Quality of earnings vs audit: what each one tests

A quality of earnings report and an audit both review a company's financials, but they answer different questions for different readers. An audit asks whether the financial statements are fairly presented. A quality of earnings report asks how much of the reported profit a new owner would actually get.

The distinction matters most to a seller. A company with clean audited statements can still see its adjusted EBITDA cut in diligence, because the audit never tested the things a buyer prices. The full diligence step is covered in the guide to quality of earnings and EBITDA adjustments; this post compares the two reviews side by side.

What each one tests

An audit looks at whether the financial statements are fairly presented under the accounting framework the company uses, and it ends in a formal opinion on those statements. The standard for that opinion is set by bodies such as the International Auditing and Assurance Standards Board (ISA 700).

A quality of earnings review is not an opinion. It is an analysis, usually for a buyer, of how repeatable the earnings are. It normalizes EBITDA, examines revenue and margin trends, measures net working capital and flags debt-like items the buyer should price.

Side by side

Illustrative comparison. Scope varies by engagement.

Why a clean audit does not protect adjusted EBITDA

Buyers price what the business will earn, not what it reported. An audit can pass a year of statements without testing whether an add-back is truly non-recurring, whether a strong quarter will repeat, or what normal working capital looks like. Those are the questions that move the price, and they are the ones a quality of earnings review exists to answer.

Common places where audited numbers still get revised in diligence:

• Add-backs. Owner pay, personal expenses and "one-time" costs that recur.
• Revenue timing. Annual contracts billed upfront and recognized over the term, and revenue pulled forward at period end.
• Working capital. The level the business normally runs at, which sets the working capital peg.
• Concentration. A few customers carrying most of the revenue.

What sellers should do

1. Do not skip the QoE because the books are audited. Expect the buyer to run one anyway.
2. Consider a sell-side review 6 to 12 months before going to market, so problems are found and fixed on the seller's timeline. See exit planning for the sequence.
3. Close the books monthly on an accrual basis and reconcile the balance sheet. Both reviews depend on it; messy records make either one slower and more expensive.
4. Build the adjustment schedule with support. Every add-back should tie to the ledger and have a document behind it.
5. Ask early whether the buyer or lender needs audited statements. Many private company deals close without them, but some contracts and lenders require them.

Both reviews reward the same habit: a finance function that closes on time, reconciles and can explain its own numbers. The sale process that follows is covered in the guide to selling a business.