Dear Insider,

For deals of a certain size, a Quality of Earnings (QoE) report is a recurring topic during due diligence discussions, whether you're a prospective seller, a strategic or financial acquirer, you can expect to see or have one conducted.

For acquirers, a QoE report helps ensure you are buying what you think you are buying. It mitigates the risk of overpaying by clarifying the underlying earnings drivers and their reliability. The report can reveal issues that might inflate reported profits—such as one-time gains or aggressive accounting practices—or obscure financial risks like undisclosed cost trends or cyclical sales patterns. With a QoE report, you gain confidence in the deal’s financial foundation, which can strengthen your negotiating position or signal when to walk away.

For sellers, preparing a QoE report in advance provides a clear, reliable financial picture. It demonstrates serious commitment to a potential transaction, often leading to a premium in price and more favorable deal timing by reducing perceived risk.

Considerations for Sellers Investing in a QoE Report

• Cost: The expense of a QoE report can be significant and varies based on the provider and the complexity of the firm having it done.

• Value Threshold: This investment typically makes good sense for deals between $10 million and $20 million, and for any deal over $20 million.

What Does a Quality of Earnings Report Cover?
A well-prepared QoE report typically includes:

• Adjusted EBITDA Analysis: Evaluates adjustments such as seller add-backs, one-time expenses, or non-recurring revenues.

• Revenue Quality: Examines revenue recognition practices, customer concentration risks, and the sustainability of recurring revenue streams.

• Cost and Expense Trends: Identifies unusual or poorly documented costs.

• Working Capital Analysis: Assesses whether the business consistently maintains adequate working capital.

• Cash Flow Dynamics: Provides insights into actual cash generation versus reported “paper” profits.

Generally, preparing a QoE report takes about 2–4 weeks, though timing can vary based on the scope of work and the quality of the seller’s financial records.

Why is a Quality of Earnings Report Needed?
Beyond verifying the seller’s financials, a QoE report helps minimize surprises post-close by clarifying profitability drivers. It also serves as a benchmark for future business forecasts. Additionally, lenders often require QoE reports during the underwriting process, making them essential for acquirers who plan to finance the acquisition through loans.

QoE Report vs. Business Valuation
A QoE report focuses on the accuracy and sustainability of earnings, while a business valuation estimates the seller’s overall worth by considering broader factors like market trends, competitive landscape, and strategic potential. For example, a valuation might use an EBITDA multiple to estimate value, whereas a QoE report delves into whether that EBITDA is valid or potentially inflated.

Limitations of a Quality of Earnings Report

• Historical Focus: QoE reports emphasize past performance and do not predict future earnings.

• Scope Limitations: Areas such as fraud or non-financial operational risks may not be covered if they fall outside the report’s scope.

• Seller Cooperation: Incomplete or mismanaged financial records can limit the accuracy of the report.

Who Prepares QoE Reports?
Most QoE reports are prepared by firms specializing in accounting services. When selecting a provider, consider the following credentials:

• Professional Qualifications: Certified Public Accountants (CPA) and Chartered Financial Analysts (CFA).

• Relevant Experience: Expertise in transaction advisory, private equity, and familiarity with the target’s industry.

• Proven Track Record: Experience with deals of comparable size or complexity.

• Tailored Insights: The provider should address your specific investment questions and simplify complex financial jargon into actionable insights.

Conclusion
For buyers serious about mitigating risk, engaging a QoE provider early—ideally alongside the execution of a Letter of Intent (LOI)—is essential. Whereas sellers benefit most greatly from having a QoE completed prior to the LOI, so that it can have the greatest impact on underpinning the amount.

A thorough QoE report is not merely a checklist item; it is an investment in ensuring long-term, sustainable earnings. By providing detailed data to support a revised EBITDA and identifying potential red flags, a QoE report can pay for itself if ordered by either side of the deal and enhance the overall success of the acquisition process.

If you are an acquirer, have you used a QoE with your acquisition targets in the past? If you’re thinking about selling, are you curious if this would be a valuable investment for your firm? We're happy to discuss these topics with you. Let us know with a comment below or feel free to book a time with us to discuss at the link below.

*All comments are reviewed by PSMJ’s M&A advisory and ownership transition practice and are not shared publicly unless you request them to be.