Quality of Earnings Report: What Buyers Look For

A quality of earnings (QoE) report examines the underlying drivers of a company’s reported earnings and the adjustments proposed to present a more representative view of performance. It helps buyers and sellers understand revenue trends, margins, accounting practices, and items that may not continue after a transaction. Depending on the engagement, financial due diligence may also include working capital, cash flow, and debt-related analysis.

When a transaction is valued using adjusted EBITDA, changes to the earnings figure can materially affect valuation discussions. For example, a $100,000 adjustment at an unchanged 6× multiple would imply a $600,000 difference in enterprise value. The final outcome still depends on the negotiated multiple, transaction structure, and other deal terms.

What a quality of earnings report may include

The scope should reflect the business, transaction, and questions the parties need answered. Agree on the historical periods, analyses, and deliverables before the work begins.

• Earnings bridge: A reconciliation from reported results to EBITDA and proposed adjusted EBITDA, with support for each adjustment.
• Revenue analysis: Trends by customer, product, service, or channel, including concentration and changes in pricing or volume.
• Margin analysis: The factors driving changes in gross profit and operating costs.
• Cash reconciliation: Analysis connecting accounting activity with cash receipts and payments, where included in scope.
• Accounting observations: Revenue timing, expense recognition, reserves, capitalization, and other practices affecting reported performance.
• Working capital analysis: Monthly trends, seasonality, and potential adjustments, where included.
• Debt and debt-like items: Obligations requiring consideration in the transaction, subject to the purchase agreement.

Adjusted EBITDA: the adjustments buyers test

Proposed adjustments may address accounting errors, unusual transactions, owner-related costs, or changes intended to show ongoing performance. Each requires a clear explanation and supporting records. Adjustments can increase or decrease earnings, and their treatment depends on the facts and the purpose of the analysis.

Adjustments that require supporting evidence

• Owner compensation compared with the cost of replacing the owner’s actual responsibilities.
• Unusual expenses supported by evidence that they are not part of normal ongoing operations.
• Transactions recorded in the wrong accounting period.
• Related-party arrangements compared with appropriate market terms.
• Missing or inconsistent accruals that affect reported earnings.

Proposals that need closer examination

• Costs described as one-time when similar expenses recur.
• Projected benefits from pricing changes, new customers, or cost savings not yet demonstrated in results.
• Removing compensation for roles the buyer will still need to fill.
• Excluding losses from a product or location without considering associated revenue, shared costs, and exit costs.
• Revenue or expenses recorded in periods that do not reflect the applicable accounting treatment.

Every proposed adjustment should tell a clear story and have the records to support it.

Sell-side vs buy-side QoE

A sell-side QoE is commissioned by the seller to understand financial issues, organize support for earnings adjustments, and prepare for buyer questions before or during a sale process. A buy-side QoE is commissioned by the buyer to evaluate the target’s performance and financial risks.

A sell-side report can improve preparation, but it does not eliminate the buyer’s own diligence or guarantee agreement on earnings. Sharing and reliance on any report should follow the engagement’s terms.

• Sell-side focus: Identify issues early, document proposed adjustments, and prepare management for financial review.
• Buy-side focus: Evaluate the seller’s information, investigate risks, and inform valuation and transaction discussions.

Understanding the working capital target

A working capital target, often called a peg, establishes the agreed level of working capital to be delivered at closing. Some purchase agreements adjust consideration when closing working capital differs from that target. The calculation depends on the agreement’s definitions, accounting policies, and adjustment mechanism.

• Agree which operating assets and liabilities are included and excluded.
• Review monthly trends alongside seasonality, growth, and unusual balances.
• Assess whether historical accounting adjustments also affect working capital.
• Define the treatment of deferred revenue, customer deposits, and other potentially disputed items.
• Avoid counting the same obligation in both working capital and debt-related deductions.

Understanding working capital before negotiations helps ownership discuss the target using supporting evidence. Review proposed definitions with the financial and legal advisors responsible for the transaction.

Timeline

The schedule depends on scope, record availability, business complexity, and the responsiveness of the parties. Agree on milestones with the provider rather than assuming every engagement follows the same calendar.

1. Define scope and gather records.
2. Analyze earnings, trends, and other agreed financial areas.
3. Discuss questions and proposed adjustments with management.
4. Review findings and issue the agreed deliverable.
5. Update selected analyses if the transaction requires more recent information.

The most common cause of delay is not the advisor. It is a company that cannot produce monthly trial balances, customer-level revenue, or support for its add-backs quickly. Teams that prepare these in advance often cut weeks off the process.

What a QoE costs

Fees depend on the engagement’s scope, historical periods, number of entities, accounting complexity, and condition of the records. Ask for a proposal that explains the analyses included, deliverables, management support required, and charges for additional work or updates. Compare proposals on scope rather than headline price alone.

How to prepare

• Organize monthly financial statements, trial balances, and general ledger detail for the requested periods.
• Prepare reconciliations and supporting schedules for significant balances.
• Document each proposed earnings adjustment with calculations, records, and a business explanation.
• Gather revenue and margin information by customer, product, project, or channel as relevant.
• Identify accounting changes, unusual transactions, and related-party arrangements.
• Assign someone to coordinate requests, management responses, and outstanding questions.

If you expect to sell, raise, or refinance in the next year, our transaction advisory team prepares sell-side QoE reports and helps management get the numbers ready before diligence starts.