Quality of Earnings

What Is a Quality of Earnings Report?

A quality of earnings (QoE) report is a detailed financial analysis commissioned during M&A due diligence — typically by the buyer, but sometimes by the seller in preparation for a sale. Its purpose is to determine whether the target company’s reported earnings accurately represent its sustainable, recurring profitability.

The QoE analysis strips away one-time items, non-recurring events, accounting policy choices, and management adjustments to arrive at an “adjusted EBITDA” figure that reflects the true underlying economics of the business. This adjusted number forms the basis for transaction pricing and valuation multiples.

Why Quality of Earnings Matters

The purchase price in most M&A transactions is derived from an EBITDA multiple, as detailed in our M&A valuation guide. If the EBITDA figure is inflated by non-recurring items or aggressive accounting, the buyer overpays. Conversely, if legitimate expenses are excluded, the seller may leave value on the table.

Consider a company reporting $10M EBITDA that includes $2M from a one-time contract settlement. At an 8x multiple, this inflates the enterprise value by $16M. A proper QoE analysis would normalise EBITDA to $8M, resulting in a $64M valuation rather than $80M.

Common Adjustments

Addbacks (Increase Adjusted EBITDA)

Items that reduce reported earnings but are not part of ongoing operations:

• One-time legal settlements or restructuring charges — non-recurring expenses that will not continue post-acquisition
• Owner-related expenses — above-market compensation, personal expenses, or related-party transactions that will not persist under new ownership
• Transaction costs — advisory fees, due diligence costs, and other deal-related expenses
• Start-up costs — investment spending on new product lines or geographies that will generate future returns
• Non-recurring professional fees — one-time consulting, audit, or regulatory compliance costs

Deductions (Decrease Adjusted EBITDA)

Items that inflate reported earnings but are not sustainable:

• Non-recurring revenue — one-time contracts, grants, insurance recoveries, or asset sale gains
• Below-market rent or services — related-party arrangements at non-arm’s-length terms
• Deferred maintenance — underinvestment in capex, R&D, or staffing that artificially inflates near-term profitability
• Aggressive revenue recognition — recognition ahead of performance obligations or channel stuffing
• Customer concentration risk — revenue dependent on a single customer that may not renew

Pro Forma Adjustments

Adjustments reflecting the full-year impact of events that occurred during the period:

• Acquisitions or divestitures — annualising partial-year contributions
• Price increases — reflecting the full-year effect of mid-year pricing changes
• New contracts — annualising revenue from contracts signed during the period
• Cost savings — run-rate impact of cost reduction initiatives already implemented

The QoE Process

1. Engagement — buyer (or seller) retains an accounting firm to perform the analysis
2. Data collection — the QoE team requests detailed financial records, trial balances, general ledger data, and management reports
3. Analysis — line-by-line review of revenue, expenses, working capital, and balance sheet items
4. Management interviews — discussions with the target’s finance team to understand unusual items and accounting policies
5. Report delivery — a written report presenting adjusted EBITDA, working capital analysis, and key findings
6. Price negotiation — the QoE findings directly inform purchase price discussions and the completion accounts mechanism (Corporate Finance Institute)

Sell-Side QoE Reports

Increasingly, sellers commission their own QoE reports before launching a sale process. Benefits include:

• Identifying and addressing potential issues before buyers discover them
• Controlling the narrative around adjustments and pro forma items
• Accelerating the due diligence checklist timeline
• Demonstrating professionalism and transparency to prospective buyers

Quality of Earnings in Asia Pacific

QoE analysis in Asia Pacific transactions often requires more extensive work due to differences in accounting standards and financial reporting quality. Many private companies in the region maintain separate management accounts and tax accounts, requiring reconciliation. Adjustments for related-party transactions are particularly important in family-owned businesses, which are prevalent across Southeast Asia and Greater China. AI-native platforms like Amafi help advisors access and standardise financial data across Asia Pacific markets, providing the foundation for rigorous QoE analysis.