A Quality of Earnings (QoE) report peels back layers in an M&A transaction, offering a clear, unbiased view of financial results – almost like a medical second opinion that may avert a costly error.
A QoE assessment asks whether a company’s reported earnings actually reflect operational results or, instead, accounting maneuvers. Traditional audits focus on compliance, while QoE analysis digs deeper into sustainability and predictability. The distinction carries significant weight during deal-making.
A recent PwC study found that 68% of private equity deals involve material earnings adjustments during due diligence, usually shifting reported EBITDA by 15-20%. These aren’t minor corrections—they often separate a sound acquisition from a troubled one.
Ultimately, the question a QoE report aims to answer is: Can these profits reliably fund future operations or support acquisition debt? The findings often challenge assumptions about revenue reliability and cost controls.
A thorough QoE assessment depends on four core areas, each cutting through financial presentation to unearth genuine economic results.
Revenue Analysis reviews recognition methods for alignment with GAAP or IFRS standards. This highlights issues like “pull-forward” sales or channel-stuffing. For example, a software firm booking multi-year licenses immediately might inflate short-term results and misrepresent sustainable performance.
Expense Scrutiny focuses on identifying both hidden one-time costs and delayed expenses. According to Bain & Company, 40% of deals had overstated margins due to understated maintenance or underfunded employee benefits. These aren’t trivial—they can create issues that surface after the deal closes.
Working Capital and Cash Flow Analysis links reported earnings to actual cash creation. Red flags include excess inventory or extended payment terms. If profits do not convert to cash flow, that’s a risk that merits deeper investigation.
EBITDA Normalization involves adjusting earnings for items like owner-related expenses, non-market transactions, or unusual events. This requires both technical knowledge and practical judgment — to differentiate between reasonable adjustments and overly optimistic corrections.
For a more detailed perspective on the financial modelling behind these figures, see this guide on M&A valuation financial modelling best practices.
Earnings quality doesn’t just affect price—it can change how deals are structured, and sometimes whether they happen at all.
Sellers often overstate EBITDA through heavy-handed add-backs, with a KPMG survey showing overstatements of 10-25% across sectors. The impact is immediate.
Purchase price reductions are common, with valuations often dropping by 1-2x EBITDA multiples. For a deal priced at 8x EBITDA, dropping to 6x means millions less paid out, especially in mid-market transactions.
Earnout clauses are increasingly popular, appearing in over half of surveyed deals in 2023. These clauses tie a portion of payment to future earnings, offering some protection against overstated results. To better understand their structures and risks, refer to this article on earnout valuation techniques and risk assessment in M&A.
The most drastic result, deal termination, occurs when hidden liabilities or unsustainable profits emerge. Roughly 12% of deals are abandoned post-QoE review when these issues come to light.
The process behind a QoE review resembles a methodical investigation, each phase removing layers of presentation to reveal the underlying business.
Data Collection usually takes 4-6 weeks, amassing not only financial statements but also operational data and management reports. The goal is to understand financial patterns, not just tick boxes.
Forensic Testing uses targeted procedures: sample-based revenue tracing matches invoices with bank deposits, while trend analysis spots seasonality and anomalies.
Management Interviews supply context that numbers lack, clarifying policies and revealing operational realities behind reported results.
Reporting produces a clear “normalized EBITDA” model that explains the rationale for each adjustment. This document is central to valuation discussions and negotiations.
Some signs repeatedly surface in QoE reviews and call for extra scrutiny.
Revenue Concentration—when more than 30% of revenue comes from a single client—poses a major risk. Losing that customer could upend operations.
Margin Inconsistencies with industry benchmarks deserve examination. A company’s gross margin that is over 5% away from sector averages is worth questioning.
Excessive “Add-Backs”—routine costs labeled as “non-recurring”—are frequent culprits. Harvard Law research linked these practices to 70% of post-acquisition legal disputes.
A careful approach is required to separate normal business variations from patterns of questionable accounting.
Normalizing earnings means aligning reported results with ongoing operational performance, and certain adjustments are especially common.
According to Alvarez & Marsal research:
| Adjustment Type | Frequency in Deals | Median Impact on EBITDA |
|---|---|---|
| Owner Compensation | 65% | +8% |
| Non-Recurring Costs | 50% | +12% |
| Revenue Timing | 30% | -5% |
Owner Compensation adjustments often appear in smaller company sales, where executives may set high personal pay to reduce taxable income. Adjustments aim to estimate market-based compensation.
Non-Recurring Costs range from legal fees to facility moves, but it’s important to determine if these costs are truly one-off or actually represent recurring expenses disguised as exceptions.
Revenue Timing adjustments usually reduce normalized EBITDA, correcting for accelerated revenue recognition or aggressive sales cut-offs.
For practical insights on building models that factor in these issues, see the three-statement financial model guide.
Different buyers focus on distinct QoE elements, depending on their own methods and risks.
Private Equity groups focus on debt-service capacity and recurring cash generation. Working capital efficiency and sustainable revenue matter greatly, because leverage can amplify gains and losses. To learn more, see leveraged buyouts in private equity.
Strategic Buyers prioritize synergy validation and sustaining product investment. For instance, technology buyers reduce offers by 15% if research capitalization appears aggressive — they know innovation needs continuous funding.
Distressed M&A focuses on cash runway and hidden liabilities, where maintaining liquidity overrides other concerns.
New technology is transforming how QoE reviews are performed.
Machine Learning models can scan thousands of past deals to detect abnormal trends instantly. Research by McKinsey finds that AI shortens the QoE process by almost a third, while improving depth.
Blockchain Technology could allow instant revenue verification through smart contracts, reducing the need for extensive sample checks, especially in digital-first industries.
ESG Integration is also rising in importance, as environmental costs and supply chain risks are now factored into both historical and forecasted earnings. These considerations can have real, measurable financial impacts.
A QoE report does more than check accounting—it offers strategic information about a business’s resilience and its leaders’ competence.
Boston Consulting Group found that deals with well-normalized earnings delivered 25% higher returns over three years. This outperformance underscores the value of seeing economic reality, rather than relying on surface-level results.
The key is to judge which adjustments reflect short-term one-offs, versus those signaling deep-seated business weaknesses. Making this distinction is what sets successful dealmakers apart.
As financial data quality and review tools continue to improve, QoE is moving from a simple diligence step to a central feature of valuation. Those who get ahead of these changes will have systematic advantages in M&A.
The lesson: In finance, surface appearances often conceal vital facts. A disciplined QoE process reveals the facts and, in doing so, helps place capital where it belongs.
Quality of Earnings diligence is the gateway to informed decisions, resilient valuations and successful outcomes in M&A. By rigorously examining revenue recognition, expenses, cash flow and normalization adjustments, dealmakers uncover the true economic picture. In an environment of rising complexity, integrating advanced analytics, AI and ESG considerations will further sharpen insights. Ultimately, disciplined QoE work places capital where it belongs and underpins sustainable growth and value creation.
