Quality of Earnings Reports: What They Are, What They Cost, and Why Sellers Should Get One First

A Quality of Earnings report — commonly called a QofE or QoE — is a financial analysis conducted by an independent accounting firm that validates the accuracy, sustainability, and adjustability of a business’s reported earnings. In the lower middle market, QofE reports have become the standard of care in M&A due diligence, and understanding what they reveal (and what they can cost you) is critical for any seller going to market.

What a Quality of Earnings Report Is

A QofE is not an audit. An audit verifies that financial statements conform to GAAP or other accounting standards. A QofE goes deeper — it analyzes the economic reality behind the numbers to determine whether the earnings the business reports are real, repeatable, and transferable to a new owner.

The analysis typically covers adjusted EBITDA validation, revenue quality and sustainability, customer concentration and trends, expense normalization, working capital analysis, and identification of one-time or non-recurring items. The end product is a detailed report — usually 30-80 pages — that the buyer uses as the financial foundation for their investment decision.

Why Buyers Require Them

Every sophisticated buyer — private equity firms, family offices, and experienced strategic acquirers — will commission a QofE as part of their due diligence process. The reasons are straightforward.

The purchase price in most lower middle market deals is based on a multiple of adjusted EBITDA. If the buyer is paying 5x EBITDA for a business reporting $3M in adjusted EBITDA, the purchase price is $15M. If the QofE determines that sustainable EBITDA is actually $2.5M, the business is now worth $12.5M — a $2.5M difference based entirely on the quality of the earnings analysis.

Beyond EBITDA validation, the QofE identifies risks that affect the go-forward earnings potential of the business. Customer concentration, revenue cyclicality, key person dependency, pending contract expirations, and unsustainable cost structures are all flagged in a well-executed QofE.

What the QofE Analyst Examines

A QofE engagement typically takes four to eight weeks and involves extensive access to your financial records, management team, and accounting systems. Here is what the analyst is looking at.

Revenue quality. Is revenue recurring, contracted, or project-based? What is the customer retention rate? Are there unusual revenue recognition practices? Has revenue been pulled forward or deferred to smooth earnings? What percentage of revenue comes from the top 5, 10, and 20 customers?

EBITDA adjustments. Every EBITDA addback you have made — owner compensation, personal expenses, one-time costs, below-market rent, related party transactions — will be scrutinized. Some will be validated. Some will be partially allowed. Some will be disallowed entirely. The QofE analyst is the final arbiter of whether your adjustments are legitimate and supportable.

Expense normalization. Are current expense levels representative of what a new owner would experience? Are there below-market contracts that will reprice? Are there deferred maintenance items that represent future capital expenditures? Are key employees underpaid in a way that creates retention risk?

Working capital trends. The QofE includes a detailed analysis of working capital — receivables aging, inventory turnover, payables patterns, and seasonal variations. This analysis directly feeds the working capital target in the purchase agreement.

Tax and compliance review. Are tax positions defensible? Are there potential exposures from prior years? Has the business been properly classifying employees vs. contractors? Are there state and local tax obligations that have not been addressed?

How a QofE Helps Sellers

While buyers commission the QofE, smart sellers increasingly commission their own — called a sell-side QofE — before going to market. Here is why.

A sell-side QofE lets you identify and address issues before a buyer discovers them. If your EBITDA adjustments include items that will not survive scrutiny, you want to know that before you set your asking price — not after a buyer uses it to reprice the deal.

It establishes credibility. Presenting buyers with an independent QofE from a reputable firm signals transparency and preparedness. It accelerates due diligence because the buyer’s analyst has a validated starting point rather than building the analysis from scratch.

It protects your negotiating position. When the buyer’s QofE analyst pushes back on your adjustments, you can point to the independent analysis that already validated them. This is significantly more persuasive than simply arguing your case without third-party support.

What a Sell-Side QofE Costs

In the lower middle market, sell-side QofE reports typically cost between $30,000 and $75,000, depending on the complexity of the business, the quality of your financial records, and the scope of the engagement. For a business selling at $10M-$25M, this investment typically pays for itself many times over by preventing price reductions, accelerating due diligence, and strengthening your negotiating position.

Buy-side QofE reports — which the buyer commissions — are usually more expensive ($50,000-$150,000) because they include more extensive analysis and diligence. The cost is borne by the buyer, but it is worth understanding what they are spending because it reflects the depth of scrutiny your financials will receive.

Common Issues That QofE Reports Flag

Based on our experience advising lower middle market business owners, the issues that most frequently cause problems in QofE analysis include:

Owner compensation addbacks that exceed market-rate replacement costs. If you are adding back $500K in owner compensation but the market rate for a replacement CEO is $250K, the QofE will only allow $250K as a legitimate addback.

Related party transactions at non-market rates. If you are leasing your building to the business below market rate, buying supplies from a family member’s company, or paying relatives for services that do not clearly justify their compensation, these will be flagged and adjusted.

Revenue concentration with contract risk. If your top customer represents 25%+ of revenue and operates without a long-term contract, the QofE will highlight this as a material risk that may affect the valuation multiple, even if the EBITDA number is solid.

Inconsistent accounting practices. If you have changed accounting methods, recognized revenue differently across periods, or have inconsistencies between your tax returns and management financials, the QofE analyst will identify every discrepancy and the buyer will ask questions.

The Bottom Line

A Quality of Earnings report is the financial microscope through which your business will be examined. The buyers who are most likely to pay premium prices are the same buyers who conduct the most thorough due diligence. Preparing for this level of scrutiny — ideally by commissioning your own sell-side QofE before going to market — is one of the highest-ROI investments a seller can make.

If you are considering selling your business and want to understand how to prepare for QofE-level scrutiny, schedule a confidential conversation with Icon Business Advisors. We help sellers prepare their financials, identify potential red flags, and position their business for the strongest possible outcome.