How a quality of earnings review works
What the accountant is really testing
A QofE asks one question: would these earnings repeat under a new owner? The accountant rebuilds EBITDA from the general ledger, ties revenue to bank receipts and contracts, tests every add-back and reviews twelve to thirty-six months of balance sheets. The output is a normalised EBITDA figure, a net debt schedule and a working capital analysis.
Buyers price on that normalised number, so every dollar the accountant removes comes off the offer at the multiple. On a 7x deal, a $150K adjustment is a $1.05M price cut.
The issues that move price
These are the findings that most often change the headline price or the structure behind it.
| Area | Typical finding | Effect on the deal |
|---|---|---|
| Revenue recognition | Upfront multi-year cash booked as revenue | Restated revenue and EBITDA |
| Add-backs | One-off costs that recur each year | Lower normalised EBITDA |
| Working capital | No monthly balance sheet | Wide peg dispute, price adjustment |
| Customers | Top customer above 20% of revenue | Earnout or escrow on that customer |
| IP and people | Contractors without IP assignment | Specific indemnity or condition to close |
| Tax | Sales tax or payroll exposure | Escrow or price reduction |
Revenue recognition for SaaS
Annual or multi-year prepayments are deferred revenue, released monthly as the service is delivered. Implementation fees are usually spread over the expected customer life, not taken on day one. Usage revenue is recognised when it is used. Most SaaS restatements come from cash-basis books that never built a deferred revenue schedule.
A clean ARR schedule that reconciles to recognised revenue each month is the single most valuable document in a software diligence. Pair it with the SaaS valuation calculator (opens in a new tab) to see what the corrected numbers are worth.
Add-backs that survive diligence
Owner pay above a market salary, documented personal costs and genuinely non-recurring items are accepted. Recurring “one-offs”, pro-forma savings and lost revenue added back as if it will return are not. Grade each add-back in the EBITDA normaliser (opens in a new tab) to see how much of your adjusted number a buyer will keep.
Working capital and the peg
The QofE sets the normal level of working capital the business needs, which becomes the peg in the purchase agreement. Without monthly balance sheets, the accountant has to estimate it, and estimates turn into disputes. Model yours with the NWC peg calculator (opens in a new tab).
A 90-day preparation plan
Month one: move to accrual accounting with a monthly close and build the deferred revenue schedule. Month two: document every add-back with invoices and board minutes, and collect signed IP assignments from every past and present contractor. Month three: reconcile the customer revenue schedule to the ledger, review sales tax registrations and assemble the data room.
Businesses that arrive with this done close faster and give buyers far less room to re-trade.
Frequently asked questions
- What is a quality of earnings report?
- A quality of earnings (QofE) report is an independent review of a company’s historical earnings, usually by an accounting firm. It tests whether reported EBITDA is real, recurring and supported by cash, and produces the normalised EBITDA a buyer uses to set the price.
- What is normalised EBITDA?
- Normalised EBITDA is reported EBITDA adjusted for items that will not continue under a new owner, such as above-market owner pay, one-off legal costs or personal expenses. It also removes revenue or cost timing effects so the number reflects a normal year of trading.
- Should a seller commission its own QofE?
- For businesses with more than about $2M of EBITDA, or any sale run with several institutional bidders, a sell-side QofE usually pays for itself. It surfaces problems while you still control the timetable, shortens buyer diligence and makes price chips harder to justify.
- How long does a QofE take?
- Typically four to eight weeks, depending on the quality of the monthly close, the number of entities and how quickly data can be produced. Clean monthly accruals and a reconciled revenue schedule are the two things that shorten it most.
- How do accountants treat multi-year upfront contracts?
- Cash received upfront for a multi-year SaaS contract is deferred revenue and is recognised month by month as the service is delivered. If the cash was booked as revenue on receipt, the QofE will restate revenue and EBITDA downwards for the periods affected.
- What are the most common QofE deal-breakers?
- Revenue recognised too early, add-backs that turn out to be recurring, customer concentration, missing IP assignments from contractors, unrecorded tax exposures and working capital that swings so much the peg becomes a negotiation of its own.