Quality of Earnings Checklist for M&A

As a business buyer, you must verify financial information before closing on the acquisition. Without a structured approach, critical issues can slip through the cracks.

Buyers rely on the broker and/or seller’s version of the P&L statement to put together a valuation. This valuation is then accepted by a broker/seller, an LOI is put together, and then the due diligence period starts. However, as a buyer, you need to perform due diligence to understand if the claims made in the P&L are accurately reflected in the actual operations of the business.

This is where a Quality of Earnings (QoE) checklist comes into play. QoE ensures nothing gets overlooked when analyzing a target acquisition’s actual financial performance. This systematic framework covers everything from revenue recognition patterns to working capital trends, giving you the clarity needed to go through with the acquisition, re-negotiate terms, or back out of the deal.

In this article, we will lay out a detailed QoE checklist that you or your M&A advisor can follow when doing due diligence. 

What is Quality of Earnings (QoE)?

A Quality of Earnings report examines whether a company’s reported profits reflect its true financial capacity. It digs deeper than standard financial statements to analyze the sustainability and accuracy of earnings.

Regular audits verify that financial statements follow accounting rules. QoE reports go further by identifying one-time events, accounting choices, and operational trends that affect future profitability.

The report answers a key question for buyers: Can this business maintain its current earnings after acquisition? 

A QoE separates recurring revenue from temporary spikes and normalizes expenses to show what profits look like under normal operating conditions.

Who Prepares a QoE?

Typically, third-party accounting firms prepare QoE reports. However, you have industry M&A experts who also perform QoE. In the ideal world, as a buyer, you should hire someone who has both QoE and industry expertise; get the best of both worlds.

The professionals conducting the analysis typically hold Certified Public Accountant (CPA) credentials and specialize in transaction advisory services. They need deep expertise in Generally Accepted Accounting Principles (GAAP), accounting, financial analysis, and M&A due diligence.

CPAs must perform their professional responsibilities with competence and diligence and perform professional services to the best of a member’s ability. This standard ensures QoE reports meet professional quality benchmarks.

Most firms that prepare QoE reports come from three categories. 

1. Big Four accounting firms handling large, complex transactions
2. Regional accounting firms serve middle-market deals
3. Specialized boutique firms focus exclusively on quality of earnings work (e.g., WebAcquisition falls into this category)

The key requirement is independence. The firm preparing the QoE cannot have existing audit or consulting relationships with the target company that would compromise objectivity.

Quality of Earnings Checklist for M&A

A comprehensive QoE checklist examines specific financial areas that impact a company’s true earnings power. Each category requires detailed analysis to uncover potential risks and opportunities.

Revenue Quality Analysis

Revenue analysis forms the foundation of any QoE review. It determines whether reported sales represent sustainable business performance or temporary gains.

Revenue recognition policies

• Check timing and basis for revenue generation (e.g., SaaS companies recognizing subscription revenue monthly versus upfront). 
• Review contracts to ensure revenue is recognized when business control transfers to you.

Recurring vs. one-time revenue

• Separate core operational income from non-recurring sources.
• Identify one-time sales, asset disposals, or unusual transactions.
• Calculate the percentage of revenue from repeatable business activities.

Customer concentration

• Analyze revenue dependence on major customers.
• Assess risk if key customers leave or reduce purchases.
• Review customer contract terms and renewal rates.

Seasonal variations

• Examine revenue patterns across reporting periods.
• Identify business cycles that affect sales timing.
• Adjust for seasonality when comparing performance.

Expense Normalization

Normalizing expenses removes one-time and non-recurring costs to reveal sustainable operating performance. This adjustment directly impacts Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), a key valuation metric.

Non-recurring expenses

• Identify one-time legal fees, settlements, or litigation costs.
• Remove expenses from facility relocations or restructuring.
• Exclude costs related to discontinued operations or product lines.

Owner compensation adjustments

• Compare owner salaries to market rates for similar positions.
• Adjust for above-market or below-market compensation levels.
• Account for family member wages that exceed fair market value.

Related party transactions

Related parties include family members (spouses, siblings, parents, children) and business relationships where an individual owns more than 50% of a corporation. These transactions receive heightened scrutiny.

• Review transactions with related parties or entities.
• Verify pricing aligns with arm’s-length transactions.

Discretionary spending

• Identify the owner’s personal expenses run through the business.
• Remove costs for personal vehicles, entertainment, or travel.
• Adjust for above-market rent or other non-arm’s-length arrangements.

Working Capital Assessment

Working capital analysis determines the cash needed to support daily operations. It examines current assets minus current liabilities to assess liquidity and operational efficiency.

Accounts receivable (AR) aging

• Analyze how long invoices remain unpaid.
• Review collection patterns by customer.
• Identify potentially uncollectible accounts.

Inventory valuation

• Examine inventory turnover rates.
• Identify slow-moving or obsolete stock.
• Review valuation methods (FIFO, LIFO, weighted average).
• Check for proper cost adjustments.

Accounts payable terms

• Review payment terms with suppliers.
• Assess whether payables are being stretched.
• Examine how long the business takes to pay suppliers. 
• Verify no material amounts are past due.

Cash conversion cycle

• Calculate time from cash outlay to cash collection.
• Measure how long cash is tied up in operations.
• Compare cycle length to industry benchmarks.
• Identify opportunities to improve cash flow.

Working capital is calculated as current assets minus current liabilities. Current assets typically include cash, accounts receivable, and inventory, while current liabilities include accounts payable, wages, and short-term debt.

EBITDA Adjustments

EBITDA adjustments normalize earnings to reveal sustainable operational performance. This metric is central to business valuations.

Add-backs verification

• Validate all proposed add-backs with supporting documentation.
• Verify depreciation and amortization amounts from financial statements.
• Confirm interest expense calculations.
• Review tax provisions for accuracy.

Pro forma adjustments

• Assess management’s assumptions for post-acquisition changes.
• Evaluate cost savings or synergy estimates.
• Review revenue projections for reasonableness.
• Verify timing of anticipated adjustments.

Synergy assumptions

• Examine the basis for claimed operational efficiencies.
• Review market data supporting revenue synergies.
• Assess integration costs not reflected in projections.
• Compare assumptions to industry benchmarks.

Run-rate calculations

• Annualize recent changes that occurred mid-period (e.g., a new enterprise client added in October, contributing $50,000 in Q4 would represent $200,000 annual run-rate revenue)
• Adjust for new contracts or customer additions.
• Account for price increases implemented during the period.
• Normalize for one-time implementation costs.

Customer and Contract Analysis

Customer relationships drive recurring revenue and business sustainability. Analyzing customer concentration and contract terms reveals stability risks.

Contract terms review

• Examine contract duration and renewals.
• Review termination clauses and notice periods.
• Assess pricing escalation mechanisms.
• Verify service level agreements and penalties.

Customer retention rates

• Calculate annual customer churn rates.
• Analyze revenue retention trends.
• Review customer satisfaction metrics.
• Assess the likelihood of contract renewals.

Customer concentration risk

• Measure revenue dependence on top customers.
• Identify vulnerabilities from key customer loss.

As a general rule of thumb, a customer that contributes more than 10% of total revenue, or the top five customers contributing more than 25%, are deemed potential red flags.

This threshold matters significantly in M&A. Businesses with high customer concentration face valuation discounts and deal structure complications.

Backlog verification

• Review contracted but not yet delivered work.
• Verify revenue recognition timing.
• Assess quality and profitability of backlog.
• Compare backlog to historical trends.

Contractual obligations

• Identify unfavorable contract terms.
• Review change order processes.
• Assess warranty or service obligations.
• Examine penalty or liquidated damages clauses.

Accounting Policies Review

Accounting policy analysis ensures financial statements follow established standards and remain consistent across periods.

Policy consistency

• Review revenue recognition methods for consistency.
• Examine inventory valuation policies.
• Assess depreciation methods and useful lives.
• Verify expense capitalization practices.

Accounting changes

• Identify any policy changes during the review period.
• Assess the impact of accounting standard updates.
• Verify proper disclosure of changes.

Estimates and assumptions

• Evaluate management’s key estimates.
• Review bad debt reserve calculations.
• Assess inventory obsolescence reserves.
• Examine warranty and return assumptions.

Balance Sheet Quality

Balance sheet analysis verifies asset values and liability completeness to ensure accurate financial position representation.

Asset verification:

• Confirm existence and valuation of tangible assets.
• Review fixed asset depreciation schedules.
• Verify intangible asset amortization.
• Assess the collectibility of receivables.

Liability completeness:

• Identify all debt obligations and terms.
• Review lease commitments and obligations.
• Verify accrued expenses.
• Assess contingent liabilities.

Off-balance-sheet items:

• Identify operating leases and commitments.
• Review guarantees and indemnifications.
• Assess variable interest entities.
• Examine related party arrangements.

Net worth accuracy:

• Verify equity account balances.
• Review retained earnings calculations.
• Assess distribution or dividend history.
• Confirm ownership structure.

The balance sheet shows assets, liabilities, and equity at a specific point in time. Assets must equal liabilities plus equity, providing a snapshot of financial position.

Cash Flow Verification

Cash flow analysis distinguishes between reported earnings and actual cash generation, revealing a business’s true financial sustainability.

Operating cash flow:

• Analyze cash generated from core operations.
• Compare net income to operating cash flow.
• Identify non-cash expenses affecting earnings.
• Assess the quality of earnings through cash conversion.

Cash flow trends:

• Examine multi-period cash flow patterns.
• Identify seasonal fluctuations.
• Assess improvement or deterioration trends.
• Compare to industry benchmarks.

Free cash flow:

• Calculate cash available after capital expenditures.
• Assess the ability to service debt.
• Evaluate the capacity for growth investment.
• Determine the distribution capability of owners.

Working capital changes:

• Analyze impact of receivables changes.
• Review inventory investment requirements.
• Assess payables management.
• Identify cash trapped in operations.

The statement of cash flows divides activities into operating, investing, and financing categories. Operating activities reflect cash from the core business, investing shows capital deployment, and financing indicates debt and equity transactions.

FAQs About QoE

Do I need a Quality of Earnings report for my acquisition?

QoE reports prove most valuable for transactions involving significant financial complexity, material purchase prices, or financing requirements. Banks and SBA lenders often require these reports before approving acquisition financing.

For smaller acquisitions where you possess intimate knowledge of the business operations and financials, the cost may outweigh the benefits. 

However, for deals involving unfamiliar businesses, complex financial structures, or substantial investment, professional QoE analysis provides essential protection against financial surprises.

How much does a Quality of Earnings report cost?

Pricing varies based on business size, complexity, and the quality of financial records. 

For example, WebAcquisition offers a comprehensive Quality of Earnings Report that starts at $7,900, with pricing potentially varying based on engagement complexity and scope. 

Industry-wide, costs differ significantly by provider and transaction size.

Final Thoughts

A comprehensive Quality of Earnings checklist transforms due diligence from guesswork into a proper systematic analysis. Each component, from revenue quality to legal compliance, serves a specific purpose in revealing the target acquisition’s true financial condition.

Professional QoE analysis protects acquisition investments by identifying issues before you acquire the business.

Ready to protect your next acquisition? WebAcquisition specializes in comprehensive financial analysis for online business transactions. Our experienced team examines every aspect of target financials, from revenue sustainability to working capital requirements, providing clarity you need for confident decision-making.

We offer two types of QoE:

• Full QoE – covers everything covered above. You will receive a deep-dive Excel Workbook and PDF analysis report. This is the gold standard
• QoE Lite – covers the major aspects in a deep dive Excel workbook. Commentary is included inside the workbook. No PDF report. 

Reach out with details about your acquisition and we can provide a quote for our services.