Quality of Earnings Reports: What Sellers Need to Know

If you're selling a business for more than $2M, there's a near-certainty that your buyer — or their lender — will commission a Quality of Earnings (QofE) report. This is the single most important piece of financial diligence in any deal, and it's where more transactions get repriced or killed than anywhere else.

Understanding what a QofE is, what the analysts are looking for, and how to prepare for it can be the difference between holding your price and watching your deal erode.

What Is a Quality of Earnings Report?

A QofE is a financial analysis performed by an independent accounting firm (usually hired by the buyer) that validates the seller's reported earnings. It goes far beyond a standard audit. While an audit confirms that financial statements conform to accounting standards, a QofE answers a different question: what are the true, sustainable, recurring earnings of this business?

The QofE firm will reconstruct your adjusted EBITDA from scratch, challenge every add-back, and normalize your financials to reflect what a new owner can realistically expect to earn.

What QofE Analysts Actually Do

A typical QofE engagement takes 3-6 weeks and includes:

Revenue Analysis

• Revenue quality assessment — What portion of revenue is recurring vs. one-time? Are there any revenue recognition timing issues?
• Customer cohort analysis — Are you growing by adding new customers, or are existing customers spending more? What's the churn rate?
• Contract analysis — What's the remaining term and renewal probability of key contracts?
• Revenue trend decomposition — Separating organic growth from price increases, new customer acquisition, and one-time projects

Expense Normalization

• Add-back validation — Every add-back you've claimed will be scrutinized. The analyst will determine whether each adjustment is legitimate, properly calculated, and truly non-recurring.
• Run-rate expense analysis — Are there expenses that should be higher going forward? Did you defer maintenance, underspend on marketing, or understaff to inflate short-term earnings?
• Owner compensation normalization — What would it actually cost to replace the owner's functions with market-rate employees?
• Related-party transactions — Are you paying family members or related entities at market rates?

Working Capital Analysis

• Net working capital calculation — Defining and calculating the "normal" level of working capital the business needs to operate
• Seasonal adjustments — Identifying working capital fluctuations driven by seasonality
• Working capital peg negotiation support — The QofE informs the working capital target that goes into the purchase agreement

Debt and Debt-Like Items

• Identifying hidden liabilities — Deferred revenue, customer deposits, accrued vacation, pending legal claims, deferred maintenance
• Capital lease vs. operating lease treatment
• Off-balance-sheet obligations

Common QofE Findings That Hurt Sellers

Aggressive Add-Backs

The most common issue. Sellers (or their brokers) claim add-backs that don't hold up under scrutiny. Examples:

• "One-time" expenses that recur — If you've had a "one-time" legal expense three years in a row, it's not one-time. Analysts look at multi-year patterns.
• Understated replacement cost — Adding back your full $400K compensation when a competent replacement GM costs $250K means only $150K is a legitimate add-back.
• Personal expenses without documentation — If you can't prove an expense is personal vs. business, the analyst won't add it back.

Revenue Quality Issues

• Channel stuffing or pull-forward revenue — Aggressive end-of-period sales incentives that borrow from future periods
• Unsustainable customer concentration — A QofE will flag if a material portion of revenue is at risk due to contract expiration, customer financial health, or relationship dependency on the owner
• Declining unit economics — Revenue might be growing, but if margins are compressing, the earnings trajectory isn't what the topline suggests

Working Capital Surprises

Working capital disputes are among the most common post-QofE negotiation points. If the business has been managed with unusually low working capital (e.g., stretching payables), the buyer will argue that a higher working capital peg is needed — effectively reducing the seller's proceeds.

Understated CapEx Requirements

If equipment is aging and maintenance has been deferred, the QofE will identify the true maintenance CapEx requirement. This often gets treated as a reduction to normalized EBITDA or a separate price adjustment.

How to Prepare for a QofE

Conduct a Sell-Side QofE First

Increasingly, sophisticated sellers commission their own QofE before going to market. This sell-side QofE identifies issues before buyers find them, gives you time to fix problems, and provides a credible financial narrative you control.

A sell-side QofE typically costs $30K–$75K — a fraction of the value it protects.

Stress-Test Your Add-Backs

For every add-back, ask yourself:

• Can I document this with receipts, contracts, or third-party evidence?
• Would a skeptical accountant agree this is a legitimate adjustment?
• Has this expense truly not recurred, or am I claiming the same type of add-back every year?

If an add-back is borderline, it's better to exclude it from your marketing materials than to have a buyer's QofE firm reject it — which damages credibility on your other adjustments too.

Organize Your Financial Detail

QofE analysts need granular data — general ledger detail, bank statements, invoices, payroll records, customer-level revenue data. Having this organized and accessible before diligence starts signals professionalism and speeds up the process.

Fix Issues in Advance

If you know there are financial issues — a year with messy books, a period of aggressive revenue recognition, an undisclosed related-party transaction — address them proactively. Disclosure beats discovery every time.

Brief Your CPA

Your accountant will field questions from the QofE analysts. Make sure they understand the deal context, know where the bodies are buried, and can speak competently about your financials.

How QofE Findings Affect Deal Terms

When a QofE comes back with findings, the impact flows through to deal terms in several ways:

EBITDA adjustments — If the QofE determines that adjusted EBITDA is $4.2M rather than the $5M you marketed, and the deal was priced at 5x, you've just lost $4M in enterprise value.

Working capital adjustments — A higher working capital peg means more cash stays in the business at closing, reducing your net proceeds.

Earnout structures — If the buyer is uncertain about earnings sustainability, they may propose shifting a portion of the price to an earnout tied to future performance.

Representation and warranty insurance (RWI) exclusions — QofE findings can create specific exclusions in RWI policies, shifting risk back to the seller.

Deal repricing or termination — Material QofE findings give the buyer leverage to renegotiate or walk away entirely.

The Seller's Mindset

The best approach to QofE is transparency and preparation. Sellers who try to hide issues or aggressively inflate their add-backs almost always end up worse off — either through repricing, deal fatigue, or broken deals.

Think of the QofE as an opportunity to validate your business's earnings power with independent verification. A clean QofE is one of the strongest closing tools you can have.

Need Help Preparing?

If you're thinking about selling and want to make sure your financials can withstand buyer scrutiny, I can help you prepare. From recommending sell-side QofE firms to stress-testing your add-backs, preparation is where the real value is created.

Book a confidential call to discuss your situation.