Part 1: What Is a Quality of Earnings Report?

A quality of earnings (QoE) report is a detailed examination of a company’s earnings and cash flows that seeks to answer a fundamental question: How real are these earnings and cash flows, and how likely are they to continue? A QoE report differs from an audit, where the concern is whether or not the financials are fairly stated in accordance with generally accepted accounting principles (GAAP).

Why a Quality of Earnings Report Matters for Buyers

A Quality of Earnings report is important to a buyer in an M&A transaction because the purchase price is typically based on earnings multiples. If nonrecurring items or unusual related-party transactions inflate those earnings, it becomes much easier to overpay for the target company. A Quality of Earnings report normalizes historical earnings to what they might be going forward by analyzing unusual items such as unusual bonuses, perks to the owner, divisional or subsidiary allocations, or timing differences.

Why Sellers Benefit From a Sell-Side Quality of Earnings Report

For the seller, engaging in the QoE process before the sale can be just as effective. It helps the management team view the business from the buyer’s perspective, which can lead to problems being addressed and/or justifications being developed to preserve or even increase value. A sell-side QoE process can also save time and build credibility with buyers by providing a clear and well-supported view of normalized earnings.

How a Quality of Earnings Report Supports Better Valuation

Ultimately, a QoE report is valuable because it converts raw financial data into information that is decision-ready. It supports better valuations, stronger negotiations, and fewer post-closing regrets after a deal is closed by providing all parties with an accurate and unbiased understanding of what the business is really capable of earning going forward.

Part 2: How a QoE Report Reduces Deal Risk

A QoE report is also one of the most effective methods for reducing deal risk. It re-examines a company's earnings to help both sellers and buyers identify problems and resolve them before they lead to costly disputes after a deal is closed.

Key Ways a QoE Report Reduces Transaction Risk

1. Identifying unsustainable earnings

QoE work separates recurring operating profits from one-time items, accounting changes, and unusual gains or losses. This prevents buyers from pricing the deal based on peak or nonrecurring results, the risk that the business underperforms expectations after closing. 

2. Exposing working capital and cash flow issues

A QoE typically analyzes working capital needs, seasonality, and cash conversion. This helps avoid underestimating the cash required to run the business, reduces the chance of post-closing working capital disputes, and informs the design of working capital targets and purchase price adjustments.

3. Highlighting accounting policies and judgment areas

Different revenue recognition methods, reserve policies, or capitalization practices can materially affect earnings. QoE procedures compare these policies to industry norms and assess their consistency, giving buyers visibility into areas where changes after closing could affect reported results.

4. Surfacing related-party and owner-dependent items

Many private businesses embed owner compensation, personal expenses, or related-party transactions that will not continue in the same way after the deal. QoE normalizes for these factors, reducing the risk that buyers misjudge true profitability or overlook dependencies on the current owners.

5. Informing structure, protections, and covenants

In many cases, the results presented in the QoE report will directly influence certain deal terms such as earnouts based on normalized metrics, customized indemnification, tailored reps and warranties, and escrow amounts based on identified risks. This helps reduce the financial impact of problems that may arise after the deal is completed.

6. Reducing surprises and broken deals

When issues are found late in diligence, or worse, after signing, they can derail a transaction or force last-minute price reductions. A thorough QoE, started early, brings issues to light in time for collaborative solutions, making it less likely that the deal falls apart or that trust between the parties erodes.

Why Quality of Earnings Matters in M&A Due Diligence

The short answer is that a QoE report converts unknowns into knowns. By providing a clear, normalized view of earnings and cash flow, both parties can structure the transaction around facts rather than assumptions, minimizing the risk of overpaying, underperforming, or litigating. Are you getting ready for a deal and want to gain more insight into the earnings, cash flow, and deal risks? Reach out today, and we can assist you with your deal process, providing the buyer and the seller with the financial information required to ensure sound decision-making and deal negotiation.

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