Sellers arrive with an audit and assume diligence is covered. Buyers arrive asking for a quality of earnings report and are told the accounts have already been audited. Both are reasonable positions, and they are answering different questions.
The 2 questions
An audit asks whether the financial statements are fairly stated, in all material respects, in accordance with a reporting framework. It is backward-looking, opinion-bearing, and its reader is anyone entitled to rely on published accounts.
A quality of earnings analysis asks what the business actually earns on a sustainable basis, and therefore what a buyer should pay for it. It is forward-leaning, opinion-free, and its reader is one party to a transaction.
An audit can be clean and the earnings still be low quality. That is not a contradiction. Reported profit can be entirely correct under the framework and still contain items no buyer will pay a multiple for.
| Audit | Quality of earnings | |
|---|---|---|
| Question | Are the statements fairly stated? | What will this business sustainably earn? |
| Commissioned by | The company or its owners | A buyer, or a seller preparing |
| Output | An opinion | Normalized EBITDA and a bridge |
| Standard | Auditing standards, materiality | No standard; negotiated scope |
| Who may rely on it | Broadly, per the engagement | The commissioning party |
| Period | The financial year | Typically 36 months plus LTM |
| Typical cost | Varies widely by size | $20,000 to $100,000+ at the large firms |
What a quality of earnings tests that an audit never does
The whole of the value sits in 4 areas an audit has no reason to examine, because none of them affects whether the statements are fairly stated.
- Normalisation. Owner salary above or below market, related-party rent, one-off legal costs, a founder’s vehicle. All correctly recorded. None of them recurring for the next owner.
- Revenue cut-off and quality. Not whether revenue is in the right period, but whether it is repeatable. Customer concentration, contract length, churn, and whether last year’s growth came from price, volume or one large customer who is now in month eleven of a 12-month deal.
- Working capital. A normalised level, month by month, so the buyer knows what has to be left in the business at completion. This is the single most commonly disputed number in a deal and an audit produces no view on it at all.
- Net debt and debt-like items. Deferred revenue, accrued bonuses, unfunded leave, capex commitments, tax exposures. Items that reduce the price even where they sit correctly on the balance sheet.
What an audit does that a quality of earnings never does
An audit gives an opinion. It applies a materiality threshold, tests controls, confirms balances with third parties, and produces something a lender or a regulator can rely on. A quality of earnings report expresses no opinion on whether the accounts are correct. It takes the ledger largely as given and asks a commercial question of it.
This is worth stating plainly because it is where sellers get caught: if a buyer’s advisor finds that the underlying records will not support the analysis, the quality of earnings does not fix that. It reports it.
An audit tells you the number is right. A quality of earnings tells you what the number is worth.
What a buyer asks for when you hand them the wrong one
Hand a buyer an audit in place of a quality of earnings and the request comes back the same way every time: a monthly profit and loss for 36 months, a normalisation schedule with support for every adjustment, a working capital analysis by month, and a net debt schedule as at a recent date.
None of that is in an audit file. Producing it under deal timetable pressure, while the buyer waits, is where the price starts moving. Which is the argument for running the exercise on yourself first.
Our own boundary, stated plainly
We do quality of earnings work. We do not audit. We are not a licensed CPA firm and we issue no attestation or assurance opinion. If what you need is an opinion a third party can rely on, you need a licensed audit firm and we will say so on the first call rather than the third.
Our quality of earnings engagements start at $1,750 and report in 15 business days. The large-firm range for comparable scope sits between $20,000 and well over $100,000, which is a function of who signs it as much as what is in it.
One thing to check before you commission either
Write down your last 12 months of EBITDA. Now list every cost in it that would not exist under a new owner, and every cost that would. If that list takes more than an hour to build, a buyer will build it for you, and they will build it in their own favour.