Quality of Earnings Reports Explained
A quality of earnings report is an independent analysis that evaluates whether a company’s reported earnings are real, recurring, and sustainable. Prepared by a CPA firm’s transaction advisory practice, it rebuilds historical financial statements to isolate operating performance from one-time items, accounting anomalies, and owner-specific costs. The report is a consulting engagement, not an audit, and it issues no opinion or assurance. It has become standard due diligence on virtually every private-market transaction of consequence.
What Is a Quality of Earnings Report?
A quality of earnings (QoE) report answers one foundational question before a deal closes: does the target company actually earn what it says it earns? Audited financials confirm that the books follow GAAP. A QoE report goes further by asking whether the earnings reflected in those financials are repeatable going forward.
The engagement focuses on adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) rather than GAAP net income, because EBITDA more closely approximates the cash a buyer is acquiring the right to generate. Analysts comb through 24 to 36 months of historical financials, interview management, and test individual revenue and expense lines to determine which items are truly recurring.
Who Prepares It
QoE reports are typically prepared by the transaction advisory services (TAS) practice of an independent CPA firm. The engaging party, either the buyer or the seller, commissions the report and the firm works under the AICPA’s consulting services standards (CS Section 100), which require professional competence, due professional care, and sufficient relevant data. Because it is a consulting engagement rather than an attest service, the firm does not issue an opinion under GAAS (Generally Accepted Auditing Standards).
Who Uses It
The primary users are:
- Private equity buyers and their deal teams running buy-side due diligence
- Strategic acquirers evaluating a target’s normalized earnings base
- Sellers preparing for a process and wanting to present earnings proactively
- Lenders sizing acquisition financing and assessing debt service capacity
- Business owners exploring a sale and wanting to understand how a buyer will view their financials
What a Quality of Earnings Analysis Covers
A thorough quality of earnings analysis typically includes four core workstreams.
1. EBITDA Normalization and Adjustments
This is the heart of the report. Analysts identify every item that inflates or deflates reported EBITDA and either add it back or deduct it to arrive at adjusted EBITDA. Common adjustments include:
- Excess owner compensation above market-rate replacement cost
- One-time legal settlements, litigation costs, or restructuring charges
- Revenue pulled forward or deferred due to non-standard recognition policies
- Related-party transactions at non-arm’s-length pricing
- Non-recurring professional fees tied to a specific event
- Personal expenses run through the business
Each adjustment requires documentation and a credible narrative. Adjustments that cannot be substantiated will not survive buyer scrutiny, so a rigorous QoE surfaces the defensible ones and removes the questionable ones before they become negotiating friction.
2. Revenue Quality Assessment
The revenue analysis goes behind the top line to ask whether revenue is truly earned. Analysts review customer concentration, contract terms, renewal rates, and the timing of cash collection relative to revenue recognition. A business that recognizes revenue before delivery, or that derives 60% of sales from one customer, carries earnings quality risk that GAAP financials do not make obvious.
3. Working Capital Analysis
A working capital peg is established from 12 to 24 months of normalized data. This peg defines the level of working capital a buyer expects to receive at closing, net of normal seasonal swings. Without this analysis, a seller could accelerate collections or delay payables in the weeks before closing, handing the buyer a cash windfall at signing that evaporates immediately after. Most deal agreements tie working capital adjustments directly to the QoE peg.
4. Balance Sheet and Debt-Like Items
The report identifies liabilities that behave like debt but sit off the debt schedule: deferred revenue that will require future service delivery, unfunded pension obligations, environmental reserves, or contingent earnout payments. These items affect the equity value a buyer receives and must be quantified before a purchase price can be finalized.
Quality of Earnings Report vs. Audit: Key Differences
Many business owners assume that an existing audit answers the buyer’s questions. It does not. The two engagements answer different questions, follow different standards, and serve different audiences.
| Financial Statement Audit | Quality of Earnings Report | |
|---|---|---|
| Purpose | Confirm GAAP compliance | Evaluate recurring earnings |
| Standard | GAAS / PCAOB | AICPA consulting services |
| Output | Opinion on financial statements | Analytical report, no opinion |
| Focus | Balance sheet accuracy | Adjusted EBITDA sustainability |
| Materiality | Audit-level | Transaction-level (much lower) |
| Audience | Financial statement users | Deal party that commissioned it |
A company that has been audited every year still needs a QoE report before a sale. The audit confirms the books are correct; the QoE tells the buyer what the business actually earns and what they are paying for. The two documents are complementary, not substitutes.
For more on what a financial statement audit covers, see Modus’s guide to the audit process.
Sell-Side vs. Buy-Side Quality of Earnings
The same analytical work can be commissioned by either party in a transaction, and the framing matters.
Buy-Side QoE
A buyer commissions a buy-side QoE to validate or challenge the seller’s earnings claims and to uncover risks before signing a definitive agreement. The report is delivered to the buyer’s deal team and shared with lenders on a non-reliance basis. It is the standard first step in financial due diligence on any middle-market acquisition.
Sell-Side QoE
A seller commissions a sell-side QoE before launching a process. The rationale is straightforward: the seller controls the narrative rather than waiting to react to a buyer’s version of the numbers. Research from GF Data, an M&A data provider, found that across 360 transactions completed since the third quarter of 2024, sellers using a sell-side QoE achieved average TEV/EBITDA multiples of 7.4x versus 7.0x for those who did not, a 0.4x gap. That premium concentrates in deals above $50 million in enterprise value; below that level, a sell-side QoE tends to buy deal certainty rather than a higher headline multiple.
A credible sell-side QoE can also compress the deal timeline. When buyers receive a thorough report from a reputable firm, they often move more quickly through confirmatory diligence, reducing the window during which a deal can fall apart.
Sell-side QoE reports have shifted from a differentiator to an expectation in most private equity processes. Not having one increasingly signals unpreparedness rather than cost discipline.
When Do You Need a Quality of Earnings Report?
The threshold for commissioning a QoE varies by transaction size and complexity, but the general guideline is:
- Buy-side: Any acquisition above roughly $5 million in enterprise value. Private equity firms typically require a QoE on every deal regardless of size.
- Sell-side: Any business with $1 million or more in EBITDA that is running a formal sale process, particularly if PE buyers are likely to participate.
- Recapitalization or minority investment: Any time a financial investor is taking a stake and pricing it on an EBITDA multiple.
- Acquisition financing: Most lenders require a QoE before underwriting a leveraged acquisition loan.
Businesses that carry complex revenue recognition, significant owner compensation, or multiple product lines tend to benefit most. The more moving parts in the P&L, the greater the risk that unadjusted EBITDA does not represent economic reality.
How Much Does a Quality of Earnings Report Cost?
Fees vary considerably based on company size, data quality, and scope of work. Typical ranges:
- Small businesses (under $5M revenue): $15,000 to $35,000
- Mid-market ($5M to $50M revenue): $35,000 to $75,000
- Larger or more complex engagements: $75,000 to $150,000 and above
These costs are almost always recoverable through better deal terms. A single defensible EBITDA add-back of $500,000, applied to a 7x multiple, adds $3.5 million to enterprise value. The fee pays for itself many times over when the analysis is rigorous.
Most engagements take 4 to 8 weeks to complete, depending on the quality of the company’s financial records and management’s responsiveness to data requests.
The Role of Technology in Modern QoE Work
Transaction advisory practices have begun using AI-assisted data analysis to process transaction-level data at a scale that was impractical a few years ago. Rather than sampling, modern QoE teams can run population-level tests on revenue transactions, expense coding, and journal entries. This approach surfaces anomalies that sample-based reviews miss and compresses the time between data delivery and findings.
At Modus, our transaction advisory practice applies the same AI-native methodology to QoE work that we use across our audit and assurance services, delivering source-linked workpapers and faster turnarounds without sacrificing analytical depth.
Frequently Asked Questions
What is a quality of earnings report?
A quality of earnings report is an independent analysis, prepared by a CPA firm’s transaction advisory practice, that evaluates whether a company’s reported earnings are real, recurring, and sustainable. It focuses on adjusted EBITDA and identifies one-time items, accounting anomalies, and owner-specific costs that distort reported profitability. It is a consulting engagement, not an audit, and issues no formal opinion.
Is a quality of earnings report the same as an audit?
No. An audit confirms that financial statements comply with GAAP and issues an opinion under auditing standards. A quality of earnings report is a consulting engagement that evaluates the sustainability of earnings for transaction purposes. A company can have audited financials and still need a QoE report before a sale, because the two documents answer different questions for different audiences.
Who pays for a quality of earnings report?
Either the buyer or the seller can commission and pay for a QoE report. In most buy-side processes, the buyer pays for their own QoE as part of due diligence. In a sell-side process, the seller pays for a pre-market QoE and makes it available to prospective buyers, often retaining enough credibility with buyers that they reduce the scope of their own diligence.
How long does a quality of earnings report take?
Most quality of earnings engagements take 4 to 8 weeks from kickoff to delivery. The timeline depends on the complexity of the business, the quality and availability of financial records, and how quickly management responds to information requests. Businesses with clean, well-organized books and a dedicated finance team typically move faster.
What is adjusted EBITDA and why does it matter for a QoE?
Adjusted EBITDA is earnings before interest, taxes, depreciation, and amortization, further normalized to remove one-time, non-recurring, or non-operational items. In an M&A transaction, purchase price is typically expressed as a multiple of adjusted EBITDA, so every dollar added to or removed from that figure has a direct multiplier effect on the transaction price. The QoE report is the primary mechanism for substantiating and defending the adjustments.
Can a quality of earnings report kill a deal?
Yes. A QoE can surface issues severe enough to cause a buyer to reprice the deal, restructure terms, or walk away entirely. Common deal-killers include undisclosed customer concentration risk, revenue that does not meet FASB ASC 606 recognition criteria, or material contingent liabilities. From the seller’s perspective, this is an argument for commissioning a sell-side QoE early: knowing the issues before buyers do gives the seller time to address them or frame them appropriately, rather than being blindsided in diligence.
Filed under: Transaction Advisory Private Equity