Introduction
In most private company sales, the price is agreed as a multiple of adjusted earnings before interest, taxes, depreciation and amortization (EBITDA), and the adjustments are where the money is. A seller's management team presents a figure built from reported results plus add-backs; the buyer's advisers test each add-back, look for problems management did not mention, and arrive at their own number. The document that carries that work is the quality of earnings report, usually shortened to QoE, and at a 10x multiple every $1 million of EBITDA it removes takes $10 million off the price.
The name describes the question it answers. Audited financial statements say whether the accounts follow the rules; a QoE asks whether the earnings are real, repeatable and correctly measured for the purpose of valuing and financing the business. It also produces the two other numbers a purchase agreement needs: the working capital peg that sets the closing price adjustment, and the list of debt-like items deducted on a cash-free, debt-free basis.
What a QoE Report Is, and What It Is Not
A QoE is prepared by the transaction services teams of accounting firms and by specialist advisory firms, for either side of a deal. A sell-side QoE, commissioned by the seller before a sale process launches, tests management's figures in advance so that buyers start from numbers that have already been challenged. A buy-side QoE, commissioned by a bidder or its lenders, tests the same figures from the opposite direction.
- Quality of earnings report
A financial due diligence report that tests whether a company's reported earnings, usually EBITDA, are accurate, sustainable and representative of the business being acquired. It rebuilds reported EBITDA into adjusted EBITDA and analyzes working capital, net debt and cash conversion.
The distinction from an audit, which tests compliance with generally accepted accounting principles (GAAP), matters, because the two are easy to confuse:
| Audit | Quality of earnings | |
|---|---|---|
| Question answered | Do the statements follow GAAP? | Are the earnings real and repeatable? |
| Output | An opinion on the financial statements | Adjusted EBITDA, peg, debt-like items |
| Period | Fiscal years | Monthly, usually the last two to three years plus the latest twelve months |
| Who relies on it | Shareholders, lenders, regulators | Buyers, sellers, lenders, insurers |
| Assurance | Formal assurance engagement | Advisory work, no audit opinion |
A QoE often uncovers the issues an audit would not flag, because an audit tolerates accounting choices within GAAP that a buyer would still want to normalize. A company can have a clean audit opinion and an adjusted EBITDA well below what its management presents. The analytical toolkit is the same one bankers apply to any company, described in how bankers analyze financial statements, pushed to monthly detail and backed by source documents.
Beyond earnings, working capital and net debt, a full report usually covers a few further areas that feed the buyer's model:
- Capital expenditure (capex), split between maintenance spending the business needs to stand still and growth spending, because adjusted EBITDA without the capex it requires overstates cash generation.
- Headcount and payroll, including open roles, recent hires and pay changes that will alter the cost base.
- Taxes, usually through a separate tax diligence workstream that looks for exposures from prior periods.
Who Commissions It and Who Relies on It
The two kinds of report serve different interests, and readers should know which one they hold. A sell-side report is paid for by the seller and shared with bidders, so buyers treat it as a well-organized starting point rather than a conclusion; most serious bidders still commission their own. In European processes, the seller's version is often called vendor due diligence, and the provider may give the eventual buyer a right to rely on it, which reduces how much new work the buyer needs to do.
A buy-side report is the buyer's own evidence. When a deal is financed with debt, the lenders usually want to rely on it too, typically through a reliance letter from the provider, because the adjusted EBITDA in the report is the figure they will lend against. For a sponsor-backed buyout, that makes the buy-side QoE one of the few documents read by the investment committee, the lenders and the insurers alike, a point that comes up again in how the sponsor evaluates a deal.
How the Work Is Done
The work follows a recognizable sequence, compressed into a few weeks of a sale process:
Data request
Monthly trial balances, general ledgers, bank statements, customer and product data, and management's own adjusted EBITDA bridge.
Databook
The provider rebuilds monthly financials in a standard format so every adjustment can be traced to source data.
Management sessions
Each add-back, reserve and unusual movement is discussed with the target's finance team and supported with documents.
Findings
Draft conclusions on adjusted EBITDA, working capital, net debt and key risks are shared with the client and its bankers.
Final report
The written report, with reliance extended to lenders or insurers where required.
The databook matters more than it sounds. Because every adjustment is tied to monthly data, the buyer's model, the lenders' credit papers and the purchase agreement definitions can all be built from the same numbers.
The EBITDA Bridge: From Reported to Adjusted
The core of every QoE is a bridge from reported EBITDA, taken from the financial statements, to adjusted EBITDA, the recurring earnings of the business as it will exist under new ownership. The bridge usually appears twice, once as management presents it and once as the QoE provider concludes. A typical comparison for a business with $40 million of reported EBITDA:
| Line item | Management | QoE | Difference |
|---|---|---|---|
| Reported EBITDA | 40.0 | 40.0 | 0 |
| Legal settlement (non-recurring) | 2.0 | 2.0 | 0 |
| Owner compensation above market | 1.5 | 1.0 | (0.5) |
| Revenue recognized in the wrong period | 0 | (1.2) | (1.2) |
| Inventory reserve shortfall | 0 | (0.8) | (0.8) |
| Run-rate cost savings | 3.0 | 0 | (3.0) |
| Adjusted EBITDA | 46.5 | 41.0 | (5.5) |
At a 10x multiple, the 5.5 difference is worth 55 of purchase price.
The bridge is a reminder that a deal can carry three EBITDA figures at once: reported EBITDA from the statements, management-adjusted EBITDA in the marketing materials, and diligence-adjusted EBITDA in the buyer's QoE. Knowing which one a multiple, a leverage ratio or a headline price refers to is the first question to ask about any of them, and the reported figure's own definition is set out in operating income, EBIT and EBITDA.
Each line belongs to one of a few families of adjustment, and each family invites a different kind of challenge.
Non-Recurring Items
Costs or gains that will not happen again, such as a litigation settlement, a one-off restructuring or a gain on an asset sale, are removed so that adjusted EBITDA reflects normal operations. The test is evidence and recurrence: a "one-time" cost that appears every year under different names is a recurring cost. Earnings normalization in valuation works the same way, as covered in normalized EBITDA.
Owner and Related-Party Items
Founder-owned businesses often pay owners above or below market, rent property from related parties at non-market rates, or run personal expenses through the company. The QoE adjusts these to what the business will pay under new ownership. The adjustment can go either way: an owner who draws a small salary but does the work of a chief executive needs a replacement whose market salary reduces EBITDA.
Accounting Corrections
Some adjustments fix how earnings were measured rather than which items count. Smaller targets keeping cash-basis or hybrid books need converting to the accrual basis, the gap explained in accrual vs cash accounting. Revenue booked in the wrong period, under-provided reserves for bad debts, inventory or warranties, and expenses capitalized that should have been expensed all reduce adjusted EBITDA when corrected.
Pro Forma and Run-Rate Adjustments
The most contested line is the one that adds earnings the business has not yet produced: cost savings from initiatives under way, the full-year effect of a price increase or a recent acquisition, or synergies a buyer could achieve. QoE providers typically accept adjustments for actions already completed and documented, and reject or heavily discount those that depend on future execution.
Credit analysts have measured how adjusted figures hold up once deals close. Institutional Investor's report on an S&P Global study of leveraged buyouts and mergers struck in 2015 notes that EBITDA turned out 29% lower than projected in 2016 and 34% lower in 2017, well short of what the deals were marketed on.
Testing That the Earnings Are Real
Adjusting EBITDA assumes the reported figures are right to begin with. Two analyses test that assumption directly.
Proof of cash reconciles the revenue and expenses in the accounts with the cash that actually moved through the company's bank accounts, month by month. Revenue that never turns into collections, or expenses that bypass the bank, show up as unexplained differences. For a business without audited accounts, it is often the single most persuasive test in the report.
- Proof of cash
A diligence procedure that reconciles reported revenue, expenses and balance sheet movements with the cash receipts and payments shown on bank statements over the same periods, to confirm that reported earnings are backed by real cash flows.
Revenue quality analysis then asks whether the revenue that is real will continue. The QoE breaks revenue down by customer, product, channel and geography, and looks at concentration, churn, pricing versus volume, and one-off contracts. A business whose largest customer provides a third of revenue, or whose growth came from a single non-recurring order, earns a lower multiple even if every dollar of its revenue was correctly recognized under Accounting Standards Codification (ASC) 606, the standard set out in how revenue recognition works.
The same lens applies to margins. Monthly gross margin by product line shows whether a price increase stuck or whether a cost spike is behind the latest quarter, and comparing EBITDA to operating cash flow shows how much of the earnings convert into cash, the same divergence examined in accounting red flags.
When Audited Numbers Are Not Enough
Audited accounts are a starting point, not a guarantee, and the most expensive diligence failures involve revenue that looked real on paper. Hewlett-Packard agreed to buy the UK software company Autonomy for about $11 billion in 2011; the following year it took an $8.8 billion impairment charge on the acquisition and, as Accounting Today reported, attributed more than $5 billion of it to accounting improprieties, disclosure failures and misrepresentations at Autonomy before the deal. Autonomy was a listed company with audited financial statements.
The lesson for diligence is not that every target is suspect, but that revenue quality deserves its own analysis. The questions a QoE asks of revenue, such as what exactly was sold, to whom, on what terms and with what cash collected, are the questions that expose revenue that does not behave like the business claims it does.
Net Working Capital and the Peg
Most US purchase agreements include a working capital adjustment: the price assumes the business is delivered with a normal level of working capital, and moves up or down dollar for dollar with the amount actually delivered at closing. The QoE proposes both the definition of working capital for the deal and the normal level, the peg.
- Working capital peg
The target level of net working capital agreed in a purchase agreement, usually based on a trailing average. If working capital delivered at closing is below the peg, the purchase price falls by the shortfall; if it is above, the price rises.
The peg is usually set from a trailing twelve-month average of monthly working capital, which smooths out seasonality. The adjustment itself is what protects the buyer: without it, a seller that collects receivables aggressively and delays supplier payments just before closing would extract cash from the business at the buyer's expense. Deal working capital also differs from the balance sheet definition: it typically excludes cash, debt, income taxes and transaction-related items, which are settled through other mechanisms.
Consistency matters as much as the level. The closing working capital statement must be prepared with the same accounting policies used to compute the peg; a seller that tightens its inventory reserve or a buyer that changes the accrual approach after closing can move the adjustment without any real change in the business. Purchase agreements therefore specify the policies to be used, and disputes over the closing statement usually go to an independent accountant rather than to court.
The mechanics differ under European-style locked box deals, where the price is fixed on a historical balance sheet and no closing adjustment applies; the comparison is set out in locked box vs completion accounts, and the US adjustment process in more detail in the post on net working capital adjustments.
Net Debt and Debt-Like Items
Deals are usually priced on a cash-free, debt-free basis: the buyer pays the enterprise value, and the seller keeps excess cash and repays debt out of the proceeds. The QoE identifies everything that should be treated like debt in that bridge, beyond the obvious borrowings. Typical candidates include:
- Finance lease obligations and, depending on the deal, operating lease liabilities.
- Accrued but unpaid bonuses, severance and deferred compensation.
- Income taxes owed for periods before closing.
- Deferred revenue where the cost to deliver the remaining service is material.
- Underfunded pension obligations and other long-term employee liabilities.
- Deferred capital expenditure, customer deposits and unpaid transaction fees.
Cash is negotiated too. Not all of a target's cash is excess: cash trapped in foreign subsidiaries may only be repatriated with tax leakage, customer deposits may be held on behalf of others, and a business needs a minimum level of cash to operate. Buyers argue that such amounts should not be paid for as excess cash, and the QoE usually quantifies a normalized cash level to anchor that discussion.
Each debt-like item is negotiated as well, because each dollar treated as debt-like reduces the equity price dollar for dollar. Deferred revenue is a frequent battleground: the seller argues it is part of normal working capital, while the buyer argues it is cash already collected for work the buyer will have to perform. The same logic of what belongs between enterprise value and equity value is covered in the equity value to enterprise value bridge.
How Bankers Use the QoE
For a sell-side banker, a QoE is a tool for protecting value and timetable. Commissioning one before launch lets the seller defend its adjusted EBITDA with third-party support, find and fix problems before bidders do, and present figures in the information memorandum that will survive confirmatory diligence. A price agreed on numbers that later shrink in a buyer's QoE invites a renegotiation late in the process, when the seller's leverage is weakest.
For a buy-side banker or a financial sponsor, the QoE's adjusted EBITDA anchors the bid, the financing and the model. Lenders size debt as a multiple of it, and the credit agreement's definition of EBITDA often borrows the same categories of add-back. It also feeds the deal's insurance: underwriters of representations and warranties policies generally review third-party due diligence reports, including quality of earnings reports, before deciding what the policy will cover.
What Happens When the QoE Finds Problems
Findings rarely end a deal on their own; they change its terms. The usual responses, roughly in order of how often they are used:
- Price: the buyer re-bases its multiple on the lower adjusted EBITDA, the most direct consequence.
- Specific indemnity: an identified exposure, such as a tax issue or an under-accrued liability, is covered by a seller indemnity rather than priced in.
- Escrow or holdback: part of the price is held back until the exposure is resolved.
- Earnout: where the disagreement is about future performance, part of the price is made contingent on it.
- Insurance exclusion: issues the buyer knows about are typically excluded from a representations and warranties policy, so they have to be handled through one of the other routes.
The earnout route is common when the dispute is over a run-rate add-back: rather than argue about whether the savings will appear, the parties pay for them if they do, a structure whose accounting is covered in earnouts and contingent consideration. A buyer walks away mainly when findings reach the credibility of the numbers as a whole, rather than a specific line item.
Covenant EBITDA
The adjusted EBITDA in the QoE also travels into the credit agreement. Leveraged loan documents define EBITDA for covenant and debt-capacity purposes, and those definitions usually permit add-backs similar to the QoE's categories, including cost savings expected within a set period, sometimes capped as a percentage of EBITDA. The looser the definition, the more debt a borrower can incur and the later a covenant breach appears, which is why lenders negotiate those definitions as carefully as sellers defend their add-backs. Ratios built on covenant EBITDA are not comparable with ratios on reported EBITDA, a distinction to keep in mind when reading leverage and coverage ratios.
The broader skill is the same one the QoE applies: separating what a company reported from what it will earn. Public companies present their own version of that exercise as adjusted EBITDA and other non-GAAP measures, subject to Securities and Exchange Commission (SEC) rules; private targets present it in the seller's adjusted EBITDA. In both cases, the reported figure is where the analysis starts, and an introduction to the report itself, written for candidates, is in the explainer on what a quality of earnings report covers.
