I. Introduction: What Is a Quality of Earnings Study and Why It Matters
In the high-stakes environment of mergers and acquisitions, Quality of Earnings (QoE) reports function as the buyer’s truth serum—a financial due diligence tool that deconstructs the façade of reported profits and reconstructs them with objectivity and rigor.
The traditional P&L statement, as published by the seller, is not a lie—but it is a version of the truth filtered through layers of accounting judgments, accruals, deferrals, non-recurring adjustments, and even aspirations. A QoE study slices through those layers, offering buyers a cleaner, normalized, and sustainable view of the economic earning power of the target business.
Across my participation in eight M&A transactions—ranging from tech platforms to industrial services—QoE reports have played a decisive role in shaping final purchase price, negotiating working capital adjustments, structuring earn-outs, and even identifying deal-killing red flags. A well-executed QoE report often leads to adjustments in EBITDA ranging from 5–25%, significantly impacting valuation.
II. Purpose of a Quality of Earnings Study
The core objective of a QoE study is to assess the sustainability, accuracy, and repeatability of a target company’s earnings, typically EBITDA. But its true value lies deeper:
A. Key Purposes
- Normalize EBITDA
- Remove non-recurring or one-time items
- Adjust for owner compensation and related-party transactions
- Align accounting methods with buyer’s expectations
- Validate Revenue Recognition
- Test whether revenue is recognized in line with GAAP/IFRS
- Identify early revenue pulls or channel stuffing
- Assess Cash Conversion
- Convert accrual earnings to cash-based analysis
- Measure working capital efficiency and seasonality
- Identify Risk Factors
- Customer or vendor concentration
- Declining margins or revenue irregularities
- Dependence on tax credits or incentives
- Assist in Valuation and Purchase Price Structuring
- Validate or challenge headline EBITDA
- Support negotiation of earnouts or holdbacks
- Confirm working capital peg and balance sheet health
? Case Example from Deal #5 (SaaS platform, $380M EV):
QoE reduced reported EBITDA from $34M to $29.5M by removing:
- $2.2M in non-recurring legal settlements
- $1.8M in capitalized development cost misclassified as opex
- $500K under-accrual in bonuses
Result: $50M reduction in purchase price at 10x multiple
III. Key Elements of a QoE Report
A robust QoE report, usually conducted by a Big Four firm or a reputable transaction advisory group, goes far beyond a financial audit. Its anatomy includes:
1. Executive Summary
- Deal overview
- Key findings (EBITDA adjustments, revenue risks)
- Summary bridge from reported to adjusted earnings
2. Income Statement Normalization
- Removal of non-recurring items
- Adjustments for accounting irregularities
- Owner-related compensation normalization
3. Revenue Analysis
- Cohort trends, churn, customer LTV
- Revenue recognition testing
- Deferred revenue trends (for SaaS or subscription models)
4. Cost Structure Review
- Gross margin trends and composition
- Variable vs fixed costs analysis
- Impact of volume changes
5. Balance Sheet Analysis
- Working capital trends
- Receivables aging and bad debt reserves
- Inventory obsolescence or write-down practices
6. Cash Flow Reconciliation
- Adjust EBITDA to cash flow from operations
- Highlight working capital drain or excess
- Measure cash conversion ratio
7. Accounting Policy Review
- Identify aggressive or conservative policies
- Compare to industry standards
8. Risk Factors and Recommendations
- Concentrations, dependence, legal risks
- Key employee retention or transition issues
IV. How Is Quality of Earnings Calculated?
While the mechanics vary by industry and firm, the following step-by-step framework captures the general flow:
Step 1: Establish Reported EBITDA Baseline
Start with the seller’s income statement, usually over 2–3 years + trailing twelve months (TTM).
Example:
- Revenue: $120M
- Gross Profit: $72M
- Operating Expenses: $45M
- Reported EBITDA: $27M
Step 2: Identify and Adjust for Non-Recurring or Non-Operational Items
Remove or add back items such as:
- Legal settlements
- One-time restructuring costs
- Gain/loss on asset sales
- Transaction expenses
- PPP loan forgiveness
Adjustments: -$1.2M restructuring, -$600K PPP forgiveness
Adjusted EBITDA: $25.2M
Step 3: Normalize Owner-Related Items
This includes:
- Excess owner salaries or under-market wages
- Personal expenses (travel, insurance, auto)
- Related-party rents
Adjustment: -$1.1M excess compensation
Normalized EBITDA: $24.1M
Step 4: Adjust for Accounting Methodologies
- Capitalization vs expensing
- Revenue cutoffs
- Reserve adequacy (bad debts, warranties)
Adjustment: -$800K under-accrued bad debt
Final QoE Adjusted EBITDA: $23.3M
Step 5: Bridge Reported to Adjusted EBITDA
| Item | Amount ($M) |
|---|---|
| Reported EBITDA | 27.0 |
| Less: Non-recurring items | (1.8) |
| Less: Owner comp normalization | (1.1) |
| Less: Bad debt reserve adjustment | (0.8) |
| QoE Adjusted EBITDA | 23.3 |
V. Inclusions and Exclusions: The Art of the QoE
QoE studies operate at the intersection of accounting rigor and judgment. Not everything gets included, and not all exclusions are controversial—but the rationale must be clear.
Common Inclusions in QoE Adjustments
| Category | Examples |
|---|---|
| Non-recurring Items | Lawsuit settlements, one-off consulting fees |
| Owner Compensation | Salaries above market, discretionary bonuses |
| Related-Party Transactions | Rent above/below market, subsidized costs |
| Aggressive Accounting | Deferred revenue, under-accruals, prepaids |
| Capitalization Policies | Dev costs, R&D expense manipulation |
Common Exclusions (Unless Flagged)
| Category | Rationale |
|---|---|
| Normal Operating Expenses | Unless out of trend or unusually structured |
| Taxes | Unless deferred or aggressively provisioned |
| Depreciation/Amortization | Generally excluded in EBITDA, but reviewed |
| GAAP-to-non-GAAP differences | Not all differences are meaningful |
| Immaterial Items (<$100K) | Tracked but not adjusted unless systemic |
? Caution: Just because something is GAAP-compliant doesn’t make it economically normal.
VI. Do’s and Don’ts: Buyer and Seller Playbooks
A. Buyer Side: The Investor’s Edge
Do:
- Conduct QoE before signing or have a post-LOI break clause
- Hire specialist advisors, not just auditors
- Request detailed GL and trial balances
- Validate revenue recognition policies
- Compare actuals to forecasted EBITDA bridges
Don’t:
- Accept seller-adjusted EBITDA at face value
- Assume a clean audit equals clean earnings
- Skip cash-to-EBITDA reconciliation
- Overlook tax treatment in QoE (e.g., R&D credits)
B. Seller Side: The Credibility Game
Do:
- Prepare a sell-side QoE report before going to market
- Reclassify personal/owner expenses clearly
- Be transparent about non-recurring events
- Provide a walk-forward bridge from GAAP to adjusted EBITDA
Don’t:
- Inflate EBITDA through working capital manipulation
- Treat growth costs as one-time expenses
- Omit liabilities or reserve inadequacies
- Hide customer churn or margin compression
Pro Tip
A clean, seller-prepared QoE added $12M to the deal price due to buyer confidence.
VII. Red Flags Identified in QoE Reports
Buyers should be particularly alert to the following:
| Red Flag | Implication |
|---|---|
| Rapid revenue growth + declining cash flow | Aggressive revenue recognition |
| Large deferred revenue balance + high churn | Customer dissatisfaction / unearned rev |
| Expense capitalized >10% of OPEX | Inflated EBITDA through accounting tricks |
| Low DSO + high bad debt | Collectibility issues |
| High related-party transactions | Risk of future dis-synergies |
? Deal #2 (Consumer Goods)
A QoE flagged that 38% of net income came from favorable foreign tax credits unlikely to recur post-close. This led to a $6M haircut.
VIII. Strategic Use of QoE Findings
Quality of Earnings is not just defensive—it is strategic. A savvy buyer will use QoE to:
- Structure contingent payments (earn-outs)
- Adjust working capital targets
- Determine debt vs equity financing (based on cash flow)
- Negotiate indemnities and escrow amounts
It also supports valuation modeling, especially in:
- LBO transactions (debt service capacity)
- Roll-ups (synergy verification)
- Cross-border deals (accounting harmonization)
IX. Final Thoughts: The Wisdom in the Weeds
A Quality of Earnings study is the economic compass in the M&A terrain. It points not just to where the business has been, but where it’s likely to go—and whether the map matches the terrain. More than once, a QoE has been the reason we re-negotiated, delayed, or walked away. And in several cases, it has given us the conviction to pay a premium—knowing the earnings were real, sustainable, and cash-convertible.
As Warren Buffett once wrote:
“You only find out who’s swimming naked when the tide goes out.”
A QoE report, done right, drains the tide before you make your first bid.
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