monthly trends.
• Reconcile to tax returns. If your reported P&L and tax returns show different revenue, expect detailed scrutiny.
• Have a clear story for unusual months. Big revenue spikes or expense dips will get questioned; have the explanation ready.