Your Quality of Earnings Report May Skip the Expense Side

A quality of earnings review is a check many small-business buyers pay for before closing, and it tests only what the engagement says it tests. Some reviews check the cash coming in and take the expenses on faith. You find out which kind you bought by reading the scope, not the title page.

A quality of earnings review (QoE) questions management, works through the records in its agreed scope and challenges the adjustments to reported earnings. It isn't an audit, and it doesn't bring the statements up to accounting standards. Our quality of earnings versus audit comparison covers the difference.

What the review should show you

Ask for two things kept apart: the seller's reported earnings and the provider's proposed adjustments. Each adjustment should say what changed and what supports it. If you can't follow the reasoning, a clean summary page doesn't help.

Seller add-backs get the same treatment. An add-back removes an expense from reported earnings, and the seller's explanation for it is a claim to test. It isn't evidence.

The review sits inside the wider business acquisition due diligence process. Having "earnings" in the name doesn't mean it answered your operating questions.

Takeaway: ask what work was done, not what the report is called.

Cash in and cash out

Revenue on the books and cash in the bank are different numbers. A cash proof ties them together. Incoming cash should reconcile with revenue and accounts receivable (what customers still owe). Outgoing cash should match recorded payments, sorted into expenses, debt principal and asset purchases.

The outgoing side is the harder half, and some reviews skip it. The report still looks thorough. It just assumes the recorded costs are right.

Here is how that gap gets past buyers:

• The proposal mentions bank statements, and the buyer reads that as testing.
• The provider receives the statements but only reconciles deposits.
• The exclusion is described as background instead of a limit.
• The earnings number looks settled even though nobody checked the expenses.

So ask directly. Will you match outgoing bank activity to recorded payments? How will you test expenses? Where will that work appear in the report? The proof of cash definition has background. If expenses are out of scope, ask how that limits the earnings conclusion. A limit you can see is a question you can still work on.

Supported revenue also says nothing about why customers buy or whether they'll keep buying. That belongs in revenue quality diligence, not the QoE.

Ask the provider	The report should
How will you connect incoming cash with revenue and receivables?	Say which records were compared and which differences are unresolved.
Will you match outgoing cash to recorded payments and test expenses?	Say whether the expense side was tested or excluded.
How will you handle management explanations that have no records behind them?	Keep explanations separate from supported findings.
What if the records limit the work?	Name the limit and the questions it leaves open.

Takeaway: get it in writing whether the cash going out was tested.

The review should push back on you too

The seller isn't the only one with a story to protect. A buyer who has spent months on a deal will read unclear numbers in whatever way keeps the deal alive. Financial experience doesn't fix that. Building a model and examining a set of books are different skills.

Each kind of buyer has a reason to go easy on the numbers:

• An operator buying an add-on may think the target looks familiar.
• A self-funded searcher may not want to start the search over.
• An independent sponsor may have already put work into presenting the deal.

Ask who will do the review and who will check their conclusions. Ask what ties the provider has to the seller or anyone else in the deal, and how they'll disclose them. Then ask what happens when they disagree with you. Will a concern you think you can explain away stay in the report?

Takeaway: a finding that changes your mind is what you're paying for.

Scope sets the limits

The proposal says what the provider plans to examine. The final report says what they actually examined. Read the two side by side, because missing records can shrink the work after it starts.

Where the provider used management's numbers without checking them, the report should say so plainly. A category mentioned only as background shouldn't read like a tested finding. An exclusion doesn't mean the business has a problem. It means the question is still open.

What I'd do

Before signing the engagement letter:

1. Ask which earnings claims the provider will challenge.
2. Confirm the cash work covers money going out, not only money coming in.
3. Ask how each proposed adjustment will be explained.
4. Ask where unsupported explanations and unresolved differences will show up.
5. Confirm someone other than me can object to my assumptions.
6. Ask which missing records could stop the work from finishing.
7. Get a plain list of what the engagement leaves untested.

When the report comes back, I'd read it against the proposal line by line. If I couldn't explain the supported findings and the open questions in my own words, I wouldn't be done with it.

Source notes

The source interviews on The SMB Investor podcast are paraphrased. Examples and provider questions are ours.