Quality of Earnings Report: What It Is and How to Prepare for One

You have accepted a Letter of Intent, and the buyer's due diligence team is requesting a Quality of Earnings (QoE) report. If you have never been through this process, the QoE can feel invasive, time-consuming, and even threatening. But understanding what it is and preparing for it in advance can be the difference between a smooth closing and a blown deal.

What Is a Quality of Earnings Report?

A Quality of Earnings report is a detailed financial analysis performed by an independent accounting firm — typically hired by the buyer — to verify and normalize a company's earnings. It goes far beyond a standard audit.

While an audit confirms that financial statements follow accounting standards, a QoE digs into whether the reported earnings are sustainable, repeatable, and accurately represent the business's true earning power.

Think of it as the buyer answering one critical question: "If I buy this business today, what will it actually earn tomorrow?"

Why Buyers Commission a QoE

Buyers are not just purchasing your current revenue. They are purchasing a stream of future cash flows, and they are applying a multiple to your EBITDA or SDE to determine the price. If those earnings are inflated, one-time in nature, or dependent on factors that will not continue post-sale, the buyer overpays.

Common reasons buyers require a QoE:

To validate the seller's adjusted EBITDA or SDE
To identify non-recurring revenue or expenses
To uncover accounting irregularities or aggressive revenue recognition
To satisfy their lender's requirements (most acquisition financing requires one)
To renegotiate the purchase price if earnings are lower than represented

What a QoE Examines

A thorough Quality of Earnings analysis typically covers the following areas:

Revenue Quality

Recurring vs. non-recurring revenue: Is revenue from long-term contracts, or is it project-based and unpredictable?
Customer concentration: What percentage of revenue comes from the top 5-10 customers?
Revenue recognition timing: Is revenue recognized when earned, or are there aggressive accounting practices?
Revenue trends: Are sales growing, flat, or declining on a monthly/quarterly basis?

Expense Normalization

Owner add-backs: Are the claimed add-backs legitimate and properly documented? Personal expenses run through the business, above-market owner compensation, one-time legal fees, and similar items are scrutinized closely.
Below-market expenses: Is the owner paying themselves below market rate? Is the business using family members at below-market wages? Are facilities rented from a related party at below-market rates? These items will be adjusted upward.
Non-recurring expenses: One-time costs like lawsuit settlements, relocation expenses, or COVID-related disruptions are identified and normalized.

Working Capital Analysis

Accounts receivable aging: Are receivables collectible, or are there significant write-offs hiding in the aging report?
Inventory valuation: Is inventory properly valued? Is there obsolete or slow-moving inventory that should be written down?
Accounts payable trends: Is the business stretching payables to improve cash flow appearances?
Working capital peg: The QoE establishes a normalized working capital target, which becomes a critical closing adjustment.

Cash Flow Verification

Cash vs. accrual differences: The QoE reconciles reported earnings with actual cash flows.
Capital expenditure requirements: Are maintenance capex needs being deferred to inflate short-term earnings?
Off-balance-sheet obligations: Are there commitments or contingencies not reflected in the financials?

Red Flags a QoE Catches

These are the findings that most commonly lead to purchase price reductions or deal terminations:

Revenue that cannot be verified against bank deposits or third-party data
Owner add-backs that are unsupported by documentation or receipts
Declining revenue trends that were obscured by annual reporting
Significant related-party transactions at non-market rates
Deferred maintenance or capex that masks true ongoing costs
Customer concentration above 20% with no contractual protection
Inconsistencies between tax returns and financial statements
Undisclosed liabilities such as pending litigation, tax disputes, or environmental issues

Typical Cost and Timeline

A Quality of Earnings report is not inexpensive. Costs vary based on business size and complexity:

| Business Revenue | Typical QoE Cost | |---|---| | Under $5M | $15,000 - $25,000 | | $5M - $20M | $25,000 - $40,000 | | $20M - $50M | $35,000 - $50,000 | | Over $50M | $50,000+ |

The buyer typically pays for the QoE, but sellers should be aware that the cost ultimately comes out of deal economics. Some sellers commission their own sell-side QoE before going to market, which costs roughly the same but gives them the advantage of identifying and addressing issues proactively.

Timeline: A QoE typically takes 3-6 weeks to complete, depending on the responsiveness of the seller and the complexity of the financials.

How Sellers Should Prepare

Preparation is everything. Sellers who are organized and transparent during the QoE process build buyer confidence and reduce the chance of adverse findings.

12+ Months Before Sale

Move to accrual-based accounting if currently on cash basis
Eliminate personal expenses from business accounts entirely
Ensure financial statements are prepared monthly and consistently
Begin tracking and documenting all owner add-backs with supporting evidence

6 Months Before Sale

Reconcile bank statements with reported revenue for the past 3 years
Review accounts receivable aging and write off uncollectible amounts
Conduct a physical inventory count and address obsolete items
Review all related-party transactions and document fair market value

When the QoE Begins

Designate one internal point of contact for QoE data requests
Respond to information requests within 24-48 hours
Provide clean, organized data — labeled clearly and formatted consistently
Be transparent about known issues (surprises kill deals, honesty builds trust)

Should You Get a Sell-Side QoE?

For businesses valued above $3-5 million, a sell-side Quality of Earnings is increasingly common and highly recommended. Benefits include:

Identifying and fixing issues before buyers find them
Supporting your asking price with independent validation
Accelerating buyer due diligence
Strengthening your negotiating position
Reducing the risk of last-minute price reductions

The Bottom Line

A Quality of Earnings report is not something to fear — it is something to prepare for. The sellers who fare best are those who treat their financials as a product: clean, well-documented, and ready for scrutiny.

Start by understanding your numbers. Use our EBITDA calculator and SDE calculator to see your business the way a buyer will. Then review the full due diligence checklist to ensure you are ready for every aspect of the process.

When you are prepared, a QoE becomes a validation exercise rather than a discovery process — and that is exactly where you want to be.