Most writing about quality of earnings is written for buyers. This is written for the other side of the table, because the seller is the one with something to lose and the one who can still do something about it.
Here is the shape of that loss. A business agrees a sale at six times EBITDA. Diligence produces a quality of earnings report that finds $400,000 of adjustments the seller had not anticipated. Nobody argues about the multiple. The purchase price falls by $2.4 million, and it falls as arithmetic rather than as a negotiation, which is much harder to push back on.
What is a quality of earnings report?
A quality of earnings report is a diligence analysis that tests whether a company’s reported earnings are sustainable and repeatable, adjusting reported profit to an EBITDA figure a buyer is willing to apply a multiple to.
It is not an audit. An audit gives an opinion on whether financial statements are fairly stated under an accounting framework, and it is an attest engagement performed by an independent licensed firm. A quality of earnings report is a consulting engagement with no opinion attached, and it asks a different question: not “are these numbers right” but “how much of this profit will still be here next year under a new owner.”
A typical report covers:
- Adjusted EBITDA, with every adjustment listed, quantified and supported
- Revenue quality: customer concentration, contract terms, recurring versus one-off, pricing durability
- Monthly trend analysis, usually thirty-six months, to test seasonality and momentum
- Working capital analysis and a proposed normal level, which becomes a deal term
- Cash proof: a bridge from reported earnings to actual cash generated
- Key accounting policies and whether they are conservative, aggressive or inconsistent
The five adjustment categories a QoE will find
Adjustments are not accusations. Most are legitimate and expected. The problem is discovering them in week three of diligence rather than eighteen months earlier, when four of these five could have been fixed or documented in advance.
- Owner discretionary items. Above-market or below-market owner compensation, family members on payroll, personal vehicles, travel, memberships, and rent paid to a related-party entity at something other than market. Buyers add back the genuine ones and refuse the ones that look like a real cost of running the business. The determining factor is documentation, not intent: an add-back with an invoice, a policy and a market comparison survives, and the same add-back asserted verbally does not.
- Non-recurring items. Legal settlements, a one-off equipment failure, a bad-debt write-off from a customer who no longer exists, startup losses on a location that has since matured. Genuinely non-recurring costs come back out of EBITDA. The argument is always about the word “genuinely,” and a seller who has three non-recurring items in each of three consecutive years is describing a recurring category.
- Run-rate and pro-forma adjustments. These cut both ways and sellers under-use them. A price increase implemented in month nine only shows for three months in the trailing year, and annualising it is a legitimate adjustment if it is documented and holding. So is the full-year effect of a contract signed in November, or the savings from a lease renegotiated mid-year. Buyers propose the negative versions of these routinely. Sellers who have not prepared the positive versions leave money behind.
- Accounting policy and cutoff. The quiet one. Cash-basis books converted to accrual, revenue recognised at the wrong moment, deferred revenue never recorded, inventory expensed on purchase, accrued expenses missing at period end, capitalisation policies applied inconsistently. These do not just adjust EBITDA, they move it between periods, which can turn a growth story into a flat one. This is the category that most often produces the surprise, because it is invisible to an owner reading their own P&L every month, and it is why the cash versus accrual decision is a transaction decision as much as a tax one.
- Working capital normalisation. Technically not an EBITDA adjustment but usually the second-largest number in the deal. The buyer sets a normal level of working capital that must be delivered at closing, and anything below it reduces proceeds dollar for dollar. Sellers who have been managing cash by stretching payables discover that the stretch is being treated as a deficit. Understanding your own cycle is the defence, and it is the same discipline as the 13 week cash flow forecast a CFO runs during the year.
Four of those five are preparable. The fifth is negotiable if you understand how the peg was calculated before you see it in a draft agreement.
DEAL READINESS
Find your adjustments before a buyer’s team does
exact_ works with founders, independent sponsors and PE-backed businesses on the reporting a transaction actually runs on: normalised EBITDA, a clean thirty-six month trend, and a working capital position you can defend.
Sell-side QoE: worth it lower down the market than people assume
The received wisdom is that a sell-side quality of earnings report is for larger deals. The logic runs backwards.
The smaller the company, the more likely the books are cash basis, the more owner discretionary spending runs through them, the less formal the revenue recognition, and the thinner the documentation behind any add-back. That means the proportional adjustment risk is higher at the bottom of the market, not lower. A $2 million EBITDA business with $300,000 of unanticipated adjustments loses 15 percent of its value. A $30 million EBITDA business with the same dollar surprise loses one percent.
What a sell-side report buys is not a better number. It is three things: time to fix what can be fixed, documentation for the add-backs you intend to claim, and the ability to hand a buyer an analysis rather than react to theirs. Deals where the seller has done this move faster, and speed protects value in its own right, because every extra month of diligence is another month for a buyer to find something else or for the business to have a soft quarter.
Getting ready: what to do eighteen months out
| Timing | What to do | Why then |
|---|---|---|
| 18 to 24 months out | Move to accrual-based management reporting; fix revenue recognition and cutoff | Buyers look at three years; policy changes need time to become the trend |
| 12 to 18 months out | Clean up related-party arrangements, document owner add-backs contemporaneously | An add-back documented as it happens is credible; one reconstructed later is not |
| 12 months out | Build the monthly reporting pack a buyer will ask for | Thirty-six months of consistent monthly data is the core diligence request |
| 6 to 12 months out | Model your own working capital cycle and its seasonal range | You need your own view before someone proposes a peg |
| 3 to 6 months out | Commission the sell-side QoE | Enough time to act on findings, recent enough to still be current |
One caveat on that timeline. It assumes a planned sale. Roughly half of lower-middle-market transactions start with an unsolicited approach, and in that case the honest answer is that you compress everything above into whatever window exists and accept that some findings will be documented rather than fixed. Documented is still far better than discovered.
After the deal: the filing both sides have to agree on
One item catches sellers after closing, when the advisors have gone home.
In an asset sale, the purchase price has to be allocated across asset classes, and the allocation drives the tax treatment for both parties. Both the seller and the purchaser of a group of assets that makes up a trade or business must file IRS Form 8594, where goodwill or going concern value attaches or could attach to the assets and the purchaser’s basis is determined only by the amount paid. It is a bilateral filing, and the two sides are expected to report the same allocation.
Since buyer and seller have opposing tax interests in how the price is split, this is a negotiation, and it belongs in the purchase agreement rather than being left to two accountants filling in forms separately in the spring. A seller who agrees a headline price without discussing allocation has agreed to a number, not to what they will keep. That conversation sits with business tax services and should happen before signing.
Frequently asked questions
Is a quality of earnings report the same as an audit?
No. An audit is an attest engagement giving an opinion on whether financial statements are fairly stated. A quality of earnings report is a consulting engagement with no opinion, focused on whether earnings are sustainable and what a buyer should treat as normalised EBITDA. Having an audit does not remove the need for a QoE, and having a QoE does not satisfy anyone who requires an audit.
Who pays for a quality of earnings report?
Whoever commissions it. Buy-side reports are paid for by the buyer, sell-side reports by the seller. A sell-side report does not replace the buyer’s own work, but it does shorten it and it changes who sets the starting point.
What is adjusted EBITDA and why does it differ from net income?
Adjusted EBITDA starts from earnings before interest, taxes, depreciation and amortisation, then adds back or removes items a buyer would not expect to recur under new ownership. Interest is removed because the buyer will have their own capital structure. Taxes because they will have their own. Depreciation and amortisation because they are non-cash and reflect historical purchase decisions. Then come the adjustments described above. The result is meant to approximate the cash earning power a new owner would inherit, which is why every adjustment has to be defensible: each one is being multiplied by six or eight in the price.
How long does a QoE take?
Typically three to six weeks from data access, and the variable is almost always the state of the data rather than the analysis. A company with a clean monthly close and organised support finishes at the fast end. Getting to that state is ordinary outsourced accounting work done consistently, not a special project.
Do I need a QoE if I have audited financial statements?
Usually yes. They answer different questions, and buyers commission a QoE on audited companies routinely.
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About the author. This article was written by Dan Spada, CPA, at Exact Partners, a national outsourced accounting, fractional CFO and business tax firm founded in Buffalo, New York in 2021 and named No. 152 on the 2026 Inc. 5000 list of America’s fastest-growing private companies. Dan and the Exact team support founders, independent sponsors and PE-backed businesses through M&A advisory, due diligence and the reporting that transactions run on. Learn more about Dan Spada and the Exact Partners team.
This article is general information, not accounting, tax, valuation or transaction advice. Confirm your position with qualified advisors before acting on it.
