A quality of earnings (QoE) report is an independent financial analysis — ordered by the buyer, performed by an accounting firm — that stress-tests a business's historical earnings before you commit to a price. In the ETA world, it is not optional. It is the document that separates what the seller says the business earns from what the business actually earns under a normalized, sustainable operating scenario.
What a QoE Report Is Not
A QoE report is not an audit. An audit verifies that financial statements comply with GAAP. A QoE report examines whether the EBITDA the seller is presenting would hold up under scrutiny — different scope, different purpose, different conclusion. Most small businesses are not audited and do not have GAAP-compliant financials. The QoE report exists specifically for this gap.
It is also not a legal or operational review. QoE firms (Stout, BDO, Alvarez & Marsal, FTI, and dozens of boutiques) focus exclusively on financial statement quality, revenue sustainability, cost normalization, and earnings repeatability. You still need legal, environmental, and operational diligence separately.
What a QoE Actually Covers
A standard lower-middle-market QoE engagement covers three years of trailing financials (if available), with particular focus on the trailing twelve months (TTM). The scope typically includes: revenue reconciliation (tying line items to bank statements and contracts), EBITDA normalization (removing owner add-backs, one-time items, and related-party distortions), working capital analysis (identifying seasonality, collection lag, and inventory obsolescence), and off-balance-sheet liabilities (deferred revenue, unfunded pension obligations, equipment replacement backlog).
For ETA-sized businesses in the $1M–$10M EBITDA range, most QoE engagements cost $15,000–$45,000 and take three to five weeks. This is 0.3%–0.5% of a $10M purchase price. It is the highest-ROI spend in your diligence process.
What QoE Reports Typically Find
Stout Risius Ross and BDO have both published lower-middle-market diligence surveys covering their QoE work. The most common findings by frequency of occurrence: revenue timing and recognition issues (found in approximately 68% of engagements), add-back inflation where the seller included items that do not qualify (61%), deferred expenses that reduce current-period costs but represent real future obligations (54%), related-party transactions at non-market rates (47%), one-time revenues included in the TTM without disclosure (43%), and undisclosed customer losses discovered only through contract review (31%).
The median adjustment to seller-stated EBITDA in lower-middle-market transactions — per BDO's 2023 M&A report — is approximately 15–22%. If the seller is presenting $2M of EBITDA, a QoE-adjusted figure of $1.6M–$1.7M is a reasonable base case before negotiations begin.
Revenue Recognition Red Flags
Revenue timing is the most common issue because it is easy to manipulate without technically lying. A seller who pulls forward a Q1 contract payment into December Q4 can show a stronger TTM without changing any annual numbers. Watch for: billings in advance of delivery, quarterly customers paying annual invoices in Q4, deferred revenue on the balance sheet that does not match revenue recognized, and project-based businesses with lumpy timing.
The fix is to reconcile revenue to cash received and to contract dates — both of which should be in the QoE workpapers. If a provider will not give you access to their workpapers, find a different provider.
How to Use QoE Findings in Negotiation
Do not use QoE findings to blow up the deal — use them to reprice it. A well-documented QoE gives you three levers: reduce the purchase price (apply your multiple to adjusted EBITDA, not stated EBITDA), add an escrow or holdback (retain 5–10% of purchase price for 12–18 months pending confirmation of run-rate earnings), or adjust working capital peg targets to reflect the true cash cycle of the business.
Sellers will push back. The ones worth buying from will engage with the data. The ones who refuse to discuss QoE findings are telling you something important about how they will behave post-LOI on every other diligence item.
Who Should Order the QoE
Order your own, buyer-side QoE — do not rely on a sell-side QoE the broker provides. Sell-side QoEs are written to support the asking price. A buyer-side engagement is instructed to find problems. In a competitive process you may not have time, but for proprietary deals — the norm in self-funded search — you should always control your own QoE provider.
Ask your ETA investor, search fund sponsor, or SBA lender for QoE provider referrals. Providers who regularly work ETA deals understand the scale and scope of the engagement and will not over-engineer it for a $3M acquisition the way a Big Four firm might.