Quality of Earnings Report: Why It Matters in Business Sales

A quality of earnings (QofE) report gives buyers and sellers an independent view of a company’s earnings, cash flow, and financial statements during a business sale or merger.

A specialized CPA firm completes the QofE during the due diligence process. The goal is to check if reported earnings are real, repeatable, and backed by operating cash flow.

A QofE takes two to four weeks to complete, and for good reason. Accountants need time to look deeper than net income or EBITDA. The report separates sustainable earnings from non-recurring items, one-time costs, and accounting adjustments. It also tests revenue recognition, working capital trends, and the balance sheet.

Reported metrics give both the buyer and seller a clearer view of how the business really performs. They also support better forecasting, cleaner negotiations, and a smoother closing.

QofE vs. Tax Returns vs. Audit

A business buyer usually needs more than basic financial records to understand true earning power. Different reports serve different purposes, but each has its limits.

• Quality of earnings report: Tests revenue recognition, working capital, operating cash flow, and adjusted EBITDA. Breaks out recurring vs. one-time activity and reviews balance sheet sustainability.
• Tax returns: Built for tax rules, not business analysis. They can understate profitability, skip detail, and hide timing issues.
• Audit: Confirms GAAP compliance at a point in time but does not separate recurring vs. non-recurring items or focus on business valuation.

Unlike tax returns or an audit, a QofE looks ahead. It focuses on sustainable earnings and cash flow after closing so buyers can forecast accurately and set realistic deal terms.

When Is a QofE Used?

A QofE is common in deals above $2 million. Buyers, lenders, and private equity groups rely on it to confirm earnings, cash flow, and working capital.

Many sellers commission a sell-side QofE before going to market. It helps defend financial health, clean up reporting, and reduce disputes during buyer due diligence.

You also see QofE work when:

• A business has complex revenue streams
• There are related-party transactions
• Margins shift quickly
• There are questions around accounting standards
• The company grew quickly with limited internal controls

In these cases, the report provides clarity, highlights red flags, and tests earnings sustainability.

What Does a QofE Evaluate?

A QofE is a deep review of financial performance and earnings drivers, including:

• Revenue quality and sustainability: Reviews revenue recognition, contracts, customer concentration, and recurrence.
• Normalization of financials: Removes non-recurring items, one-time gains, and owner-related expenses.
• EBITDA and adjusted EBITDA: Rebuilds earnings to reflect ongoing operations.
• Working capital: Analyzes receivables, payables, inventory, and cash flow to set closing targets.
• Balance sheet health: Reviews debt, liabilities, depreciation, amortization, and related-party items.
• Accounting policies: Evaluates GAAP alignment and the impact of policy changes.

The report also flags issues such as declining cash flow, large accruals, mismatched revenue and expenses, and unexplained discrepancies.

Cost of a QofE Report

QofE costs vary based on deal size, complexity, and data volume. While fees can be significant, the payoff is often greater.

Benefits for Buyers

• More confidence in reported earnings
• Better valuation accuracy
• Clear visibility into hidden risks
• Stronger lender support
• Improved negotiating position

Benefits for Sellers

• Greater transparency for buyers
• Faster closing timelines
• Stronger valuation support
• Competitive market positioning

In most deals, the buyer engages and pays the QofE firm. On sell-side projects, sellers may work with their M&A advisor to define scope and include the fee in transaction costs.

Is QofE Right for Your Deal?

A QofE makes sense when deal risk is tied closely to financial performance. Larger, leveraged, or fast-growing businesses benefit most from validating earnings before pricing is finalized.

Consider a QofE when:

• The business generates meaningful, stable profits
• There are multiple products, locations, or entities
• Customer contracts or pricing are complex
• The buyer requires bank, SBA, or private equity financing
• Both sides want fewer surprises between LOI and closing

A full QofE is often unnecessary when:

• The transaction is small and primarily asset-based
• The business has simple, owner-operated financials
• Basic reports and tax returns capture most of the story

For many lower middle-market deals, the decision comes down to cost versus confidence. A QofE adds time and fees but can reduce price cuts, support lender underwriting, and lower post-closing disputes.

BizQuest Valuation Tools

To learn more about business valuation, visit BizQuest’s Valuation Research Resources designed to help business owners and buyers make informed decisions. Our valuation tools include a Valuation Calculator and Average Business Valuation Multiples designed to help you understand the key drivers of value and identify areas for improvement.