What a Quality of Earnings Report Covers

Conor Meyers — Co-Founder & Business AttorneyHas built and run businesses; advises owners on contracts, transactions, and risk. About Conor →

An audit asks whether the numbers are right. A quality of earnings report asks whether they will happen again.

A seller presents EBITDA. A buyer wants to know how much of it recurs, how much depends on the departing owner, and how much reflects accounting choices rather than cash generation. QoE vs audit is the clearest way to understand the distinction: an audit tests compliance with accounting standards at a point in time; a quality of earnings analysis tests whether the earnings are real and repeatable.

We handle these matters for growth-stage companies in Idaho and California. This is general information — not legal or tax advice on a specific situation.

Test the number before you build a deal on top of it.

What the analysis covers

A quality of earnings review examines revenue recognition, customer concentration and retention, margin trends and their drivers, working capital patterns, one-time and non-recurring items, related-party transactions, and the accounting policies underlying the reported figures.

The output is normalized earnings — what the business would have earned under consistent policies, excluding items that will not recur. That figure, rather than reported EBITDA, becomes the basis for valuation.

Normalized earnings, not reported EBITDA, is what gets valued.

Add-backs and where they get contested

Add-backs in a QoE analysis are adjustments claimed to represent costs a buyer will not inherit — above-market owner compensation, personal expenses run through the business, one-time legal fees, discontinued product lines.

Some are plainly legitimate. Others are contested, particularly where the expense is arguably recurring in a different form. A seller adding back the owner’s salary in full while the buyer will need to hire a general manager is claiming a saving that does not exist, and it is the sort of item a QoE surfaces immediately.

An add-back for a cost the buyer will still incur is not a saving.

Who pays and when to commission

Who pays for quality of earnings depends on who commissions it. Buyers usually pay for buy-side work as part of diligence. Sellers increasingly commission sell-side reports before going to market.

When to commission a QoE is the more useful question. Sell-side, early enough that findings can be addressed rather than merely disclosed. Buy-side, after the letter of intent but early in diligence, so findings inform negotiation while there is still room to move.

Early enough to fix. Not so late that all you can do is disclose.

How findings affect price

QoE findings affecting price operate through the multiple. If normalized EBITDA comes in ten percent below the presented figure and the business is valued at five times earnings, the implied price change is substantial and immediate.

Findings can also reshape structure rather than price. Concentrated customer revenue may produce an earnout tied to retention. An unresolved tax position may produce a specific indemnity or a larger escrow. Not every finding is a price reduction.

Not every finding cuts the price. Some change the structure instead.

Using a QoE well

For a seller, the value is control. A sell-side report surfaces the questions a buyer’s advisors would raise and allows them to be addressed on the seller’s timetable, with explanations prepared and supporting documents assembled.

For a buyer, the value is confidence in the number and a defensible basis for negotiating. Either way the report is a financial analysis rather than a legal one, and it should be read alongside legal diligence — a revenue recognition question often turns out to rest on contract terms. IRS positions, SEC small business guidance, and SBA materials all bear on how the findings get applied.

Financial findings usually rest on legal facts. Read them together.

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