What happens during a Quality of Earnings assessment, and what red flags routinely surprise owners?

Question

Tyler Smith · Accepted Answer

A sell-side Quality of Earnings assessment is a forensic financial audit conducted by a third-party accounting firm to validate the sustainability and accuracy of your EBITDA. It is not a standard tax review. A CPA looks backward to minimize taxes; a QofE team looks forward through the eyes of an institutional acquirer to find reasons to deduct from your earnings.

The process dissects your revenue recognition, proof of cash, margin trends, working capital fluctuations, and balance sheet integrity. The goal is to separate true normalized operating earnings from one-time events, aggressive accounting, and owner-related perks.

The red flags that catch owners flat-footed usually fall into three categories. First is informal revenue recognition, such as booking annual software or service contracts upfront on cash receipt rather than earned ratably over time under GAAP principles.

Second is messy owner add-backs. Owners love to boast about high EBITDA by claiming their country club dues, personal vehicles, and family member salaries can simply be added back. Institutional buyers demand ironclad documentation. If your personal expenses cannot be audited down to the cent, the buyer will reject the add-back and your valuation drops accordingly.

Third is unrecorded liabilities, like accrued PTO or unearned customer deposits. Commissioning your own QofE eighteen months before marketing allows you to fix these reporting discrepancies quietly, ensuring you control the narrative when buyers begin due diligence.