Quality of earnings
AccountingA diligence exercise that rebuilds the bridge from reported profit to a defensible EBITDA and tests every adjustment against the underlying records.
Also written: QoE, quality of earnings report
A buyer commissions a quality of earnings report from an accounting firm to answer one question: how much of the earnings being sold are real and repeatable? The work goes behind the audited figures into the ledger, testing the composition of revenue, the timing of costs and every line of the add back schedule.
It is not an audit and expresses no opinion on whether the accounts are true and fair. It is a negotiating document, produced for one client, and its conclusions frequently move the price rather than the accounts.
It usually finds movement in both directions. Add backs fail, and adjustments the seller had missed turn up, along with matters that are not adjustments at all but change the view of the business: revenue concentrated in a handful of customers, margin flattered by a supplier rebate that has since ended, or a working capital position that has been managed hard into the year end.
In European mid market processes the seller often commissions its own version in advance as part of vendor due diligence. That does not remove the buyer's work, but it does change the argument from whether the numbers hold to whose analysis is more credible.
Worked example
A seller presents adjusted EBITDA of 50 against 38 reported.
Diligence accepts 6 of the 12 in add backs, and separately finds 2 of cost that had been capitalised and should have run through the income statement. The defensible figure becomes 42 rather than 50, and at 9.0x that is 72 of price.