Quality of Earnings vs. Financial Model Review
Executive Summary
Key Takeaways
- ✓ Quality of earnings analysis and financial model review test fundamentally different things and are sequential, complementary exercises rather than substitutes for each other.
- ✓ Quality of earnings establishes whether historical earnings are a reliable, normalized baseline; financial model review establishes whether the forward-looking model built on that baseline calculates correctly.
- ✓ A target's model can pass a clean quality of earnings review and still contain material structural errors — an untraceable synergy figure, a hardcoded forecast override — that a QoE review was never scoped to catch.
- ✓ A transaction relying on only quality of earnings, without an independent structural model review, has no assurance that the forecast the price is actually based on is free of formula errors, regardless of how reliable the historical baseline is.
- ✓ Both are typically commissioned as part of financial due diligence, but they are distinct deliverables, often prepared by different specialists, and should be scoped and reviewed as separate, complementary work products.
Definitions¶
Quality of earnings analysis, as defined on the Quality of Earnings glossary page, reconciles a target's reported EBITDA to a normalized figure by removing one-off, non-recurring, and non-operational items.
Financial model review, covered in full on the Financial Model Due Diligence pillar, tests whether the forward-looking transaction model — its formulas, structure, and assumption traceability — calculates correctly.
Side-by-Side Comparison¶
| Dimension | Quality of Earnings | Financial Model Review |
|---|---|---|
| What it tests | Reliability and normalization of historical earnings | Structural integrity of the forward-looking forecast model |
| Time orientation | Backward-looking (historical performance) | Forward-looking (the model's calculation logic) |
| Typical output | A reconciliation from reported to normalized EBITDA | A findings report on formula errors, assumption traceability, structural risk |
| Typical provider | Financial due diligence / accounting advisory specialist | Specialist model audit provider |
| What it does not test | Whether the forecast built on the normalized baseline is correctly constructed | Whether the historical baseline itself is a reliable starting point |
Decision Framework¶
Use quality of earnings analysis to establish whether a target's reported historical performance is a reliable basis for a valuation multiple — this is foundational to any transaction and is essentially universal practice for a transaction of meaningful size.
Use financial model review to establish whether the model built on top of that historical baseline — incorporating the QoE adjustments, forecast assumptions, and, for an M&A transaction, combination mechanics — actually calculates correctly. This is a distinct, complementary check that a clean quality of earnings review does not provide.
Use both together, as standard institutional practice for any transaction of meaningful size — the two address genuinely different risk categories, and commissioning only one leaves the other entirely untested.
Common Misconceptions¶
"A clean quality of earnings review means the deal model can be trusted." A QoE review confirms the historical baseline is reliable — it says nothing about whether the forecast model built on top of it is structurally sound, free of hardcoded overrides, or has traceable synergy and growth assumptions.
"Financial model review duplicates what quality of earnings already covers." The two overlap only at the point where QoE outputs (normalized EBITDA) become model inputs — a model review's actual scope, testing formula logic, structural risk, and combination mechanics, is entirely distinct from and not covered by a QoE review.
"Only one of these is necessary for a smaller transaction." Structural model errors — a hardcoded override, an untraceable synergy figure — occur in models of every transaction size, and the proportional risk to a smaller deal's investors or lenders is not necessarily lower.
References & Further Reading¶
- Rosenbaum, J. and Pearl, J., Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions, Wiley
- ICAEW, Financial Modelling Code, Institute of Chartered Accountants in England and Wales
Continue Reading¶
Prerequisites¶
Related Pillars¶
Related Glossary¶
Related Technical Guides¶
How OXXON tests thisRun a free structural check with FMAE
Frequently Asked Questions
What is the core difference between quality of earnings and financial model review?
Quality of earnings analysis establishes whether a target's historical, reported EBITDA is a reliable, normalized baseline. Financial model review establishes whether the forward-looking financial model built on top of that historical baseline calculates correctly and is structurally sound — a different question entirely.
Can a model pass a quality of earnings review and still be structurally unsound?
Yes. A clean quality of earnings review confirms the historical baseline is reliable — it says nothing about whether the forecast model built on top of that baseline contains a hardcoded override, an untraceable synergy assumption, or a broken purchase price allocation link, since a QoE review was never scoped to test those structural elements.
Are quality of earnings and financial model review typically performed by the same advisor?
Not always — quality of earnings is typically performed by a financial due diligence or accounting advisory specialist, while a structural financial model review is typically performed by a specialist model audit provider, and the two are often, though not universally, distinct engagements even within the same transaction.
What risk does a transaction carry if only quality of earnings is performed?
No assurance that the forecast model the price is actually based on is free of formula errors — a target could have a perfectly reliable historical baseline and still present a forecast model with a hardcoded revenue override or an untraceable synergy figure inflating the deal case, undetected by a quality of earnings review alone.
Should both always be commissioned together?
For any transaction of meaningful size, yes — the two address genuinely different risk categories (historical reliability versus forecast structural integrity), and commissioning only one leaves the other risk category entirely untested.
Related Articles
Financial Model Due Diligence
Financial model due diligence is the discipline of testing whether the financial model used to price, structure, or finance a transaction is itself structurally sound — a distinct question from whether the target business's historical financials are reliable (the domain of financial due diligence) or whether its commercial prospects are durable (commercial due diligence). A model can be structurally unsound — an untraceable synergy figure, a broken purchase price allocation link, a hardcoded override masking the true output of a formula — independent of whether the underlying business is fundamentally healthy, and this risk is what financial model due diligence is specifically built to catch. This page is the hub for the Knowledge Centre's model-risk-in-transactions content: how model review differs by audience (independent, lender, investor, vendor), how it differs from a quality of earnings review, and how transaction-specific model risk maps onto FMAE's own structural rule set.
Quality of Earnings
Quality of earnings (QoE) analysis is the central financial due diligence deliverable — a detailed reconciliation from a target's reported EBITDA to a normalized figure, removing one-off items, non-recurring items, and non-operational items to arrive at a figure that more reliably represents sustainable, ongoing earnings. Because the resulting normalized EBITDA is typically the earnings base a transaction's valuation multiple is applied to, an unsupported or aggressive quality of earnings adjustment has a direct, dollar-for-dollar effect on the price paid.
Financial Due Diligence
Financial due diligence investigates a target company's historical financial performance — earnings quality, working capital trends, net debt, and off-balance-sheet obligations — to establish a reliable, normalized baseline before a transaction is priced. It is distinct from a forward-looking financial model review: financial due diligence establishes what actually happened historically and whether reported earnings are a reliable indicator of sustainable performance, while a model review tests whether the forecast built on top of that baseline is structurally sound. This guide covers financial due diligence's core areas and how its outputs — normalized EBITDA, the net working capital peg, net debt — flow directly into deal pricing.
Model Risk During Transactions
Model risk during a transaction concentrates in mechanics that do not exist in either party's ordinary-course, standalone model — purchase price allocation, financing structure, pro-forma consolidation, and synergy assumptions — each a new potential point of structural failure introduced specifically by the transaction itself. This guide maps where that risk concentrates and why it is structurally independent of whether the underlying business being acquired is fundamentally sound.
Independent Model Review in Transactions
An independent model review, in a transaction context, is commissioned by the deal team itself for its own internal assurance ahead of investment committee approval — testing the transaction model's structural integrity separately from, and in addition to, the commercial and financial due diligence already underway. It shares its underlying methodology with the general independent model audit discipline, applied specifically to the transaction model and its combination mechanics.