Quality of Earnings Report: What a QoE Is, How It Differs From an Audit and Typical Adjustments

A quality of earnings (QoE) report is a financial due diligence deliverable prepared in connection with a transaction, usually the sale of a private business. It answers a narrow, practical question: what level of earnings, usually expressed as adjusted EBITDA, can a buyer rely on as sustainable, and what does the business need in working capital to produce it?

For CPA firms, QoE work draws on audit and accounting skills but is a different engagement, with a different purpose, standards and risk profile. This guide explains what a QoE is, how it differs from an audit, the adjustments it typically contains and the professional framework around it.

What is a quality of earnings report?

A QoE analyzes the historical earnings of a business to separate recurring, operational performance from items that are nonrecurring, unusual, out of period or owner-specific. The output is an adjusted earnings figure for the historical periods under review, typically the last two or three fiscal years and a trailing twelve months, along with supporting analyses.

Buyers use it to test the earnings figure on which the purchase price multiple is based. Lenders use it to size acquisition financing. Sellers commission their own QoE before a sale process to find problems early and defend the number.

Buy-side and sell-side

• Buy-side QoE: commissioned by the buyer or its lender to test the seller's representations. The scope is driven by the buyer's concerns, and the report is generally addressed to the buyer.
• Sell-side QoE: commissioned by the seller before going to market. It identifies adjustments, cleans up presentation and reduces surprises later in the process. Buyers usually still perform their own diligence.

How a QoE differs from an audit

Two practical consequences follow. First, an audited set of financial statements does not make a QoE unnecessary; an audit tests fair presentation under GAAP at a materiality level, while a QoE asks which earnings recur. Second, a QoE does not substitute for an audit. It provides no opinion on the financial statements, and the procedures are not designed to obtain reasonable assurance.

Is a QoE an attest engagement?

Not ordinarily. A QoE is usually performed as a consulting engagement under the AICPA Statement on Standards for Consulting Services. Under those standards the practitioner develops findings, conclusions and recommendations for the client, but does not express a conclusion on the reliability of a written assertion that is the responsibility of another party.

A QoE can be structured as an attest engagement if the parties want that. The usual route is an agreed-upon procedures engagement under AT-C 215, in which the practitioner performs specific procedures and reports findings without an opinion or conclusion. See agreed-upon procedures under AT-C 215. Once an engagement is under the attestation standards, the requirements of AT-C 215 on independence and reporting apply, along with the AICPA Code's independence rules for attest engagements.

The engagement letter should state which standards apply, who the client is, who may rely on the report and the limits on use. Lenders frequently ask to rely on a buy-side report; reliance letters and their terms are a significant risk area for the firm.

Typical QoE adjustments

Adjustments move reported earnings toward a normalized, recurring level. The common categories are:

Management and diligence adjustments

• Owner compensation: replacing the owner's salary, bonus and benefits with market compensation for the role going forward.
• Related party transactions: adjusting rent paid to an owner-controlled entity to a market rate, or removing related party revenue that will not continue. See ASC 850 for the related disclosures in the financial statements.
• Personal or discretionary expenses paid by the business, such as vehicles, travel or family payroll.
• Nonrecurring items: litigation settlements, one-time consulting fees, severance, relocation and transaction costs.
• Out-of-period items: expenses or revenue recorded in the wrong period, often identified by reviewing journal entries and subsequent payments.

Accounting adjustments

Many private companies keep books on a cash or tax basis, or apply GAAP inconsistently. Common accounting adjustments include:

• converting cash-basis revenue and expenses to accrual
• recording accrued payroll, bonuses and paid time off
• applying ASC 606 to deferred revenue and contract assets; see ASC 606 revenue recognition
• inventory reserves and cost capitalization
• the effect of ASC 842 on rent expense presentation and EBITDA; see ASC 842 lease accounting

Pro forma and run-rate adjustments

These are the most contested. They reflect events the business expects, such as a price increase already implemented, a new customer contract or the full-year effect of a cost reduction. Buyers generally discount run-rate adjustments without strong support, and some QoE providers present them separately from diligence-adjusted EBITDA.

Other QoE analyses

• Net working capital: a normalized monthly working capital analysis that supports the target, or peg, in the purchase agreement. Definitions matter: which accounts are included, how cash and debt are excluded, and how seasonality is handled.
• Debt and debt-like items: deferred revenue, unpaid taxes, deferred compensation, customer deposits and other items a buyer may argue should reduce the price.
• Proof of cash: reconciling bank activity to reported revenue and expenses over the review period, a strong test of whether revenue is real. See bank reconciliation.
• Revenue analytics: customer concentration, churn, cohort analysis, pricing and volume.
• Margin analysis: gross margin by product, customer or location.

How a CPA firm should run QoE work

Engagement acceptance

Consider conflicts before accepting. A firm that audits the target and then performs a sell-side QoE faces questions about whether the QoE work creates a self-review or advocacy threat to its independence as auditor; the AICPA independence rules on nonattest services and the conceptual framework apply. A firm asked to perform a buy-side QoE on a company it audits must also consider the conflicts of interest interpretation in the AICPA Code (ET 1.110.010). Document the analysis.

Quality management

SQMS 1 applies to a firm's accounting and auditing practice, which covers engagements performed under the SASs, SSAEs and SSARSs. A QoE performed as a consulting engagement under CS section 100 is outside that scope, while one structured as agreed-upon procedures under AT-C 215 is within it. As a matter of practice, many firms extend their quality management policies on acceptance, competence, review and documentation to consulting service lines such as QoE, and doing so is sensible given the reliance and liability risk. See SQMS 1 for small firms.

Documentation

Keep a clear link from each adjustment to its support: the general ledger detail, invoices, contracts and management explanations. Label which adjustments were proposed by management and which by the provider, and which were tested versus taken from management's representations. That distinction is often the first thing a buyer's counsel asks about in a dispute.

Data handling

QoE work involves confidential data from parties who are often competitors. Data rooms, access controls and confidentiality agreements need the same care as audit files, and the AICPA confidentiality rule applies.

Frequently asked questions

Is a quality of earnings report the same as an audit?

No. An audit expresses an opinion on whether the financial statements are fairly presented under a financial reporting framework. A QoE analyzes sustainable earnings and working capital for a transaction and usually provides no assurance.

What standards apply to a QoE performed by a CPA firm?

A QoE is usually performed under the AICPA Statement on Standards for Consulting Services. If the parties want an attest engagement, it can be structured as agreed-upon procedures under AT-C 215, which brings in the attestation standards, including AT-C 215's independence and reporting requirements.

Does a company with audited financial statements need a QoE?

Often, yes. An audit addresses fair presentation under GAAP at a materiality level, while a QoE focuses on which earnings recur and on adjusted EBITDA and working capital, which the audit does not address.

What are the most common QoE adjustments?

Common adjustments include normalizing owner compensation and related party rent, removing nonrecurring items and personal expenses, correcting out-of-period entries, converting cash-basis items to accrual, and in some reports, pro forma run-rate adjustments.

Can a firm perform a QoE for a company it audits?

It requires care. The firm must evaluate threats to independence under the AICPA independence rules for nonattest services and the conceptual framework, and consider conflicts of interest, particularly for buy-side work on an audit client.

Sources

• AICPA, Statement on Standards for Consulting Services No. 1 (CS section 100), Consulting Services: Definitions and Standards
• AICPA, AT-C Section 215, Agreed-Upon Procedures Engagements (SSAE No. 19)
• AICPA Code of Professional Conduct, ET 1.110.010, Conflicts of Interest; ET 1.295, Nonattest Services; ET 1.700.001, Confidential Client Information
• AICPA, SQMS No. 1, A Firm's System of Quality Management for Audits or Reviews of Financial Statements, or Other Engagements Performed in Accordance with SASs or SSAEs
• AICPA, AU-C Section 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance With GAAS
• FASB ASC 850, Related Party Disclosures; ASC 606; ASC 842

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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error