The quality of earnings report — universally referred to in M&A circles as the Q of E — is one of the most important documents produced in any private company acquisition. It is prepared by the buyer’s accounting firm and represents an independent assessment of whether the seller’s reported and adjusted EBITDA accurately reflects the true earnings power of the business. For sellers, the Q of E is both a validation opportunity and a significant risk: a positive Q of E supports the seller’s valuation and accelerates the deal, while a negative Q of E can trigger price reductions, deal restructuring, or buyer exit. Understanding what the buyer’s accountants are looking for — and preparing for it — is one of the most important things a seller can do before launching a sale process.

Scope and Purpose of Q of E Diligence

The quality of earnings process is not an audit. It is an agreed-upon procedures engagement or a review engagement in which the buyer’s accountants analyze the target company’s financial statements — typically for the trailing three years and the most recent interim period — and perform procedures designed to test the accuracy and sustainability of the company’s reported financial results. Unlike an audit, which is designed to provide reasonable assurance that financial statements are fairly presented in accordance with GAAP, a Q of E is specifically focused on the questions a buyer needs to answer before committing to a purchase price.

The core questions that a Q of E is designed to answer are: Is the EBITDA that the seller is presenting accurate and fairly calculated? Are the adjustments the seller is claiming appropriate? Is the reported revenue sustainable and recurring? Are there any costs or liabilities that are not reflected in the historical financial statements but that the buyer will need to bear going forward? Are there any accounting practices or policies that, if normalized to market standard, would change the EBITDA calculation? The answers to these questions directly affect what the buyer is willing to pay.

Revenue Quality Analysis

One of the most important components of any Q of E is the analysis of revenue quality. Buyers want to understand not just how much revenue the company generated but how reliable, recurring, and sustainable that revenue is. Revenue that comes from long-term contracts with stable customers is more valuable than revenue that comes from one-time transactions or from a concentrated group of customers who could leave. Revenue that is recognized ratably over a service period is more predictable than revenue that is recognized upon delivery of a project that may not repeat.

The Q of E accountants will examine the company’s revenue by customer, by contract type (recurring versus non-recurring), by product or service line, and by period. They will look for revenue concentration — if 20 percent of revenue comes from a single customer, the loss of that customer is an existential risk that affects valuation. They will analyze customer retention and churn rates. They will examine whether revenue recognized in a given period reflects actual performance obligations satisfied during that period or whether there are timing issues — for example, revenue pulled forward from a future period or deferred revenue that was not properly recognized. They will test whether the company’s revenue recognition policies comply with applicable GAAP, particularly under ASC 606, which governs revenue recognition for most commercial contracts.

EBITDA Normalization and Add-Back Scrutiny

The Q of E places particular scrutiny on the seller’s proposed EBITDA adjustments. Every add-back the seller claims is evaluated by the buyer’s accountants for appropriateness, adequacy of support, and truly non-recurring character. The most common add-backs that accountants challenge are owner compensation adjustments (where the claimed market-rate replacement cost is disputed), technology or advisory project costs claimed as non-recurring (where the accountants find evidence that similar costs are incurred regularly), restructuring charges claimed as one-time (where the company has a history of restructuring), and the costs of addressing compliance or regulatory issues (where the underlying issue is not fully resolved and future costs may still be required).

The Q of E accountants will also look for costs that the seller has understated or failed to include. A company that has deferred necessary maintenance capital expenditures, that has chronically understaffed a department whose workload would require additional headcount in a properly run operation, or that has been using a below-market related-party arrangement for a necessary service will have its EBITDA adjusted downward to reflect the true cost of operating the business at appropriate maintenance and service levels. These downward adjustments can be just as significant as disputed upward add-backs.

One-Time vs. Recurring: The Most Common Battleground

The characterization of revenue and expense items as one-time or recurring is the most common battleground in a Q of E engagement. Sellers want to characterize as many costs as possible as one-time (because excluding them from EBITDA increases the valuation), and buyers want to characterize as many costs as possible as recurring (because including them reduces EBITDA and therefore reduces the purchase price). The Q of E accountants try to apply an objective standard, but the determination is often genuinely uncertain.

Legal costs are a classic example. A company that has incurred $500,000 in legal fees in the past year will argue that this is a non-recurring expense associated with a specific litigation matter that has been resolved. The buyer’s accountants will examine whether the company has a history of recurring litigation costs, whether the matter has truly been resolved with no remaining exposure, and whether the company’s business activities create a continuing risk of similar legal costs. If the evidence supports the seller’s characterization, the add-back is accepted; if the evidence suggests that legal costs are a regular feature of the company’s operations, the add-back is reduced or rejected.

Similarly, revenue from large one-time projects or non-recurring government contracts will be scrutinized to determine whether they truly represent non-recurring revenue that should be excluded from the revenue and EBITDA run-rate, or whether they represent the high end of a project cycle that the company regularly participates in. The Q of E accountants will examine the company’s historical revenue mix and ask whether the prior year’s outsized project revenue is truly an outlier or simply a large example of an activity the company regularly engages in.

Working Capital Analysis

The quality of earnings engagement typically includes an analysis of working capital that is closely related to the purchase price adjustment mechanism in the definitive agreement. The accountants will examine the company’s accounts receivable aging, inventory reserves, accounts payable payment terms, and accrued liability completeness to form a view on whether the working capital presented on the company’s balance sheet is fair and accurately stated. Accounts receivable that are older than customary payment terms are potential collection risks; inventory that may be obsolete or slow-moving is a valuation risk; accrued liabilities that are underfunded create balance sheet exposure.

The working capital analysis also helps the buyer calibrate the appropriate working capital target for the purchase price adjustment mechanism. If the Q of E reveals that the company’s average working capital over the historical period is materially different from what the seller has proposed as the target peg, the buyer will use this analysis to argue for a different (typically higher) target.

How Q of E Findings Affect the Deal

A Q of E that confirms or marginally adjusts the seller’s adjusted EBITDA claims will typically have limited impact on the transaction — it validates the buyer’s confidence in the price and supports a smooth path to closing. A Q of E that identifies a material reduction in adjusted EBITDA — whether from disputed add-backs, identified cost understatements, revenue quality concerns, or balance sheet issues — will almost certainly result in a renegotiation of the purchase price.

Price chips based on Q of E findings are one of the most common forms of deal deterioration for sellers. The buyer presents the Q of E findings as objective third-party analysis (even though the accountants were engaged by and report to the buyer) and argues that the price must be reduced to reflect the true earning power of the business. Sellers who are in an exclusive negotiating period at this point have limited leverage to resist this argument unless they can credibly dispute the accountants’ conclusions. This is why sell-side quality of earnings analyses — in which the seller commissions its own Q of E before launching the process — are an increasingly valuable tool. A seller who has done its own Q of E is far better prepared to defend add-backs and challenge questionable buyer-side conclusions.

In addition to affecting purchase price, Q of E findings can affect the indemnification structure of the deal. Issues identified during the Q of E may be disclosed in the seller’s disclosure schedules, which affects whether the buyer has recourse for those issues under the indemnification provisions. Issues that the Q of E identifies but that are not adequately addressed in the disclosure schedule may expose the seller to post-closing indemnification claims. Sellers should work with legal counsel to ensure that issues surfaced by the Q of E are properly handled in both the disclosure schedules and the representations and warranties to minimize post-closing exposure.