M&A & Due Diligence
What Is a Quality of Earnings (QofE)?
A Quality of Earnings report is the financial deep-dive a buyer's accountant runs during M&A diligence. They recast your P&L to strip out add-backs they do not accept, normalize working capital, and verify revenue quality. Your reported EBITDA almost always shrinks. Founders who prep their own QofE before going to market negotiate from a stronger position.
A Quality of Earnings (QofE) is the independent accounting deep-dive a buyer commissions during M&A diligence. The buyer's accounting team validates 24-36 months of financials, normalizes EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), and produces the Adjusted EBITDA the buyer is willing to value off.
What QofE teams adjust
- Inventory write-downs: aged or unsellable inventory at over-stated carrying value
- Revenue recognition issues: deferred revenue treated as recognized, channel stuffing, gift cards never redeemed
- Under-accruals: bonus, payroll, vacation, sales tax accruals understated
- Owner compensation normalization: founder salary above or below market gets adjusted
- Non-recurring items: one-time legal, advisory, M&A costs added back; one-time gains backed out
- Capitalized expenses: aggressive capitalization re-classified to OpEx
- Working capital normalization: NWC trued up to trailing 12-month average
The reality
Reported EBITDA of $5M almost never survives QofE intact. Typical adjustment range: 10-30% reduction. Reported $5M → Adjusted $3.5-4.5M EBITDA. At a 6x multiple, that's $3-9M of enterprise value at stake.
Seller-side QofE
Commissioning your own QofE pre-sale ($30-150K) surfaces the issues before the buyer does. Lets the seller fix accounting, prep documentation, and defend valuation. The brands that walk into buyer diligence cold consistently lose 10-25% of headline value during the process.
The most common mistake
Maxing out reported EBITDA through aggressive accounting close to a sale. The QofE team identifies these adjustments faster than the seller anticipated. The buyer not only reduces valuation, they may walk because the books look manipulated. Conservative monthly accounting beats sale-time clean-up.
Frequently Asked Questions
what does QofE do?
Independent validation of reported financials, produces Adjusted EBITDA.
what gets adjusted?
Inventory write-downs, revenue rec, accruals, owner comp, non-recurring, working capital.
should sellers commission their own?
Yes if $10M+ EBITDA, surfaces issues before the buyer does.
Related Terms
- What are EBITDA add-backs?
- What is working capital true-up?
- What is EBITDA margin?
- What is net working capital?
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