Our internal bookkeeper does a decent job with our monthly statements, but we know a buyer will demand a Quality of Earnings audit. How do we prepare our financial records on our exit runway so we do not get destroyed by working capital adjustments or restatements during due diligence?

Question

Tyler Smith · Accepted Answer

A Quality of Earnings audit, or QofE, is the standard hurdle in any mid-market transaction. Do not assume your standard CPA-prepared tax returns or reviewed financial statements will satisfy an institutional buyer. Tax returns are designed to minimize taxable income; buyers want to see maximized, true economic earnings. If you wait for the buyer to run their own QofE, they will search for every discrepancy to chip away at your purchase price. To prepare for this process on your exit runway, you must clean up your balance sheet and income statement immediately. This means separating all personal, discretionary, or one time expenses from your core operating expenses. You must also transition your accounting from cash basis to full accrual basis. Accrual accounting matches revenue with the corresponding expenses in the month they occur, which is the only way a buyer can assess your true margins. Additionally, reconcile your balance sheet accounts monthly, including inventory, accounts receivable, and accrued liabilities. If your books are messy, buyers assume your operations are messy too. This assumption increases their perceived risk, which directly lowers your valuation multiple or leads to punitive net working capital requirements at closing.