Quality of Earnings: What Buyers Test Before They Pay
Buyers' accountants test every EBITDA add-back before they pay. See which hold, what a quality of earnings review changes in price and when to commission one.
The buyer multiplies the figure its accountants support, so every reversed add-back costs the seller the multiple times the item.
Payroll records, invoices, leases and signed contracts decide which add-backs a buyer's accountants accept.
Baker Tilly puts a study at 4 to 6 weeks, and the accountant quotes the fee per engagement.
A seller-commissioned report gives buyers a baseline, and buyers still run their own diligence.
BDO notes working capital has a potential dollar-for-dollar impact on the purchase price.
A quality of earnings (QoE) study takes 4 to 6 weeks, according to Baker Tilly, and its job is to test whether a company's reported EBITDA will repeat. It strips out one-off and owner-specific items to reach adjusted EBITDA, the figure a buyer multiplies to set the price.
For an owner or CFO preparing a sale, the walk below shows a EUR 0.40M gap in EBITDA costing EUR 2.8M of price at an illustrative 7x.
| Step | Change | Running total |
|---|---|---|
| Reported | 3.40 | |
| Owner pay | +0.45 | 3.85 |
| Legal one-off | +0.20 | 4.05 |
| Rent | −0.15 | 3.90 |
| Site saving | +0.30 | 4.20 |
| Mgmt adjusted | 4.20 | |
| Saving cut | −0.30 | 3.90 |
| Pay re-set | −0.10 | 3.80 |
| Diligence | 3.80 |
What does a quality of earnings report cover?
A quality of earnings analysis works through one test: how much of the reported EBITDA will the next owner still earn?
An accountant answers the test in four parts:
Revenue quality: which customers and contracts the revenue comes from, and how much of it repeats.
EBITDA adjustments: every item management added or removed, and the support behind it.
Working capital and net debt: the working capital the business needs and the debt-like items a buyer deducts.
Cash conversion: how much of the EBITDA arrives as cash.
An audit checks that the accounts of a past period are fairly stated. A QoE study takes the same accounts and asks what in them will repeat. Of the four parts, the EBITDA adjustments are the one a seller can still change before launch, by assembling the support.
On a sell-side M&A advisory mandate, spectup acts for the seller.
How does reported EBITDA become adjusted EBITDA?
Reported EBITDA of EUR 3.40M in the walk above comes straight from the books. Management then adds back what it says won't repeat and deducts what the books understate, which lifts it to EUR 4.20M, the management adjusted EBITDA shown in the teaser and in the confidential information memorandum.
A buyer's accountants then rebuild the figure from the records in their quality of earnings study. The number they support is the one the multiple is applied to.
In the walk they keep the legal item and cut the owner pay add-back by EUR 0.10M, having set the market rate for the role higher. They reject the EUR 0.30M saving from a closed site, because the trailing accounts still carry the cost and the saving exists only in a forecast. Diligence EBITDA lands at EUR 3.80M.
RSM Singapore says a prospective buyer's due diligence typically focuses on negative adjustments to EBITDA, and management's own figures carry one: related-party rent moved to the market rate takes EUR 0.15M off.
The SEC's staff guidance, which applies to public registrants only, shows why a buyer doubts a one-off label: costs called non-recurring that arise repeatedly or occasionally, including at irregular intervals.
Which EBITDA add-backs survive a buyer's review?
Every quality of earnings study starts from the documents behind each adjustment management reported. Baker Tilly advises that the rationale for each adjustment should be challenged, including by obtaining original documentation.
Sort your own add-backs the way a QoE study does before launch: documents first, forecasts last.
A saving that exists only in a forecast is reversed until it shows in the monthly accounts.
The table lists common EBITDA add-backs from those backed by records to those resting on a forecast; the outcome column is spectup's general judgement and carries no measured rate.
4 columns. Drag the table sideways; the first column stays put.
Add-back | What a buyer's accountants test | Evidence that holds | Typical outcome |
|---|---|---|---|
Owner pay above market | What a hired manager for the role would cost | Payroll records and a market-rate benchmark for the role | Held, or reduced when the market rate is higher |
One-off legal or advisory cost | Whether similar costs appear in other years | The invoice, the settlement or engagement letter, proof the matter is closed | Held if it doesn't recur, reversed if it does |
Personal expenses run through the company | Whether the expense is personal and has stopped | Receipts and the policy or board decision that ended it | Held with receipts, reduced where business use is plausible |
Related-party rent or fees | Whether the price matches the market | The lease and a market rent benchmark | Adjusted in either direction |
Run-rate on a new contract or price rise | Whether the revenue is billed | The signed contract and invoices | Reduced to the months billed |
Saving from a closed site or contract (pro forma) | Whether the saving has happened and shows in cash | A termination notice, the contract and a cash flow model | Reduced or reversed until it shows in the monthly accounts |
Keep the support for every row in the data room before a buyer asks for it.
Sell-side QoE, vendor due diligence and the buyer's own report
Three documents carry similar names, and the seller commissions two of them. A sell-side QoE tests earnings.
Vendor due diligence (VDD), the UK and European term for sell-side due diligence, is a seller-commissioned review that can reach beyond earnings. The buyer's own QoE is the buyer's accountants testing the seller's number again.
4 columns. Drag the table sideways; the first column stays put.
Sell-side QoE | Vendor due diligence | Buyer's own QoE | |
|---|---|---|---|
Commissioned by | The seller | The seller | The buyer |
Covers | Earnings, working capital, net debt | Earnings plus further areas, by scope | Earnings, rebuilt from the seller's records |
Read by | Bidders and the seller's team | Selected bidders | The buyer and its deal team |
What the seller gets | A tested number before buyers test it | One factual basis for several bidders | Questions to answer |
Deloitte Switzerland points to a competitive auction process or a dual-track process as the setting for vendor due diligence, and helps the seller decide which report format is most appropriate. A reliance report gives potential acquirers detailed information on the company, which Deloitte says speeds the process up.
Buyers run their own diligence through their accountants and counsel. A seller's report, whether a sell-side QoE or sell-side due diligence, gives that work a baseline and doesn't replace it.
How long does a quality of earnings review take, and what drives the cost?
A quality of earnings study typically takes 4 to 6 weeks, according to Baker Tilly. The company's own preparation, the monthly financials and a document for each adjustment, has to be ready before the accountants can start.
| Step | Leads to |
|---|---|
| Data request (monthly financials, ledgers, contracts) | Adjustment schedule |
| Adjustment schedule (each item with its document) | Accountant's analysis |
| Accountant's analysis (the whole study takes 4 to 6 weeks) | Adjustment held [support]; Adjustment reduced or reversed [no support] |
| Adjustment held (stays in the EBITDA figure) | Final report |
| Adjustment reduced or reversed (comes out of the EBITDA figure) | Final report |
| Final report (goes into the data room) | end |
Baker Tilly says the scope is customised to each client and transaction, with industry, market size, deal size, accounting complexities and areas of special concern as the factors; Deloitte Switzerland treats a fact book against a reliance report as a scope choice. The accountant quotes the fee per engagement.
Three items are worth having ready: monthly financials closed to one standard, one schedule that lists every adjustment next to its document, and one person on the company side who answers the accountants' questions.
A sell-side process puts this work in preparation, before any buyer sees a number.
The accountant's fee for the study is separate from the advisory fee, and spectup doesn't set or quote it.
What does a QoE change in price and deal certainty?
Price follows the diligence figure, the one a quality of earnings study leaves standing. Every EBITDA item a buyer reverses costs the seller the multiple times the item.
At an illustrative 7x, management's EUR 4.20M implies EUR 29.4M and the diligence figure of EUR 3.80M implies EUR 26.6M. The EUR 0.40M gap costs EUR 2.8M.
Working capital is the second price lever. BDO says the working capital peg is typically an average of normalized and/or adjusted net working capital for the latest trailing twelve months, and that working capital has a potential dollar-for-dollar impact on purchase price.
A seller may prepare its own net working capital analysis to anticipate the buyer's. Illustration: if the business delivers EUR 0.50M less working capital at closing than the peg requires, the price falls by EUR 0.50M.
Certainty moves with the same evidence: according to RSM Singapore, a vendor report reduces the likelihood of renegotiations after the letter of intent has been signed.
An earnout paid on adjusted EBITDA inherits the same adjustments, so each one is worth settling with its support before it's written into the purchase agreement.
When is a sell-side QoE worth commissioning?
The decision turns on four conditions, and the more of them apply, the stronger the case for a report:
Add-backs make up a large share of the EBITDA the price rests on.
The monthly financials close late or without sign-off.
Several buyers will test the same number in parallel.
The company runs a dual track, selling and raising capital in parallel.
| Item | Add-backs as share of EBITDA (0 to 100) | Buyers in parallel (0 to 100) | Note |
|---|---|---|---|
| Plain, one buyer | 8 | 12 | |
| Large, one buyer | 92 | 12 | |
| Plain, auction | 8 | 78 | |
| Large, auction | 92 | 78 |
Commission the report when a buyer's accountants would otherwise produce the first tested number.
A QoE study earns less when the earnings are plain and one buyer is already in exclusivity under a letter of intent. A report ordered during exclusivity arrives after the baseline is set, and the seller then negotiates from a figure the buyer's accountants produced.
How spectup runs earnings preparation on a sell-side engagement
spectup acts for the seller on sell-side mandates from EUR 10M enterprise value, with $150M+ of M&A advised, and is paid by the seller only. It never negotiates.
What spectup does with the earnings number, in 3 steps:
Starts the mandate from two years of accounts that the company's accountants produce and a buyer can verify, then builds the numbers pack: normalised earnings, the add-backs behind them, and the working capital and net debt positions a buyer's diligence will go after.
Finds what a buyer would otherwise price in before its diligence does, and keeps the data room, the question log and one timetable for every bidder. The company's own accountants and counsel answer the financial, tax and legal questions.
When the buyer's findings come back, briefs the client and its counsel on what the buyer will push on. The company and its counsel negotiate with the buyer.
Sequence the earnings work before the process launches
Close your books to one standard and list every adjustment next to its document. Ask the accountant for a quote and a start date. Order the quality of earnings report so the study, 4 to 6 weeks to complete according to Baker Tilly, ends before your memorandum is written.
The teaser and the memorandum carry the EBITDA figure last, once the accountants have tested it.
Three conclusions
A buyer's accountants test the EBITDA figure management shows. Fix the adjustments and their support first, so the number that goes out is one they can rebuild.
Payroll records and invoices hold up under review, forecasts and pro forma savings don't. Put the documented items first and treat the forecast items as the ones a buyer will reverse.
A sell-side report fits large add-backs, late-closing books, parallel buyers and dual tracks. With plain earnings and one buyer at exclusivity, it adds little.
Quality of earnings: questions readers ask
6 questions on M&A and secondary markets, answered by Edwin Mik, Partner & Head of IR.
01How much does a quality of earnings report cost?
The fee follows the scope of the work, which Baker Tilly says depends on factors such as industry, market size, deal size and accounting complexity, and on whether the seller orders a reliance report for acquirers. The accountant quotes the fee per engagement, after reading the scope.
02What is a quality of earnings report, and what does it tell you?
An accountant's test of whether a company's reported EBITDA will repeat. A buyer uses the result to set the price and the working capital target.
03What is adjusted EBITDA and how is it calculated?
Adjusted EBITDA is reported EBITDA plus the add-backs, items that won't repeat or belong to the owner, minus the costs the books understate. Management proposes the adjustments. The buyer's accountants decide which survive, and the surviving figure is the one the multiple is applied to. A seller whose adjustments carry documents keeps more of the figure it proposed.
04What is the difference between a QoE report and an audit?
An audit tests whether a past period's accounts are fairly stated. A QoE report takes those accounts and reads them for what will repeat.
05Who pays for a QoE report?
Whoever commissions it. A buyer commissions its own to test the seller's number. A seller can commission a sell-side QoE, or the broader vendor due diligence, before launch and pays the accountant's fee. spectup's advisory fee is separate, and the seller alone pays it.
06When should an owner or CFO hire a sell-side advisor to prepare earnings for a sale?
In preparation, ahead of launch, while the adjustments can still be documented. A sell-side M&A advisor such as spectup acts for the seller and starts from the add-backs and their support. The company's own accountants answer the financial questions.
