A quality of earnings (QoE) report is the written deliverable produced by a quality-of-earnings engagement — an independent accounting firm's deep analysis of how real, sustainable and repeatable a target's reported earnings actually are. It is the single most important document in financial due diligence, and in most middle-market deals it is what the headline EBITDA multiple is ultimately applied to.
What the report contains
A QoE report is built around an Adjusted EBITDA bridge and supporting analyses:
- The quality-of-earnings bridge — a waterfall from reported (GAAP) EBITDA to Adjusted EBITDA, validating each add-back: one-time items, owner perks, above-market compensation, related-party rents, discontinued lines. The report sorts add-backs into those it accepts, questions, or rejects — and frequently surfaces add-backs management missed.
- Revenue quality — recurring vs one-time revenue, customer concentration, churn, pricing trends, and tests for revenue recognition that flatter the period (channel stuffing, cut-off issues).
- Cost and margin analysis — gross-margin trends, the run-rate cost base (deals often raise costs that the seller's historicals understate, such as a needed manager hire), and one-time cost suppressions.
- Net working capital — the historical net working capital trend used to set the peg/target at closing; getting this wrong is a common source of post-close disputes.
- Net debt and "debt-like" items — items that reduce equity value (deferred revenue, accrued bonuses, capital leases, unfunded liabilities).
- Proof of cash — tying reported revenue to cash actually collected.
Why buyers commission it
The QoE protects the buyer from paying a multiple on overstated earnings. Because price is usually quoted as a multiple of Adjusted EBITDA, every dollar of EBITDA the QoE disproves is multiplied in the purchase price — a $300k rejected add-back at 7× is $2.1M of value. The report also feeds the working-capital target, identifies net-debt adjustments, and arms the buyer to re-trade or seek additional escrow/indemnities where it finds problems.
Sell-side QoE
Increasingly, sellers commission their own QoE before launching the process. A sell-side QoE:
- validates the add-backs before buyers can attack them, protecting Adjusted EBITDA;
- surfaces and fixes problems early, removing surprises that cause re-trades; and
- accelerates the buyer's confirmatory diligence, since the buyer can leverage the existing analysis.
It has become standard practice in competitive lower-middle-market deals and is one of the highest-ROI items in deal preparation.
What a QoE is not
A QoE is not an audit — it expresses no formal audit opinion and is not governed by audit standards — and it is not a valuation: it does not opine on what the business is worth, only on what its earnings really are. It is an investigative, deal-focused analysis, typically delivered as a detailed report plus an Excel "databook," and read closely by the buyer, its lenders and its deal counsel.
See also
- Quality of earnings — An independent accounting analysis that tests how sustainable, predictable and accurately measured a target's reported earnings are. The QofE is a near-universal pre-LOI deliverable in serious deals.
- Normalization adjustments — Adjustments to reported earnings to remove one-time, non-operating or owner-specific items, producing a run-rate EBITDA that better reflects the ongoing business.
- EBITDA — Earnings Before Interest, Taxes, Depreciation and Amortization — a measure of a company's operating profitability used as the base for most M&A multiples.
- Due diligence — The structured investigation a buyer conducts on a target between LOI and closing — covering financial, legal, tax, commercial, operational, IT, HR and environmental workstreams — to verify the seller’s claims, find risks and shape final price and deal terms.
- Working-capital target — A negotiated benchmark — usually a trailing-12-month average — for the level of net working capital the seller is to deliver at closing. Variances above or below trigger a dollar-for-dollar price adjustment.
- Data room — A secure repository (today, almost always virtual) where the seller posts due-diligence documents for buyer review. Access is staged by deal phase and bidder identity.
External resources
Practitioner guides from Main Street Wealth, the M&A advisory firm that sponsors M&Apedia (how this works):
- Understanding Business Valuation Methods — How buyers value small and mid-sized companies, with worked examples.