Quality of Earnings

Quality of earnings is a financial review that examines whether a business's reported earnings and proposed adjustments are supported by its records and underlying activity.

Why quality of earnings matters to people buying a small business

A seller's earnings summary can contain errors, loose classifications, or assumptions that don't survive review. None of that needs to be deliberate to hurt a buyer. Misread the numbers and you misread the business you'll be running.

A quality of earnings review challenges the seller's financial presentation through management questions and line-by-line work on the accounts. The goal is a real view of earnings and cash flow. It isn't a certified audit, and it doesn't try to bring the statements into full compliance with generally accepted accounting principles.

Read the small business quality of earnings guide for the broader buyer questions. The quality of earnings versus audit comparison explains why the two labels aren't interchangeable.

How a quality of earnings review is used

The buyer uses the review to understand the records behind the numbers, the reasons for proposed adjustments, and the limits of the work. Ask the provider what was examined. The report's title won't tell you.

Buyers should ask whether cash leaving the business was reconciled as well as cash coming in. Receipts support the revenue story; payments test the expense records. If the expense side wasn't tested, the report has a gap.

Suppose a seller presents earnings adjusted for spending described as unnecessary. The reviewer asks what the spending paid for and checks the supporting records. Receipts have been reconciled; outgoing payments have not. The buyer now has two open questions, one about the adjustment and one about the expense records. Having a report answers neither.

Common mistakes in quality of earnings reviews

Calling the review an audit implies a different purpose and level of assurance. Describe the engagement as it was actually scoped.

Another mistake is reading adjusted earnings as a forecast. The review explains past activity and the assumptions behind adjustments. Customers, costs, and operations can all change under a new owner.

Related terms

Proof of cash compares company records with bank activity. It may be part of a quality of earnings review, depending on its scope; other cash analysis may be separate. Add-backs are proposed earnings adjustments whose support needs examination.

Source notes

The points about review scope and cash testing are paraphrased from guest interviews on The SMB Investor podcast; examples are our own.