What Is a Quality of Earnings Report?

If you're looking to buy a business, at some point you're going to hear the term "quality of earnings" or "financial due diligence." They mean the same thing. In the US, it's commonly called a quality of earnings report (QoE). In New Zealand and the UK, you'll more often hear financial due diligence. Either way, it's a deep dive into the company's financials to understand whether the numbers are what they say they are.

It's one of the most important steps in any acquisition. You're about to commit serious capital, often with a significant chunk of debt. You need to know what you're actually buying.

How it differs from an audit

An audit is a fully featured review of a company's financial statements. It's generally required for listed companies or businesses owned by overseas entities. Auditors look at a range of things: whether the financial statements are presented correctly, whether the controls behind those numbers are sound, and whether everything complies with the relevant standards.

A quality of earnings report is narrower. It's not about presentation or compliance. It's about one core question: are the earnings real?

You're taking the management accounts, the numbers the business is putting forward as part of the sale, and pressure-testing them. How were they prepared? Do they tie to the tax returns? Are there adjustments that change the picture?

What it actually looks at

There are several areas a quality of earnings report typically covers. Not all of them will apply to every deal, but here's the core list.

Previous financials vs tax returns

Start with the historical financial statements and compare them to what's been filed with the tax authority. Your tax return is a good anchor. If the numbers the accountant prepared and the numbers in the tax return don't line up, that's worth understanding. It doesn't always mean something is wrong, but it needs an explanation.

Add-backs

This is where things get interesting. As part of a sale process, vendors will often "add back" certain expenses, arguing that a new owner won't incur them. The quality of earnings process looks at each of those and assesses whether they're legitimate.

Forecast reasonability

Sometimes you're buying a business mid-year and the vendor has a forecast for the remainder. Looking at that forecast and seeing how it compares to actual performance so far can be a useful sanity check. Is what they're projecting consistent with the trend, or are they painting a rosier picture?

Working capital

Understanding how cash moves through the business is really important. It gives you insight into how the business actually operates on a day-to-day basis, and it tells you how working capital intensive it is. That matters because working capital requirements get layered on top of the purchase price. You need to make sure you can fund it.

Revenue recognition

This one can catch you out. If the business is recognising revenue on things that haven't been delivered yet, that liability lands on you as the new owner. You'll need to deliver without the benefit of that revenue or the cash. Worth understanding how and when they book revenue.

One-offs

Has there been a one-off event that boosted revenue or created an unusual expense? You need to know about it, because it won't repeat. It's straightforward, but easy to miss if you don't ask.

Related party transactions

Understanding what's happening between the business and related parties is important. Are there transactions at arm's length? Are services being provided or received at market rates? Changes here after a sale can shift the economics.

Add-backs: where the real questions are

Add-backs deserve a closer look because they're one of the most common areas where the presented earnings diverge from reality.

The classic add-back is the owner's salary. The vendor removes it from the expenses, which boosts the apparent earnings. The quick check here is simple: what have they actually been paid through the payroll or drawn in cash?

I've seen an office lease added back because the new owners could work remotely. That might be true. But it's worth asking whether the business genuinely needs a physical space, regardless of the owner's preference.

Same with vehicles. The owner's car gets added back as a personal expense. Fine, but does the business need a vehicle? If so, you need to add a replacement cost back in.

The principle is straightforward: just because an expense is being removed doesn't mean a replacement won't appear. Each add-back needs to be assessed on its own merits.

Tailor the scope to the risk

One thing worth knowing is that financial due diligence isn't one-size-fits-all. You can go deep and comprehensive, which costs the most, or you can scale it back to a level that makes sense for the deal.

There are basic checks you'd probably do for every company. But beyond that, it's about tailoring the approach to the specific risks of the business you're looking at. Certain companies will have areas that are inherently riskier, and that's where your money is best spent.

The goal is to get comfortable with the numbers at a cost that's proportionate to the deal. Not every acquisition needs a full forensic review, but every acquisition needs some level of independent verification.

It's about knowing what you're buying

Financial due diligence, at its core, is about stripping away the owner-specific decisions, the one-off events, and the presentation choices to get a realistic picture of the business's true earnings.

If you're looking to acquire a business, this is the step that gives you confidence in the numbers. Or, just as usefully, it's the step that tells you when something doesn't add up.