When a business sale, acquisition, or major investment is contemplated, one important step in the due diligence process is the generation of a Quality of Earnings report, sometimes abbreviated as QOE. Even though a company may have strong financial statements, those may not be sufficient indicators of the financial soundness of the business. A Quality of Earnings report looks deeper into the data underlying the financial reports to determine whether there are hidden risks or inaccuracies.

What is Meant by Quality of Earnings?

The fact that a business has a high net income does not necessarily mean that level is sustainable over the long term. An unusually large sale or a temporary reduction of expenses might skew the company’s financial data for a particular reporting period, making the business look more profitable than it actually is. Likewise, data errors, changes in accounting procedures, and overoptimistic assumptions could be misleading.

To correctly interpret a company’s earnings and create accurate projections, a more extensive analysis is required. Income is only considered to be of high quality if it is sustainable and reflects cash flow. Earnings that come from cyclical trends, nonrecurring transactions, or other atypical sources are not considered high quality. The same goes for anticipated income that is tied up in accounts receivable.

Some measurements of quality earnings may include the following:

  • Year-over-year income trends
  • Consistency of accounting procedures and policies
  • Transparency in disclosure of unusual circumstances
  • Consistent measurement of earnings
  • Income-to-cash ratio of operations
  • Stock buybacks or other manipulation of earnings per share
  • Length of customer contracts
  • Assumptions made in financial forecasts

When Is a Quality of Earnings Report Needed?

A Quality of Earnings Report may be prepared for a buyer, an investor, or a seller. The timing and contents of the report may vary based on the interests of the requesting party.

A seller is typically interested in identifying any problems that might be of concern to the buyer and could slow down or jeopardize the acquisition process. The seller will likely want to generate a QOE report before making any serious attempt to attract buyers so that any issues uncovered can be addressed. Once any improvements have been completed, the seller may wish to create a new QOE report to present a better picture to potential buyers.

Buyers and investors seek to gain a thorough understanding of the company’s cash flow, operations, assets, and long-term profitability before engaging in a transaction. A buyer-side Quality of Earnings report will help build an accurate valuation of the company, helping to determine whether the potential transaction is likely to be favorable.

Sometimes a bank or other financial institution will require that a QOE Report be done prior to completing a business sale.

How Does a QOE Report Differ from an Audit?

A Quality of Earnings report differs from an audit in its process and purpose. A financial audit tends to focus on whether a company has followed generally accepted accounting principles (GAAP) in keeping its records and preparing its financial statements, while a Quality of Earnings report looks at the patterns and expectations of earnings. An audit looks at the accuracy of the documents and reports associated with GAAP reporting and notes any discrepancies. An audit is not intended to look at business trends and outlook and does not address the company’s history of earnings or its potential as a Quality of Earnings report does.

In general, an audit report focuses on the company’s balance sheet and net income. Its intent is to assure the public that the ending balances of accounts are correct, that revenue is recorded in the correct fiscal periods, and that there are no material misstatements in the financial documents.

A Quality of Earnings Report, on the other hand, focuses on the company’s financial track record and ongoing earning power. It analyzes such metrics as cash flow, EBITDA, fixed assets, and contribution margin. It not only looks at how purchases and expenses are recorded, but also whether and to what extent those transactions are necessary to business operations.

The QOE Report looks deeper into the company’s history and current position. The purpose is to assure the company and its potential buyers or investors that the business is both financially sound and headed in the right direction.

The following are often analyzed in a Quality of Earnings report:

  • Budgets and forecasts
  • Past, present, and projected revenue
  • Costs of revenue
  • Fixed assets
  • Working capital
  • Customers and customer needs
  • Vendors and suppliers
  • Operational and administrative expenses
  • Sales and marketing expenses
  • Miscellaneous income and expenses
  • Cash requirements
  • Company management
  • Human Resources (HR)
  • Information technology (IT)
  • Tax issues

Factors That Negatively Affect Quality of Earnings

Certain circumstances pointed out in a QOE report can be considered red flags that may discourage investors or serve as calls to ameliorative action for company management. Some of these are:

  • An increase in net income without a corresponding cash flow increase
  • Anomalous financial variances or trends
  • Changes in accounting principles, methods, or practices
  • Large non-recurring income or expense items
  • Transactions with related parties
  • One-time net income adjustments
  • Stock buybacks
  • Insufficient reserves
  • Overoptimistic projections
  • Deferral of debt repayment

What Does a Quality of Earnings Report Look Like?

Unfortunately, there is no generally accepted format for a QOE report. Because every company is different and the reasons for ordering the report may vary, each report tends to be somewhat unique in its content and presentation.

A typical QOE Report will include an executive summary, an analysis of the company’s income statement, and an analysis of the balance sheet. It will also include one or more lists of observations and recommendations. Often included are an EBITDA review and analyses of working capital, cash flow, customer and vendor relationships, seasonal trends, and risk management.

Various QOE templates can be found online, but they differ substantially and are usually just high-level skeletons that can be used as a starting point.

Who Prepares a Quality of Earnings Report?

Like an audit, a reliable QOE Report needs to be performed by outside, experienced professionals. Because a QOE report is not a one-size-fits-all project, the cost and timeline are variable, depending on the scope and complexity of the work.

According to several sources, it typically takes 45 to 60 days to complete a Quality of Earnings Report. This is, therefore, an expensive and time-consuming project. Nevertheless, there is a clear benefit to the investment. It can facilitate and speed up the sale of a company and reduce or prevent price negotiations.

In Summary

A Quality of Earnings Report is an important component of the due diligence needed when a business is put up for sale. The QOE Report goes beyond the scope of an audit by rigorously analyzing the past, present, and future earning power of a company. It is beneficial to a buyer because it details benefits and risks of the investment. It is also an opportunity for the seller to identify and fix potential deal-killers and present a compelling story to prospective buyers.

For more financial information and assistance, we encourage you to check out the articles at preferredcfo.com, or call and speak to one of our CFOs.

About the Author

Curtis Bigelow


Curtis is an experienced finance professional with 20 years of experience serving public and private companies in a variety of industries including SaaS, healthcare, and  manufacturing.


You may also be interested in...

How to Conduct a Market Analysis

Before starting a new business—and periodically thereafter—it is important for company executives to carry out a market analysis, also called a market evaluation. Most entrepreneurs conducted a market analysis (to the best of their abilities) when they were developing...

What is a Fractional CFO?

A fractional CFO is an experienced CFO who provides services for organizations in a part-time, retainer, or contract arrangement. This offers a company the experience and expertise of a high-end CFO without the in-house cost—salary, benefits, and bonuses—of a...

What is GAAP and Why is it Important?

Generally Accepted Accounting Priciples (GAAP) Financial reporting is an important part of business that communicates the financial performance and results of a company. It records and presents information about the company’s financial position, revenues, expenses,...

Easing the Financial Year-End Close

The end of the fiscal year can be highly stressful for financial officers and corporate executives. The year-end closing procedure is time-consuming and sometimes brings unpleasant surprises. Particularly in times of economic downturn and short staffing, year-end...

3 Reasons you Need a Financial Forecast

If Your Company Doesn't Have a Financial Forecast, You're Wasting Time and Money Every company has goals. Where do you want your organization to be 5 years from now? 10 years? Most even have a general idea of the benchmarks you need to hit to get there—"By increasing...

Determining the Payback Period of a Business Investment

Whether implementing a new software system, adding office space, acquiring another company, or any other substantial investment, companies want to know how long it will take to recoup the money they spend on major purchases. The way to determine this is by calculating...

10 Steps to Prepare for Raising Capital

Finding funding for your business is a process that takes a lot of time and effort, especially during the startup phase. Many entrepreneurs fail in their first attempts at fundraising because they are poorly prepared. Others get themselves into trouble by choosing the...

How Can a Fractional CFO Help You Save Money?

In these days of economic challenges and changes, many companies struggle with uncertainty about the future, seeking tools and resources to best position their businesses for financial success. Often it can be beneficial to bring in a financial advisor who has...

What is a Capitalization (Cap) Table and Why Does it Matter?

What is a Cap Table? Capitalization tables, commonly called “cap tables,” are highly useful spreadsheets maintained by companies that have multiple owners or investors. Cap tables are especially important for private companies at startup and in the early stages of the...

Benefits of Finance & Accounting Staff Augmentation

Many companies experience times when they find their accounting departments short on staff or short on expertise. Sometimes emergencies and financial needs arise that are beyond the capability of their financial personnel to address. This is particularly true in times...

Qualities of an Effective Profit & Loss Report

A Profit and Loss (P&L) Report, also called a Profit and Loss Statement, is a key financial document that details a company’s income and expenses over a specific period of time. This time period is typically a month, a quarter or a year. Depending on company needs...