What Is a Quality of Earnings Report?
A quality of earnings report is a financial diligence deliverable, typically prepared by the transaction advisory arm of an accounting firm, that examines whether a target's earnings reflect the true underlying economics of the business. Buyers commission a QoE on nearly every private equity deal, and sellers increasingly commission their own sell-side QoE before launching an auction so surprises surface on their timetable rather than the buyer's.
A QoE differs from an audit in purpose. An audit tests whether financial statements comply with GAAP, while a QoE asks whether the earnings a buyer is paying a multiple on will actually recur. A company can have perfectly clean audited statements and still have low-quality earnings propped up by unsustainable pricing, expiring contracts, or aggressive accrual choices.
What a QoE Analysis Examines
The centerpiece is the adjusted EBITDA bridge, which walks from reported EBITDA to a normalized figure. Common adjustments include one-time litigation or restructuring costs, above- or below-market owner compensation, pro forma effects of recently signed or lost contracts, and out-of-period revenue or expense items. The report scrutinizes each management-proposed add-back and often rejects or trims the ones that look like recurring costs in disguise.
Beyond EBITDA, the analysis digs into revenue recognition policies, customer concentration and churn, gross margin trends by product line, and the drivers of net working capital over the trailing twelve months. That working capital work directly feeds the negotiation of the working capital peg, and lenders financing the deal frequently rely on the same report when sizing debt.
Why QoE Matters in Deals
Because private targets are typically priced as a multiple of adjusted EBITDA, every dollar of adjustment moves value by that multiple. If a buyer paying 10x uncovers $2 million of unsupportable add-backs, the implied price falls by $20 million, which is why QoE findings are among the most common reasons deals get repriced or restructured between the letter of intent and signing.
For aspiring bankers and private equity investors, QoE fluency signals real deal experience. Interviewers may ask what could make reported EBITDA overstate true earnings, and strong answers cite items such as channel stuffing before a sale process, capitalizing costs that peers expense, or under-accruing bonuses. Understanding earnings quality separates candidates who have modeled companies from those who have actually diligenced them.
