How to read a quality-of-earnings report like the buyer wrote it

Most owners selling a business for the first time have never seen a quality-of-earnings report. Their accountant produces statutory accounts; their bank sees management accounts; nobody has ever produced a document whose purpose is to argue about how much of their profit is real. The first one they encounter is the buyer’s, and by then it is a negotiating instrument.

Understanding what the document is trying to do — and getting your own version done first — is one of the highest-return pieces of preparation available to a seller. This guide walks through what the report is for, the adjustments it makes and which way each one cuts, the working capital analysis that rides along with it, and what to do about all of it before a buyer arrives.

What the report is actually for

A quality-of-earnings (QoE) exercise takes reported earnings and rebuilds them as sustainable, transferable earnings: what this business will earn, for a new owner, on an ongoing basis. Two words carry the weight.

Sustainable removes what will not repeat. Transferable removes what depended on the outgoing owner. Both are legitimate. Both are also elastic, and that elasticity is where the negotiation lives.

The output is an adjusted EBITDA figure. Since price is usually a multiple of that figure, every adjustment is multiplied. A £400,000 adjustment at eight times is a £3.2 million argument, which is why these reports receive more attention than any other diligence workstream.

What is usually in it

Scope varies with the deal, but most reports cover the same ground:

• Adjusted EBITDA bridge — reported EBITDA, then each adjustment, then the figure the buyer will price off.
• Revenue and customer analysis — concentration, churn, pricing, contract terms.
• Monthly and trailing-twelve-month performance — to show trend and seasonality, not just the year-end snapshot.
• Net working capital — history, seasonality and a proposed normalised level.
• Net debt and debt-like items — everything the buyer will want deducted from the price.
• Pro forma considerations — what changes under new ownership.

The adjustments, and which way they cut

The useful way to read an adjustment schedule is by direction: which items move value towards the seller, which move it away, and how much evidence each one needs to survive.

Owner-related items — usually in the seller’s favour

Above-market owner compensation, family members on payroll, personal expenses run through the business, a property rented from the owner at a non-market rate, personal vehicles, discretionary travel. These are added back, and a well-prepared seller has documentation for each.²

The trap is the replacement-cost question. If the owner was doing a genuine job, the add-back is their compensation less the market cost of hiring someone to do that job. Sellers who cannot articulate what the replacement costs get the conservative answer.

One-off and non-recurring items — contested

A legal settlement, a restructuring, a bad-debt write-off, ERP implementation costs, one-off recruitment. Adding these back is standard — but buyers apply a hard test: is this genuinely non-recurring, or is it a recurring category of event that happens to have a different name each year?

A business with a “one-off” legal settlement in three consecutive years has a legal cost line, not an adjustment. Buyers and their lenders apply much the same logic the SEC applies to public-company “adjusted” measures: stripping out normal, recurring, cash operating expenses is misleading, and so is adjusting out one-off charges while leaving one-off gains in.³

Run-rate and pro forma adjustments — the seller’s best argument, and the most scrutinised

Annualising a price increase implemented in month eight. Full-year effect of a contract won in Q4. Cost savings from a completed reorganisation. Removal of a lost customer’s contribution.

These can be worth more than every other adjustment combined, and they are where preparation pays. A run-rate adjustment supported by signed contracts, invoiced months and clean cohort data is usually accepted. The same adjustment supported by a forecast is usually rejected.

Accounting quality — usually against the seller

This is the part sellers do not anticipate:

• Revenue recognition timing, particularly on multi-year or milestone contracts, where revenue should follow the delivery of each performance obligation rather than the invoice.⁴
• Capitalisation policy, especially software development costs.
• Inventory provisioning and obsolescence.
• Accrual completeness — bonuses, holiday pay, unbilled supplier costs.
• Cut-off and channel-stuffing patterns near period ends.
• Deferred maintenance and under-investment that flatters current EBITDA at the cost of future capex.

Buyers also look hard at quality of revenue, which is not an EBITDA adjustment but affects the multiple: customer concentration, contract length, churn by cohort, pricing power, and how much of the revenue is genuinely contracted versus repeat-by-habit.

The most damaging finding in a QoE report is rarely a number. It is a pattern — an adjustment schedule that shows the seller’s management accounts have been optimistic in the same direction for three years.

After that, every subsequent number is discounted.

Working capital: the second negotiation

The QoE report almost always produces the working capital analysis, and this is where sellers lose money quietly.

Most deals are done on a cash-free, debt-free basis with a normalised working capital target — the “peg.” Under a completion accounts mechanism you are paid the headline price and then adjusted, after closing, for the difference between actual working capital at completion and the target set in the sale agreement: if working capital comes in below the target, the seller refunds the shortfall.⁵ (A locked box works differently — the price is fixed from an earlier balance sheet — but the same analysis decides what that balance sheet is worth.)

Two things matter enormously.

How the peg is calculated

A twelve-month average in a seasonal business produces a very different answer depending on which twelve months and whether the trend is up or down. In a growing business, working capital rises — so a trailing average peg means the seller funds the growth and hands it over.

What counts as debt-like

Deferred revenue, customer deposits, accrued bonuses, unpaid capex, overdue payables stretched to flatter cash, finance leases, dilapidations. Each item classified as debt-like reduces your proceeds pound for pound.

This list is negotiated, not discovered, and the negotiation happens in the sale and purchase agreement — long after the QoE report established the facts. The EV to equity bridge calculator shows how quickly these items add up.

What sellers should do

Commission your own report before you go to market. A sell-side QoE identifies the add-backs a buyer has no incentive to find, surfaces accounting problems while there is still time to fix them, and cuts the document requests that slow a process down.² It moves the argument from the negotiation, where you have limited leverage, to the data room, where you have prepared answers.

Fix what the report finds. A sell-side QoE that identifies a revenue recognition weakness twelve months before a process gives you twelve months to correct it. The same finding in the buyer’s report is a price adjustment.

Prepare the evidence file for every add-back. Board minutes for the one-off. Signed contracts for the run-rate. Market benchmarks for the replacement cost of the owner’s role. An adjustment with documentation is a fact; an adjustment without it is an opinion, and the buyer’s opinion is the one attached to the money.

Get your finance function ready for the load. A QoE process will absorb your finance lead for weeks, on top of their day job, during a period when the trading numbers matter more than ever. This is a common cause of a process losing momentum, and it is solved with temporary help, budgeted in advance.

And what buyers should remember

A QoE report that finds nothing is a report that has not looked hard enough, and a report that finds everything is one that will cost you the deal. The useful discipline is distinguishing findings that change the sustainable earnings from findings that change your view of management — the second category matters more, and it does not appear in the adjustment schedule.

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General commentary only, not accounting or financial advice.

Sources

1. Weaver, “All About Quality of Earnings Reports and How to Read Them” — on how a QoE differs from an audit and what it typically covers. ↩

2. CBIZ, “Sell-Side Quality of Earnings: A Critical Part of Due Diligence” — on owner-related add-backs and the case for a sell-side report before going to market. ↩ ↩²

3. U.S. Securities and Exchange Commission, Non-GAAP Financial Measures — Compliance and Disclosure Interpretations, Questions 100.01 and 100.03 (updated December 2022). ↩

4. IFRS Foundation, IFRS 15 Revenue from Contracts with Customers. US GAAP equivalent: ASC 606. ↩

5. Lander & Rogers, “M&A purchase price adjustment mechanisms — completion accounts vs locked box” (September 2023). ↩