Quality of Earnings (QoE)
Quality of Earnings (QoE) is an independent accounting analysis of a target company's historical profit, commissioned by a buyer, a lender, or a seller preparing for sale, that tests whether reported and adjusted earnings are real, recurring, and supported by the underlying records. A QoE report carries no audit opinion; it produces a defensible normalized EBITDA or SDE figure and a net working capital analysis that the parties then transact on.
Also called QofE, QoE report, quality of earnings report, earnings quality analysis · Last updated 2026-08-07 · All 24 terms
What a QoE actually tests
A QoE team is not re-auditing the books. The engagement is built around one question: if the buyer owned this business next year and changed nothing, what would it earn in cash? Every procedure in the workpapers serves that question.
The core procedure in a lower-middle-market QoE is proof of cash — tying reported revenue and expenses month by month to bank statements and merchant processor deposits. On owner-managed businesses with cash-basis or hybrid bookkeeping, that single test surfaces more distortion than the rest of the engagement combined.
The second half of the engagement is the add-back schedule. The seller's recast is treated as a set of assertions rather than as a starting balance, and each assertion is tested against a source document. An add-back that cannot be tied to an invoice, a payroll register, a lease, or a board resolution generally comes out.
- Proof of cash: monthly revenue and expenses per the books reconciled to bank and merchant processor activity.
- Revenue recognition and cutoff: whether December revenue was actually earned in December.
- Add-back substantiation: every adjustment on the seller's schedule tested against a source document, line by line.
- Monthly gross margin: a stable margin supports the earnings figure; a margin that swings several hundred basis points month to month usually means inventory, work-in-process, or accrual errors.
- Net working capital: a twelve-month average of month-end balance-sheet positions, which becomes the working capital peg in the purchase agreement. This is an average of point-in-time balances, not a trailing-twelve-month income figure.
- Customer and supplier concentration, accounts receivable aging and collectability, and any deferred or unearned revenue.
- Headcount and payroll continuity: whether the reported labor cost can support the revenue being claimed.
A worked example: what a QoE does to price
A seller's CIM presents adjusted EBITDA of $2,400,000 for the trailing twelve months. The buyer's QoE firm works the schedule and arrives at a different number.
Three adjustments come out. $180,000 of add-backs have no supporting documentation. $140,000 of revenue was billed in December for work performed in January, and because the related labor cost also fell in January, the full $140,000 leaves the period. And $95,000 of legal fees presented as one-time appear in each of the last three years, which makes them recurring operating cost rather than an add-back; the QoE firm struck the line in full rather than conceding the increment above the three-year run rate.
One adjustment goes the seller's way, and its mechanics matter. The company pays $190,000 a year in rent to a building entity owned by the seller's family; comparable space in the market leases for $120,000. The buyer will still pay rent, so only the $70,000 excess is added back — not the full $190,000, which is a real cost of occupying the building.
Adjusted EBITDA per the QoE: 2,400,000 − 180,000 − 140,000 − 95,000 + 70,000 = $2,055,000. The gap is $345,000 of annual earnings. At the 5.0x multiple named in the LOI, 345,000 × 5.0 = $1,725,000 of purchase price, and enterprise value falls from $12,000,000 to $10,275,000.
That arithmetic explains why buyers pay for a QoE and why the fee rarely decides anything. It also explains why an over-aggressive add-back schedule is expensive. A seller who pads the recast by $180,000 is not reaching for $900,000 of price; they are spending credibility on the $2,055,000 that was defensible.
QoE, audit, and recasting are three different things
An audit is an opinion. Under US auditing standards — AICPA AU-C Section 700 governs the reporting — a CPA firm expresses whether historical financial statements are presented fairly, in all material respects, in accordance with an accounting framework such as US GAAP, for a completed fiscal period. Audits look backward, are framework-bound, and say nothing about whether earnings will repeat.
A QoE produces no assurance opinion and is not an attest engagement at all; it is consulting work, performed under the AICPA's consulting services standards, delivered as a databook plus a narrative and scoped to sustainable earnings, cash conversion, and working capital. Providers include CPA firms and non-CPA transaction advisory firms. Most lower-middle-market targets have never been audited, and a QoE is performed on exactly those unaudited books.
Recasting is the seller-side counterpart: the broker or the seller's accountant restates tax returns and P&Ls to show SDE or adjusted EBITDA. A recast is produced by the party being paid on the outcome. A QoE is the independent test of that recast. The two are complements, not substitutes — a recast with source citations shortens a QoE, and a vague one lengthens it and invites disallowances.
Who commissions it, when, and what it costs
A QoE is usually buy-side and post-LOI. The buyer signs the letter of intent, exclusivity starts, and the QoE kicks off in the first week of diligence because its output drives the working capital peg and any price adjustment. Fieldwork runs three to five weeks on a lower-middle-market target, longer where the books are on cash basis and have to be converted to accrual first.
As of 2026, a full buy-side QoE on a business with $1,000,000 to $5,000,000 of EBITDA commonly runs $15,000 to $50,000, with scaled-down databook-only engagements starting near $10,000. The buyer pays. Private equity buyers and mezzanine or unitranche lenders generally require one; smaller SBA-financed Main Street deals frequently close without one, relying on the lender's own cash-flow analysis and tax return verification.
Sell-side QoE has become common in the lower middle market. The seller commissions the analysis before going to market, fixes what it finds, and hands buyers a substantiated number. The cost is comparable, but it is spent while the seller still has competing buyers rather than during exclusivity, when there is one.
Where sellers lose money in a QoE
The recurring failures are not exotic. They are bookkeeping hygiene problems a seller could have fixed twelve months earlier at no cost: personal expenses run through the company with no annotation, so the add-back exists but cannot be proven; revenue recorded on deposit rather than on delivery, which distorts every cutoff; one-time expenses that appear every year; family members on payroll at rates nobody documented as market or non-market; inventory that has never been physically counted; and deferred revenue on prepaid contracts that was never recorded as a liability, which inflates both earnings and the working capital delivered at close.
The defense that works is a running add-back log kept contemporaneously — date, amount, account, business reason, and where the supporting document lives — rather than a schedule assembled from memory the week the LOI is signed.