The Quality of Earnings report is how buyers verify that the earnings they agreed to pay for are real. It is not a compliance audit. It is a sustainability test. Owners who understand what buyers are looking for — and prepare before diligence begins — are far less likely to see the price reduced after the LOI is signed.
At SeaRidge Advisory, we regularly see owners surprised by what a buyer’s accounting team finds during financial due diligence. The issue is rarely dishonesty. It is usually undocumented add-backs, untracked liabilities, or accounting practices that look different under scrutiny.
What Is a Quality of Earnings Report?
A Quality of Earnings report, often called a QofE or QoE, is a financial analysis performed by an accounting firm on behalf of the buyer. Its purpose is to determine whether the adjusted EBITDA presented during the sale process is accurate, sustainable, and properly documented.
A traditional CPA audit asks whether the numbers are accurate under accounting standards. A QofE asks a different question: are these earnings real and repeatable?
The distinction matters. A business can have accurate financial statements that still show earnings a buyer cannot count on after closing.
The EBITDA Bridge
A common output of a QofE is an earnings bridge from reported results to the buyer’s view of adjusted EBITDA. Scope and deliverables vary by accounting firm, buyer, transaction, and engagement terms.
The seller’s advisor presents supported adjustments. The accounting team tests whether those items belong in the agreed earnings measure; rejection can affect negotiations but does not impose an automatic price reduction.
Add-backs buyers typically accept
- Owner compensation above market replacement cost, with documentation of what a replacement manager would be paid
- Personal expenses that are clearly non-operational and non-recurring
- One-time professional fees tied to events that will not repeat
- Depreciation and amortization, only when bridging from a measure that still includes these expenses—not a second add-back to EBITDA
Items that reduce value during QofE
- Unaccrued employee vacation or other employee liabilities not on the balance sheet
- Deferred maintenance and capital expenditures the business has been deferring to show higher profits
- Revenue that has been recognized but not collected, particularly aging receivables
- Add-backs that cannot be documented with supporting records
- Working capital shortfalls that will require cash injection after closing
Owner takeaway: an undocumented add-back is not an add-back. Document everything before the buyer asks.
Net Working Capital: Where Deals Quietly Lose Value
The working capital peg is an agreed target for transaction-defined operating current assets less operating current liabilities. In many cash-free, debt-free transactions it excludes cash and debt, but the purchase agreement controls the included accounts and calculation. It is not simply cash the seller must leave behind.
The parties should agree on the definition, target period, accounting policies and closing adjustment mechanism. Differences between delivered working capital and the agreed target can change the purchase-price adjustment.
SeaRidge Advisory helps owners discuss working-capital expectations with the buyer and their accounting and legal advisors before definitive terms are finalized.
Industry-Specific Diligence Risks
Every industry has areas where due diligence tends to surface the most issues. Understanding your exposure helps you prepare.
Asset-heavy businesses
Buyers scrutinize inventory valuation, obsolescence and future capital needs. Inventory issues may affect working capital; capital expenditures generally affect cash requirements and value rather than being deducted mechanically from EBITDA.
Service businesses
Revenue recognition, period cutoff, and the consistency of accounting methods are common diligence areas. Whether cash- or accrual-basis reporting is appropriate depends on the company and applicable accounting and tax rules; any change should be made with the company’s accounting advisor. For the GAAP revenue-recognition framework, see FASB ASC Topic 606.
Healthcare and regulated businesses
Buyers in these industries often perform compliance reviews alongside financial diligence. Revenue tied to billing records that cannot be verified, or receivables that are older than standard collection windows, may be treated as uncollectible during the QofE.
Sell-Side Due Diligence: The Offensive Approach
For larger transactions, SeaRidge Advisory often recommends a sell-side QofE. This means the seller hires an independent accounting firm to perform a QofE before the buyer does.
The benefits are straightforward. Issues are identified and addressed before the buyer finds them. The buyer receives a seller-prepared QofE report, which shifts the dynamic from investigation to verification. And the diligence process tends to move faster because many questions are answered in advance.
Sell-side diligence requires an upfront budget. Its usefulness depends on the transaction, financial complexity and buyer requirements; it does not guarantee that its cost will be recovered.
How to Prepare Before the Buyer Arrives
The best QofE preparation is not a last-minute scramble. It is ongoing financial discipline.
- Keep business and personal expenses clearly separated
- Document every add-back with supporting records
- Maintain accurate monthly financial statements
- Track and accrue employee liabilities including vacation
- Stay current on capital expenditures rather than deferring maintenance
- Reconcile revenue with cash collections regularly
- Organize customer contracts, leases, and key agreements
Owner takeaway: the more organized your financials are before diligence starts, the faster and cleaner the process will be. Delays in diligence create fatigue and give buyers more time to find concerns.
What Happens When the QofE Finds Problems
A QofE that identifies a lower adjusted EBITDA figure may lead the buyer to seek a price or terms adjustment. The result is negotiated and depends on the agreed valuation framework, the nature of the finding, and the transaction documents; it is not automatically proportional.
The goal of preparation is to reduce the gap between what you present and what the buyer verifies. Deals that survive diligence cleanly close faster, at better terms, with less friction.
If you are thinking about selling, start with a confidential valuation conversation before your financials go under scrutiny: Free Business Valuation. For a broader look at the transaction process: M&A Advisory.
A Seller’s Quality of Earnings Triage
| Review area | Buyer question | Seller support |
|---|---|---|
| Revenue | Is it recurring, concentrated, correctly timed, and collectible? | Customer-level sales, contracts, deferred revenue, aged receivables |
| Gross margin | Do margins reconcile by product, service, location, or customer? | Monthly margin analysis and explanations for volatility |
| Adjustments | Will each proposed add-back actually disappear? | Ledger detail, invoices, payroll, contracts, written rationale |
| Working capital | What level is required to operate normally? | Monthly balances, seasonality, aging, inventory history |
| Cash conversion | Does adjusted EBITDA translate into cash after capital needs? | Capital expenditures, debt service, working-capital movements |
Sources and Scope
- Financial Accounting Standards Board, Accounting Standards Codification
- U.S. Securities and Exchange Commission, Non-GAAP Financial Measures
This article provides general educational information, not legal, accounting, tax, or investment advice. Company value, buyer behavior, timing, and transaction terms depend on the facts and the market at the time.
Frequently Asked Questions
What is a Quality of Earnings report?
A Quality of Earnings report is a financial analysis performed by an accounting firm to verify whether a business’s adjusted earnings are accurate, sustainable, and properly documented. Buyers use it to confirm that the EBITDA they agreed to pay for is real.
Who pays for the Quality of Earnings report?
The buyer typically pays for their Quality of Earnings review. If the seller chooses to commission a sell-side QofE in advance, the seller pays for that. For larger transactions, the investment often protects deal value by reducing surprises and accelerating diligence.
Can a deal survive a QofE that finds problems?
A deal may proceed with revised terms, additional support for earnings, a price adjustment, or no change. The result depends on the finding, buyer, valuation method and negotiated documents.
What is the working capital peg?
The peg is a negotiated target for the operating current assets and liabilities defined in the purchase agreement. Cash and debt are often excluded. The agreement determines how differences at closing affect price.
How long does a QofE take?
A typical QofE takes several weeks and involves data requests, management interviews, and detailed revenue and expense analysis. Being organized and responsive can shorten the timeline and reduce diligence fatigue.