What a quality of earnings review actually does
A quality of earnings review examines whether reported earnings are sustainable and correctly stated. It is not an audit. An audit asks whether the accounts comply with the applicable standard; a QofE asks whether the earnings a buyer is being asked to pay a multiple of will still be there next year.
The two questions produce very different findings. Businesses with clean audits often carry material QofE adjustments, because none of the things a QofE looks for are audit failures: one-off revenue treated as recurring, costs capitalised that should have been expensed, related-party arrangements at non-market rates, deferred maintenance in the cost base.
Why sellers should run their own
Every credible buyer will commission one. The findings will be presented to you as a reason to reduce price, at a point in the process where your negotiating position is weakest: exclusivity has usually been granted, the other bidders have gone home, and your board has already been told the deal is happening.
Running a vendor-side review inverts that. You get the same findings months earlier, with time to fix what is fixable, to prepare an explanation for what is not, and to price the asset with the adjustments already built in rather than negotiated in.
The cost is real but proportionate. For assets above roughly $75M enterprise value it usually pays for itself in preserved price. Below that, a focused review of the two or three highest-risk areas gets most of the benefit.
Where the adjustments usually are
Revenue recognition. Multi-year contracts recognised unevenly, implementation fees treated as recurring, and usage revenue from a single unusual period annualised into the run rate.
Non-recurring items in both directions. One-off costs that should be added back, and one-off revenue that should be stripped out. Sellers are enthusiastic about the first and quiet about the second, which is exactly why buyers discount seller-prepared adjusted EBITDA.
Cost timing. Deferred hiring, delayed maintenance, and marketing pulled back in the months before a process. These flatter current EBITDA and are visible to anyone who compares the last two quarters against the prior two years.
Related-party and intra-group arrangements. Transfer pricing, shared services, and intercompany contracts that will not exist post-close, or will exist at different rates.
Working capital. The seasonal pattern and the true normalised level, which then drives the peg, one of the most consequential and least-discussed numbers in the whole transaction.
Presenting the findings
Disclose them. A vendor QofE that surfaces three adjustments and explains each is far more credible than a clean bill of health that a buyer's team then contradicts.
Sellers sometimes worry that volunteering adjustments invites more of them. In practice the opposite holds: a seller who has clearly done the work and shown their reasoning gets less scrutiny on everything else, because the buyer's diligence team recalibrates its expectation of what it will find.
The timing
Commission it during preparation, not at launch. The point is to have time to act on the findings, to fix the fixable, restate what needs restating, and let one or two quarters of clean reporting pass before the numbers are put in front of anyone.
What the reviewer actually does
They rebuild the profit and loss from the underlying records rather than accepting the management accounts.
That means testing revenue against contracts and cash, tracing costs to invoices, examining the accruals and provisions, and separating what recurred from what happened once. For a subscription business it also means rebuilding the retention data from the raw subscription records rather than accepting a summary, because that is where the most consequential errors sit.
The output is a bridge from reported EBITDA to adjusted EBITDA, with each adjustment evidenced and quantified. That bridge is the document buyers negotiate against, and having your own version of it before they have theirs is the whole point.
Using the report properly
Fix what is fixable and let the fix run for a couple of quarters. An adjustment caused by a cost that has since been removed is far easier to argue than one still present in the numbers.
Where an adjustment is real and permanent, build it into the price expectation rather than hoping it goes unnoticed. A seller whose asking price already reflects the adjustments is in a much stronger position than one defending a number that assumes they will not be found.
Where you disagree with the reviewer, document why. A reasoned disagreement with evidence attached is a legitimate negotiating position. An assertion is not.
The one that catches most people
Deferred hiring. A division told to hold headcount for a year before a sale looks more profitable than it is, and the pattern is obvious to anyone comparing the last four quarters against the prior two years.
Buyers add the cost back, and they usually add back more than was actually saved, because they are now assuming the business is under-resourced in ways they cannot see. Running lean before a process is one of the few preparation tactics that costs more than it earns.
Editorial Team · Published for orientation, not as advice on a specific transaction. Any figure cited is orientation, not a valuation. See market notes.